FRAN Francescas Holdings Corporation

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This report contains statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. These statements concern our business, operations and financial performance and condition as well as our plans, objectives and expectations for our business operations and financial performance and condition, which are subject to risks and uncertainties. All statements other than statements of historical fact included in this report are forward-looking statements. These statements may include words such as “aim”, “anticipate”, “assume”, “believe”, “can have”, “could”, “due”, “estimate”, “expect”, “goal”, “intend”, “likely”, “may”, “objective”, “plan”, “potential”, “positioned”, “predict”, “should”, “target”, “will”, “would” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events or trends. For example, all statements we make relating to our estimated and projected earnings, sales, costs, expenditures, cash flows, growth rates, market share and financial results, our plans and objectives for future operations, growth or initiatives, strategies or the expected outcome or impact of pending or threatened litigation are forward-looking statements.

These forward-looking statements are based on current expectations, estimates, forecasts and projections about our business and the industry in which we operate and our management’s beliefs and assumptions. These statements are not guarantees of future performance or development and involve known and unknown risks, uncertainties and other factors that are in many cases beyond our control. All of our forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from our expectations. These risks and uncertainties include, but are not limited to, the following: the risk that we cannot anticipate, identify and respond quickly to changing fashion trends and customer preferences or changes in consumer environment, including changing expectations of service and experience in boutiques and online, and evolve our business model; our ability to attract a sufficient number of customers to our boutiques or sell sufficient quantities of our merchandise through our ecommerce business; our ability to successfully open and operate new boutiques each year; our ability to efficiently source and distribute additional merchandise quantities necessary to support our growth; our ability to attract, hire and integrate our next Chief Merchant and our ability to successfully rebound from the impact of Hurricane Harvey. For additional information regarding these and other risks and uncertainties that could cause actual results to differ materially from those contained in our forward looking statements, please refer to “Item 1A. Risk Factors,” in our Annual Report on Form 10-K for the fiscal year ended January 28, 2017 and filed with the Securities and Exchange Commission (“SEC”) on March 22, 2017 (“Fiscal Year 2016 10-K”) and any risk factors contained in subsequent Quarterly Reports on Form 10-Q or other filings we file with the SEC, as well as our disclosures under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report and in our Fiscal Year 2016 10-K.

We derive many of our forward-looking statements from our own operating budgets and forecasts, which are based upon many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors, and it is impossible for us to anticipate all factors that could affect our actual results. All written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by the cautionary statements contained in this report as well as other cautionary statements that are made from time to time in our other SEC filings and public communications. You should evaluate all forward-looking statements made in this report in the context of these risks and uncertainties.

Potential investors and other readers are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on the forward-looking statements. These forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update or revise any forward-looking statements publicly after the date of this report whether as a result of new information, future developments or otherwise.

Overview

Unless the context otherwise requires, the “Company,” “we,” “our,” “ours,” “us” and “francesca’s®” refer to Francesca’s Holdings Corporation and its consolidated subsidiaries.

francesca’s ^®  is a growing specialty retailer which operates a nationwide-chain of boutiques providing customers a unique, fun and personalized shopping experience. The merchandise assortment is a diverse and balanced mix of apparel, jewelry, accessories and gifts. As of July 29, 2017, francesca’s  ^®  operated 692 boutiques in 47 states and the District of Columbia and also served its customers through www.francescas.com, our ecommerce website. The information contained on our ecommerce website is not incorporated by reference into this Quarterly Report on Form 10-Q and you should not consider information contained on our ecommerce website to be part of this Quarterly Report on Form 10-Q.

During the thirteen weeks ended July 29, 2017, our net sales increased 4% to $119.7 million from $115.3 million, income from operations decreased by 30% to $11.9 million from $17.1 million and net income decreased 31% to $7.3 million, or $0.20 per diluted share based on 36.5 million weighted average diluted shares outstanding, from $10.6 million, or $0.27 per diluted share based on 38.8 million weighted average diluted shares outstanding, over the comparable prior year period. During the twenty-six weeks ended July 29, 2017, our net sales increased 3% to $227.4 million from $221.4 million, income from operations decreased by 33% to $19.1 million from $28.6 million and net income decreased 34% to $11.6 million, or $0.32 per diluted share based on 36.8 million weighted average diluted shares outstanding, from $17.7 million, or $0.45 per diluted share based on 39.6 million weighted average diluted shares outstanding, over the comparable prior year period.

We increased our boutique count to 692 boutiques as of July 29, 2017 from 652 boutiques as of July 30, 2016. We plan to open approximately 32 to 37 boutiques and close one to three boutiques during the remainder of the fiscal year.

