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Why Investors Should Be Skeptical of the Abercrombie Growth Story


Is the stock as exciting as its price action over the past few months? I don't think so.

Abercrombie & Fitch's (NYSE:ANF) stock is up 65% over the past three months. This stock jumped on November 14, 2012 (up 34%) as Abercrombie substantially beat analysts' earnings estimates for its third quarter of fiscal 2012 and management raised its earnings outlook for 2012. Reading the headlines, it appears as though this retailer raised earnings expectations in a difficult consumer and macroeconomic environment. And, I get it…beating estimates and raising earnings expectations usually results in an upward move in the stock price. However, I'd like to dig a bit deeper into this "growth" story, which, in my opinion, is not as exciting as this stock action would indicate.

First, let's look at Abercrombie & Fitch's most recent earnings guidance. While management did raise its earnings forecast for 2012 to a range of $2.85-$3.00 from a range of $2.50-$2.75 (provided in August 2012), this is down substantially from its guidance of $3.50-$3.75 at the start of 2012, and down even more sharply from its original EPS guidance of $4.75 (provided in April 2011 at its Investor Day)!

But let's put the conversation surrounding earnings guidance aside for a moment and look at what's going on with Abercrombie's business.

For those not familiar with this company, Abercrombie is a specialty retailer that sells casual sportswear apparel for men, women, and kids through three of its brands -- Abercrombie & Fitch, Abercrombie Kids, and Hollister -- as well as intimate apparel and sleepwear for girls under its Gilly Hicks brand. From 2005 to 2007, prior to the recession, this company had operating margins in the 20% area, as it was able to sell its jeans and hoodies at premium prices. But when the recession hit, Abercrombie maintained its premium pricing strategy, which led to substantial losses in market share to other teen retailers such as Aeropostale (NYSE:ARO) and American Eagle Outfitters (NYSE:AEO) in 2008 and 2009. As a result, in 2010, Abercrombie changed its tune and began offering discounts and promotions, which enabled it to start regaining market share in the US.

At the same time, management recognized the need to close underperforming stores domestically and decided to focus its efforts on growing internationally. From 2010 to 2012, it closed nearly 200 stores in the US, while opening more than 100 stores in Europe and Asia. (These foreign store openings consisted primarily of Abercrombie & Fitch flagship stores on high profile city streets as well as Hollister stores in malls.)

So, let's take a closer look at its recent international results.

International revenue grew 37% in the third quarter of 2012. Although this may appear strong, I would make the case that this is not very robust given that the company had 68% more stores open in the international market year-over-year and its square footage was up 82%. Why did its revenue growth trail that of its store growth? Because same-store sales were down 18% internationally. Same-store sales reflect revenue growth in stores open for 12 months or more and essentially measure the health of retailers' more mature store locations. Abercrombie's international same-store sales decline did improve from -26% in the second quarter and -22% in the first quarter of fiscal 2012, but its third quarter results had an easier comparison as sales trends slowed in Europe and its flagship stores' same-store sales turned negative in the third quarter of 2011.

While the macroeconomic environment is challenging for all retailers in both the US and Europe, my concerns with Abercrombie & Fitch going forward are more company-specific. I am not confident that this former purveyor of high-priced fashion for kids, teens, and adolescents will be able to return to its heyday. In the US, I believe that it will have to continue to discount and offer promotions in order to remain competitive. Internationally, I think that cannibalization will continue to be a problem as it grows its store base around the world. Further, this cannibalization may be extended to its flagship and tourist stores in the US, as this group of stores' same-store sales were down 12% in the third quarter of 2012. Also, fast fashion retailers such as Forever 21, H&M (STO:HM-B), and Zara (MCE:ITX) offer the latest trends at an affordable price. These retailers are growing and are a competitive threat both domestically and internationally.

And, if you are wondering what happened to Abercrombie's original outlook for earnings of $4.75 per share in 2012? Well, this relied heavily on the success of its international growth story. Not only did international same-store sales turn negative in 2012, but the company also scaled back its store growth plans for the year. To be clear, the company is not backing away from its international growth plans for its future. I, for one, am just a bit more skeptical about this "growth" story.
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