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Abercrombie & Fitch: The Good, The Bad, The Ugly


Abercrombie & Fitch goes ahead and disappoints...


Just when I was getting ready to throw in the towel, Abercrombie & Fitch (ANF) goes ahead and disappoints…

The Good:

  • ANF reported in-line earnings and sales.
  • Hollister/Ruehl continues to be extremely successful.
    • Comps increased 14% for the year and transactions increased by 55%.
  • The new launch of super secret Concept 5 is just around the corner.
    • While this should create a lot of publicity, no one knows what the heck Concept 5 is.
    • Chances are that it will be accessories, similar to Claire's (CLE). If it is, this is a crap margin business.
  • The company's balance sheet is pristine.
    • Cash accruals are huge-this company is a free cash flow machine.

The Bad:

  • This was not a clean quarter. Earnings included:
    • A $0.10 boost from a favorable tax rate.
    • A $0.02-0.03 boost from gift card breakage.
  • The numbers below the surface were pretty poor.
    • Sales were helped by a slightly higher markdown rate.
    • Expenses were up as stores and distribution expenses increased 20 bps to 30.7% and marketing, general and administrative expenses increased 50 bps.
    • Margins were down as operating margins were down a whopping 90 bps.
  • The company said it should open a London store on March 22. My guess is this will be delayed.
    • This store is around the corner from my firm's London office, it does not look like it is anywhere near finished.
  • The company seems to be behind the curve when it comes to fashion.
    • Sales of shirts drove top-line growth.
    • Jeans still continue to struggle. ANF makes wide-bottom jeans but skinny jeans are the new thing.Tops can generally be sold at outlets, but jeans, if the style changes, linger. This leads to inventory write-downs.

The Ugly:

  • Management not optimistic about the company's future.
    • ANF guided to the lower end of consensus estimates for 1H '07 on the conference call.
    • It guided to mid-single digit EPS growth for 1Q '07. Expectations had been for roughly 12%.
    • The low-end of guidance assumes flat comps, which might be problematic.
    • Near-term fundamentals have been poor as Feb. MTD sales have been negative and weather has been lousy.
    • Mitigating factors: ANF is facing some pretty easy comps this spring.
  • Inventories continue to grow.
    • Inventory per square foot is up 6%. This is somewhat mitigated by inventory turns increasing by roughly 8%.
  • All growth in the name seems to be coming from new store openings. Sales at stores open for at least a year fell 3%.
    • A lot of the bull story on the stock is that margins are improving.
    • Stores open at least three years should have the best margins, but if sales keep decreasing, margins will get squeezed (costs are mostly fixed).

ANF is trading at roughly 15x '07 estimates and 14x '08 estimates. While this is cheap to its peers, the company is not growing as fast as them. Also, this is well within its historic multiple range and would price it a p/e to growth (ratio of 1x). Finally, analyst consensus estimates still have margin expansion built into them, which is against the trend we have seen for ANF-where margins have generally been steady to declining (as noted above, it is hard to increase margins when all growth is coming from new store openings, which are expensive). Management's own analysis of its prospects was fairly sanguine, which was against form for this normally upbeat retailer. My guess is that consensus estimates will come down. As such, I think the company is fairly to overvalued-but, to be fair, not by much.
So we are starting with a fairly-to-overvalued company, now add into the mix:

  • A company that seems to have gotten the fashion mix wrong (stripey tops and wide cut jeans vs. more trendy solid tops and narrow cut jeans).
  • Inventory is still growing.
  • Poor start-of-the-year performance.

I am not sure that the vol market, which is near two year lows, is pricing in the risks.

I still think this is a good risk/reward trade, but one caveat: ANF's balance sheet is a wonder. The company does have about $4 per share in net cash, which it will use in buybacks or dividends or other financial engineering should the stock start to tumble.

Editor's Note: Steven Zausner of Vicis Capital also contributed to this article.

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Position in ANF

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