On August 21, 2017, we announced the departure of Laurie Hummel, EVP Chief Merchandising Officer. A search for a new Chief Merchant has commenced.

In August 2017, Hurricane Harvey hit south Texas and Louisiana causing widespread damage to property and infrastructure in various counties within the region. The Company’s headquarters, ecommerce fulfilment and distribution facilities (collectively, the “corporate office”) are located in Houston, Texas and all these functions were directly impacted by the storm.   Additionally, forty of our boutiques are located in the affected region and had disruption in normal operations.  Six of the Company’s boutiques were damaged.  As of September 5, 2017, the Company reopened its corporate office and all but one of the impacted boutiques. The disruption to our supply chain is impacting all of our boutiques and it is expected to take a couple weeks to normalize. As of the date of this filing, the Company has not completed its assessment of the full economic impact of Hurricane Harvey.

We are in the process of deploying a new technology suite of systems to enhance our omni-channel and customer engagement capabilities as part of our long-term strategic plan. This includes replacing our legacy point-of-sale system and introduction of a new order management system and a new customer relationship management system. We have started the rollout of our new point-of-sale system. Throughout the installation and stabilization of these new systems, we will continue to run our existing platform to ensure continuity during the conversion process. We expect that these new systems will enhance our visibility into our customers’ preferences, products and supply chain resulting in improved customer service, improved operational efficiency, enhanced management analytics and increased synergies between our ecommerce and our boutique channels.

Thirteen Weeks Ended July 29, 2017 Compared to Thirteen Weeks Ended July 30, 2016

Net Sales

Net sales increased 4% to $119.7 million in the thirteen weeks ended July 29, 2017 from $115.3 million in the thirteen weeks ended July 30, 2016. This increase was due to the addition of 40 net new boutiques since the comparable prior year period. Comparable sales were down 3% compared to flat in the same period of the prior year. The decrease in comparable sales was due to a decrease in boutique conversion rates. There were 622 comparable boutiques and 70 non-comparable boutiques open at July 29, 2017 compared to 578 and 74, respectively, at July 30, 2016.

Cost of Goods Sold and Occupancy Costs

Cost of goods sold and occupancy costs increased 5% to $64.3 million in the thirteen weeks ended July 29, 2017 from $61.3 million in the thirteen weeks ended July 30, 2016. Cost of merchandise and freight expenses increased by $1.5 million compared to the same period of the prior year primarily due to increased sales volume. Occupancy costs increased by $1.5 million due to the increase in the number of boutiques in operation during the thirteen weeks ended July 29, 2017 compared to the same period of the prior year.

As a percentage of net sales, cost of goods sold and occupancy costs increased to 53.7% in the thirteen weeks ended July 29, 2017 from 53.2% in the thirteen weeks ended July 30, 2016, an unfavorable variance of 50 basis points. This change was primarily driven by deleveraging of occupancy costs as merchandise margin was essentially flat compared to the prior year period.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 18% to $43.5 million in the thirteen weeks ended July 29, 2017 from $36.8 million in the thirteen weeks ended July 30, 2016. This variance was due to a $1.3 million increase in corporate and boutique payroll to support the larger boutique base. Additionally, professional service fees and software costs increased $1.2 million due to continuing investments in technology and infrastructure, stock-based compensation increased $0.5 million as a result of new awards and marketing expense increased $0.4 million due to incremental marketing programs this year. The prior year amount includes a $2.0 million net benefit associated with the resignation of our prior Chief Executive Officer (“CEO”) and the related search process expense.

As a percentage of net sales, selling, general and administrative expense increased to 36.3% in the thirteen weeks ended July 29, 2017 as compared to 31.9% in the thirteen weeks ended July 30, 2016 primarily due to the prior year net benefit associated with the resignation of our CEO as well as deleveraging of other expenses.

Income Tax Expense

The decrease in provision for income taxes of $1.9 million in the thirteen weeks ended July 29, 2017 compared to the thirteen weeks ended July 30, 2016 was primarily due to the decrease in pre-tax income. The effective tax rates were 38.7% and 37.9% in the thirteen weeks ended July 29, 2017 and July 30, 2016 respectively. The increase in the effective tax rate was primarily due to higher state taxes.

Twenty-Six Weeks Ended July 29, 2017 Compared to Twenty-Six Weeks Ended July 30, 2016

Net Sales

Net sales increased 3% to $227.4 million in the twenty-six weeks ended July 29, 2017 from $221.4 million in the twenty-six weeks ended July 30, 2016. This increase was due to the addition of 40 net new boutiques since the comparable prior year period. Comparable sales were down 4% compared to an increase of 1% in the same period last year. The decrease in comparable sales was due to a decrease in boutique conversion rates. There were 622 comparable boutiques and 70 non-comparable boutiques open at July 29, 2017 compared to 578 and 74, respectively, at July 30, 2016.

