A FIRST LOOK AT FRAN

Wednesday, June 13, 2012

DISCLAIMER
The information contained herein reflects the views of Longshorttrader (LST) as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. LST does not have an economic interest in the price movement of the securities discussed in this presentation, but LSTs economic interest is subject to change without notice. All information provided in this presentation is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. In addition, there can be no guarantee that any projection, forecast or opinion in this presentation will be realized. All trade names, trade marks, service marks, and logos herein are the property of their respective owners who retain all proprietary rights over their use. This presentation is confidential and may not be reproduced without prior written permission from LST.

INTRODUCTION Over the last several weeks, my friend @volslinger (who is short Francesca's Holdings, i.e. "FRAN"), has been sharing the case for going short FRAN with longshorttrader and the public. The bet initially paid off for the shorts, as the CFO was abruptly terminated for "improperly communicating Company information through social media." More recently, positive earnings led to a rebound in the shares. While the thesis remains intriguing, longshorttrader currently holds no position in FRAN, and would require more information and/or more reasons before initiating one. The case for selling FRAN below includes information and opinions provided by @volslinger, @longshorttrader, and others. ABOUT FRAN - (from the latest 10K) Francescas collections is one of the fastest growing specialty retailers in the United States. Our retail locations are designed and merchandised to feel like independently owned, upscale boutiques and provide our customers with an inviting, intimate and differentiated shopping experience. We believe we offer compelling value with a diverse and uniquely balanced mix of high-quality, trend-right apparel, jewelry, accessories and gifts at attractive prices. We tailor our assortment to appeal to our core 18-35 year-old, fashion conscious female customer, although we find that women of all ages are attracted to our eclectic and sophisticated merchandise selection and boutique setting.

THE CASE FOR SHORTING FRAN SHORT THESIS FRANs past and future earnings (therefore, normalized earnings) face the risk they are artificially overstated as a result of either (i) improper/aggressive accounting practices and/or (ii) unsustainable business practices involving related-parties. In either case, it becomes increasingly difficult for FRAN to keep up the charades, as it grows larger. The below diagram summarizes what some short-sellers believe is going on with FRAN:
Related Parties Sell Below Cost Inventory to FRAN

Capital Gains in Stock Compensate Related Parties

FRAN benefits by Achieving Artificially High Gross Margins

FRAN's Good Numbers Help Boost Stock Price

1.

FRAN's Gross Margins are noticeably higher & smoother than its peers' G.M. - According to Barrons, "Specialty retailers typically sport gross profit margins of 42% to 44% and operating margins of roughly 10%. Francesca's margins average 52% and 21%, respectively." Not only are margins high, they are quite smooth; in fact, gross margins rank 2nd 'smoothest' among 51 other retailers. This raises the question: are margins too good to be true? If margins accurately capture the true economics of the business, will competition erode margins? Will growth force FRAN to abandon its related party shenanigans, and achieve lower margins, as a result?

2.

Independent Third-Party Related Party Transactions Two inventory vendors, who account for roughly 20% of inventory purchases, are owned and operated by founders, siblings, and/or an in-law of one of the founders. Given how high and smooth margins have been, one wonders if there may be an accounting issue, or unsustainable cost advantage provided by this relationship. For example, operating margin increased approximately 800 bps from 13.3% in 2008 to 22% in 2009. KJK (as described below) was coincidentally incorporated and became a FRAN vendor in 2008 (FRAN is its sole customer; its owned/operated by one of the founders relative). Straight from the 10K:

Stony Trading Relationship

Stony Leather, Inc. (Stony) is one of our inventory vendors. We purchase inventory from Stony on a purchase order basis. Stony sources, wholesales and distributes jewelry, accessories, handbags and gift items. Stonys customers include retailers, wholesalers, individuals, television shopping networks, and internet-based merchants. We are only one of Stonys several customers. Stony is based in Houston, Texas with a showroom in New York City, New York. Stony does not own or operate conventional brick and mortar retail outlets. Chong Yi and Insuk Koo (two of the four Founders) own and operate Stony. Mr. Yi and Ms. Koo are brother and sister. Mr. Yi and Ms. Koo along with their sister Ms. Kyong Gill (our Executive Vice Chairperson and one of the four Founders) are stockholders of Francescas. We treat Stony as an independent third-party vendor. Since the founding of our company, Stony has been a supplier of a variety of our inventory items. Stony has accounted for 7%, 10% and 12% of our total inventory purchases on an annual basis in fiscal years 2011, 2010 and 2009, respectively. We negotiate and set the rates for the merchandise and services provided to us by Stony at market rates for such merchandise and services at the time each such transaction is entered into. We often request and receive from Stony merchandise on special order or modify previously ordered merchandise. Generally, Stony provides us a 3% damage allowance to cover the costs of damaged