Cost of Goods Sold and Occupancy Costs

Cost of goods sold and occupancy costs increased 4% to $123.3 million in the twenty-six weeks ended July 29, 2017 from $118.3 million in the twenty-six weeks ended July 30, 2016. Cost of merchandise and freight expenses increased by $1.9 million compared to the same period of the prior year primarily due to increased sales volume. Occupancy costs increased by $3.1 million due to the increase in the number of boutiques in operation during the twenty-six weeks ended July 29, 2017 compared to the same period of the prior year.

As a percentage of net sales, cost of goods sold and occupancy costs increased to 54.2% in the twenty-six weeks ended July 29, 2017 from 53.4% in the twenty-six weeks ended July 30, 2016, an unfavorable variance of 80 basis points. This change was primarily driven by deleveraging of occupancy costs as merchandise margin was essentially flat compared to the prior year period.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 14% to $84.9 million in the twenty-six weeks ended July 29, 2017 from $74.5 million in the twenty-six weeks ended July 30, 2016. This variance was due to a $3.3 million increase in corporate and boutique payroll to support the larger boutique base. Additionally, software costs increased $1.2 million due to continuing investments in technology and infrastructure, marketing expense increased $1.2 million due to incremental marketing programs this year, and stock-based compensation increased $0.8 million as a result of new awards. The prior year amount includes a $2.0 million net benefit associated with the resignation of our prior Chief Executive Officer (“CEO”) and the related search process expense.

As a percentage of net sales, selling, general and administrative expense increased to 37.4% in the twenty-six weeks ended July 29, 2017 as compared to 33.6% in the twenty-six weeks ended July 30, 2016 primarily due to the prior year net benefit associated with the resignation of our CEO as well as deleveraging of other expenses.

Income Tax Expense

The decrease in provision for income taxes of $3.2 million in the twenty-six weeks ended July 29, 2017 compared to the twenty-six weeks ended July 30, 2016 was primarily due to the decrease in pre-tax income. The effective tax rates were 39.3% and 37.8% in the twenty-six weeks ended July 29, 2017 and July 30, 2016 respectively. The increase in effective rate was primarily due to true-up of prior year state deferred taxes.

Liquidity and Capital Resources

Our primary sources of liquidity are cash flows from operations and borrowings under our revolving credit facility. Our primary cash needs are for capital expenditures in connection with opening new boutiques and remodeling existing boutiques, investing in improved technology and distribution facility enhancements, funding normal working capital requirements and payments of interest and principal, if any, under our revolving credit facility. We may use cash or our revolving credit facility to issue letters of credit to support merchandise imports or for other corporate purposes. The most significant components of our working capital are cash and cash equivalents, merchandise inventories, accounts payable and other current liabilities. Our working capital position benefits from the fact that we generally collect cash from sales to customers the day of or, in the case of credit or debit card transactions, within several days of the related sales and we typically have up to 30 days to pay our vendors.

We were in compliance with all covenants under our revolving credit facility as of July 29, 2017. On July 29, 2017, we had $33.3 million of cash and cash equivalents and $75.0 million in borrowing availability under our revolving credit facility. There were no borrowings outstanding under our revolving credit facility at July 29, 2017.

We expect that our cash flow from operations along with borrowings under our revolving credit facility and tenant allowances for new boutiques will be sufficient to fund capital expenditures and our working capital requirements for at least the next twelve months.

Operating Activities

Operating activities consist of net income adjusted for non-cash items, including depreciation and amortization, deferred taxes, the effect of working capital changes and tenant allowances received from landlords. Net cash provided by operating activities was $8.5 million and $25.5 million in each of the twenty-six weeks ended July 29, 2017 and July 30, 2016, respectively. The decrease in cash provided by operating activities in the current period as compared to the same period of the prior year was primarily due to higher income tax payments and lower net income partially offset by timing of payments for inventory purchases.

Our total capital expenditures for the twenty-six weeks ended July 29, 2017 and July 30, 2016 were $12.9 million and $11.1 million, respectively, with new boutiques accounting for most of our spending at $8.5 million and $6.2 million, respectively. Spending for new boutiques included amounts associated with boutiques that will open subsequent to the end of each fiscal quarter. We opened 28 boutiques in the twenty-six weeks ended July 29, 2017 compared to 41 boutiques in the twenty-six weeks ended July 30, 2016. The average cost of the leasehold improvements, equipment, furniture and fixtures, excluding tenant allowances which are reflected in operating cash flows, for new boutiques opened in the twenty-six weeks ended July 29, 2017 and July 30, 2016 was $290,000 and $226,000, respectively, while the average tenant allowance per new boutique was $57,000 and $76,000 over the same periods, respectively. The increase in the average build-out costs was principally due to higher cost of leasehold improvements while the lower average tenant allowance was the result of our continued focus in lowering rental rates. Tenant allowances are amortized as a reduction in rent expense over the term of the lease. The average collection period for these allowances is approximately six months after boutique opening. As a result, we fund the cost of new boutiques with cash flow from operations, build-out allowances from our landlords, or borrowings under our revolving credit facility. Our spending for existing boutiques totaled $3.4 million and $2.4 million during the twenty-six weeks ended July 29, 2017 and July 30, 2016, respectively. The amount spent for existing boutiques in each period was used for remodeling and relocating 17 and 20 boutiques, respectively, and in the twenty-six weeks ended July 29, 2017, for new boutique equipment in connection with the point-of-sale rollout. 

Management anticipates that capital expenditures for the remainder of fiscal year 2017 will be approximately $17.1 million to $20.1 million. The majority of this amount will be spent on new and existing boutiques as well as investments in our technology systems.

Financing Activities

Financing activities consist of borrowings and payments under our revolving credit facility, repurchases of our common stock, and proceeds from the exercise of stock options and the related tax consequence.

Net cash used in financing activities totaled $15.5 million and $44.5 million during the twenty-six weeks ended July 29, 2017 and July 30, 2016, respectively. Cash used in financing activities in each period primarily consists of repurchases of common stock.

Revolving Credit Facility

On August 30, 2013, Francesca’s Collections, Inc. (the “Borrower”), as borrower, and its parent company, Francesca's LLC, a wholly owned subsidiary of the Company, entered into a Second Amended and Restated Credit Agreement with Royal Bank of Canada, as Administrative Agent and Collateral Agent, and the lenders party thereto. The credit facility provides capacity of $75.0 million (including up to $10.0 million for letters of credit) and matures on August 30, 2018. The facility also contains an option permitting the Borrower, subject to certain requirements and conditions, to arrange with the lenders for additional incremental commitments up to an aggregate of $25.0 million, subject to reductions in the event the Borrower has certain indebtedness outstanding. At July 29, 2017, no borrowings were outstanding under the credit facility.

The credit facility contains customary events of default and requires the Borrower to comply with certain financial covenants. As of July 29, 2017, the Borrower was in compliance with all covenants under the credit facility. The credit facility restricts the amount of dividends the Borrower can pay; provided that the Borrower is permitted to pay dividends to the extent it has available capacity in its available investment basket (as defined in the Second Amended and Restated Credit Agreement), no default or event of default is continuing, certain procedural requirements have been satisfied and the Borrower is in pro forma compliance with a maximum secured leverage ratio. At July 29, 2017, the Borrower would have met the conditions for paying dividends out of the available investment basket. All obligations under the credit facility are secured by substantially all the assets of the Borrower and any subsidiary guarantor, if any. All obligations under the facility are unconditionally guaranteed by, subject to certain exceptions, by Francesca’s LLC and each of the Borrower’s existing and future direct and indirect wholly-owned domestic subsidiaries. 

Share Repurchase Program

For information regarding our share repurchase program, please refer to Note 7 to our unaudited consolidated financial statements included in Part I of this report, which is incorporated herein by reference.

Critical Accounting Policies

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, as well as the related disclosures of contingent assets and liabilities at the date of the financial statements. A summary of the Company’s significant accounting policies is included in Note 1 to the Company’s annual consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 28, 2017.

Certain of the Company’s accounting policies and estimates are considered critical, as these policies and estimates are the most important to the depiction of the Company’s consolidated financial statements and require significant, difficult, or complex judgments, often about the effect of matters that are inherently uncertain. Such policies are summarized in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of our Annual Report on Form 10-K for the fiscal year ended January 28, 2017. As of July 29, 2017, there were no significant changes to any of our critical accounting policies and estimates as disclosed in our Annual Report on Form 10-K for the fiscal year ended January 28, 2017.

Recent Accounting Pronouncements

For information regarding recent accounting pronouncements, please refer to Note 1 to our unaudited consolidated financial statements included in Part I of this Report, which is incorporated herein by reference.

Contractual Obligations

There were no significant changes to our contractual obligations and commercial commitments as disclosed in our Annual Report on Form 10-K for the fiscal year ended January 28, 2017, other than those which occur in the normal course of business.

  Off Balance Sheet Arrangements

We are not party to any off balance sheet arrangements.