merchandise. The Stony inventory purchases during fiscal years 2011, 2010 and 2009 were approximately $5.0 million, $5.0 million and $3.1 million, respectively. KJK Trading Relationship KJK Trading Corporation (KJK Trading) is one of our inventory vendors. We purchase inventory from KJK Trading on a purchase order basis. Although KJK Trading assists us in the design of several items of apparel we sell in our boutiques, KJK Trading does not act as our broker or agent in the sourcing of our merchandise. Beginning in May 2010, we subleased approximately 2,000 square feet of office space to KJK Trading within our headquarters in Houston, Texas. We did not receive any rent payments from KJK Trading in fiscal year 2010. Beginning in January 2011, the rent payment became $1,000 per month. KJK Trading employs several employees to conduct its business. We are the sole customer of KJK Trading. We treat KJK Trading as an independent third-party vendor. KJK Trading is owned and operated by Ki Juing Gu. Mr. Gu is the brother-in-law of Ms. Insuk Koo (one of our Founders). KJK Trading has been one of our inventory vendors since 2008. KJK Trading has accounted for 12%, 13% and 11% of our total inventory purchases on an annual basis in fiscal year 2011, fiscal year 2010 and fiscal year 2009, respectively. We negotiate and set the rates for the merchandise and services provided to us by KJK Trading at market rates for such merchandise and services at the time each such transaction is entered into. We often request and receive from KJK Trading merchandise on special order or modify previously ordered merchandise. Generally, KJK Trading provides us a 1% damage allowance to cover the costs of damaged merchandise. The KJK Trading inventory purchases during fiscal years 2011, 2010 and 2009 were approximately $8.1 million, $6.6 million and $2.8 million, respectively. 3. Pie in the Sky Growth Targets FRAN believes it can grow from its current store count of approximately 313 stores to over 900 in 7-10 years. For some perspective: there are 170 Anthropologie stores, 402 White House/Black Market stores, 560 Charlotte Russe stores, over 160 Brighton Collectibles, 500 Ann Taylor LOFT stores, and 74 Loft Outlet stores. These stores are listed as competitors in FRANs 10K. FRAN may have other competitors they do not mention. Even if we exclude indirect competitors, 900 stores seems aggressive. Longshorttrader believes it would necessitate that they steal share from their competitors. Insider Selling From Barrons: CCMP, a private-equity firm that bought 84% of Francesca's in 2008 for roughly $200 million, has done very well on its investment, taking out a $100 million dividend from the company in 2010. In the past year it has sold shares worth around $614 million, including a $200 million chunk in last week's secondary offering. CCMP still owns 6.395 million shares (as of 5/4/2012, down from 7.2 million shares as of 4/12/2012) Allowance for Merchandise Returns For fiscal years 2011, 2010 and 2009, we recognized $0.2 million, $0.2 million and zero, respectively, of allowance for merchandise returns. Longshorttrader wonders if it makes any sense that allowance for merchandise returns stayed flat even as revenue grew at a blistering 50+% Auditor Change, Language Changes FRAN changed auditors from BDO USA to Ernst & Young prior to the IPO. Theres nothing wrong or unusual with this in and of itself, except the issues mentioned above, as well as the fact there was a material weakness in internal control over financial reporting in the past, legitimize a healthy dose of skepticism. To make matters worse, FRAN changed/removed consignment clause language from filing to filing. More on consignment: Consignment is the holy grail of retailing because it means any unsold merchandise could be returned to the vendor, eliminating the need for it to be marked down and sold at a margin-crushing price. Veteran retailing analyst Faye Landes, now with Consumer Edge Research, says consignment deals are "a retailer's dream because you don't have the inventory risk," adding that they aren't typically done in the U.S. Barrons An investor who is short FRAN would like for the company to elaborate on the following: a. Elaborate on the revenue recognition policies pre s-1 filing for your VC investors vs the definitive s1. b. What is the policy on insiders collaring their stock vs a formal secondary to exit? c. Has the company disclosed if the company pays for taxes incurred by insiders from sales of exercised options grants?

4.

5.

6.

d. e.

Discuss the side arrangements, if any exists, between the company or related subsidiary channel in its relationship with KJK. Discuss the annual report language as it relates to inventory, specifically as it relates to consignment clause. Why did the former CFO remove language relating to consignment in the 10K ?

7.

CFO Dismissed for Poor Judgment Gene Morphis, now former CFO, was recently fired due to improper communications. He went by theoldcfo on twitter and at best, exercised poor judgment. His conduct raises further questions into the other concerns previously mentioned, a la the cockroach theory. Francesca's Holdings Corporation (Nasdaq:FRAN) today announced that it has terminated for cause the employment of Chief Financial Officer Gene Morphis, based on an investigation by the Board of Directors with the assistance of outside counsel, which has found that he improperly communicated Company information through social media. The investigation was launched after the Company discovered this activity on May 11, 2012. Press Release

8.

Stock Promoters Love FRAN Longshorttrader has identified several promoters in the public sphere that were also cheerleading dodgy momentum stocks in 2010/2011stocks that fell 70%-90%, from peak to trough.

LONGSHORTTRADERs TAKE 1. FRAN Generates Cash Flow, Can Fuel Growth Plan FRAN is generating free cash flow, paying off its debt, and growing aggressively without requiring external capital (unlike the ponzi-financed Green Mountain Coffee Roasters). The Company only has $10 million remaining in debt, which is a drop in the bucket for them. 900 stores may be out of reach, but it seems precarious to short FRAN without understanding the growth trajectory. Longshorttrader would prefer shorting FRAN if it were nearing saturation, SSS growth was slowing, FRANs growth was ponzi-financed, marginal store growth was uneconomic, was buying back inflated stock, etc. CFO Dismissal May Be a Good Sign Some may view the dismissal of the CFO as validation of the cockroach theory, and that the worst is yet to come. Longshorttrader is not comfortable with this view, and actually gives the Company credit for swiftly dismissing the CFO. Contrast the swift, decisive action against, say GMCR. GMCRs CFO has been lying about CPA credentials for years (among other things), which means she lied on numerous SEC filings. Yet their CFO, to this day, remains untouched. It seems FRAN acted within days, if not weeks. If FRAN hires a smarter CFO than the one they had, it might inspire confidence among marginal buyers. Unsavory Business Practice vs. Accounting/Other Fraud Puzzle Requires Catalyst Longshorttrader takes the shorts thesis very seriously. In fact, longshorttrader has thought of few different theories as to what is going on between FRAN and its related parties. The best case for FRAN is it can maintain an artificial cost advantage longer than shorts are willing/able to maintain their positions. At worst case, there may be something more elaborate and sinister going on. Either way, shorts need an impetus for FRANs game to unravelperhaps shorts should kindly ask David Einhorn to present a 110 slide presentation on FRAN sometime. Of course, there is the remote chance FRAN is actually a great business, and its margins reflect lasting competitive advantage, rather than an artificial advantage provided by related parties. The Gross Margin Inflations Impact on Cash Flows is Unclear if theyre overstating gross margin, that means their related party suppliers are undercharging them, perhaps receiving kickbacks, or just bearing losses to help the company. If this is the game that is being played, it has to be economically gainful for the parties involved. Said differently, the related parties loss (or foregone profit/margin) from selling inventory at below cost must be widely off set by some combination of kickbacks and/or capital appreciation in their stock holdings. This means that FRANs economics are currently distorted, and that true ROIC/margins are lower, much closer to industry norms. One implication: the event shorts are waiting for is a quarterly earnings or pre-earnings warning, where earnings surprises to downside, and reflects margins without the related parties help. If on the other hand, the issue is an accounting misstatement, it isnt clear to longshorttrader how this affects their true profitability, since cash flow would be unaffectedunlessthere is cash fraud involved here. If thats the case, all bets are off, and the shorts would have to approach the problem from a very different angle. Now if an accounting misstatement does affect earnings, the stock could get hit, even as cash flow from operating activities remains untouched (though the adjustments to reconcile nearings to CFFO would presumably change).

2.

3.

4.