ABERCROMBIE & FITCH -CL A ANF
July 12, 2012 - 10:56am EST by
mack885
2012 2013
Price: 32.50 EPS $3.63 $0.00
Shares Out. (in M): 86 P/E 8.0x 0.0x
Market Cap (in $M): 2,800 P/FCF 6.0x 0.0x
Net Debt (in $M): -294 EBIT 485 0
TEV ($): 2,507 TEV/EBIT 5.2x 0.0x

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  • Depressed Earnings
  • Retail
  • Share Repurchase
 

Description

Abercrombie & Fitch Co. (ANF)

Abercrombie & Fitch is a premium priced, mall-based teen apparel retail brand currently valued at a rock bottom 3.5x EBITDA multiple on near trough 10% EBIT margins. As a result of sky high prior year cotton prices and overreactions around European exposure, ANF offers investors a compelling opportunity to buy a very high ROI business at a bargain bin discount price.  Further, management sees the undervaluation and the company has been aggressively repurchasing stock.

Business basics:

ANF operates two primary brands consisting of Abercrombie & Fitch with 280 US based stores and 14 international stores and Hollister with 494 US based stores and 84 international stores.  Abercrombie is positioned as Rooted in East Coast traditions and Ivy League heritage, Abercrombie & Fitch is the essence of privilege and casual luxury.” It is priced at a premium to its own Hollister brand as well as American Eagle, Aeropostale, Banana Repbulic, JCrew, and most other comparables.  Hollister is positioned as “the fantasy of Southern California. It’s all about hot lifeguards and beautiful beaches” and is priced at a modest discount to Abercrombie. (For more entertaining hyperbolic descriptions of the brand see the 10-K)

 Abercrombie also operates 21 Gilly Hicks stores, which is their intimates brand comparable to Victoria Secret Pink and American Eagle’s aerie.  ANF is still internally debating how, or if to expand the concept and whether or not to move forward with stand-alone stores or as stores-within an existing Abercrombie & Fitch.

 Abercrombie also operates abercrombie kids, however it has shrunk its store count from 205 to 159 in the last 3 years and will continue to close stores going forward. The children segment has been an unsolvable puzzle for teen retailers further evidenced by competitor American Eagle’s recent exit from its comparable concept AE77 Kids.

 

Store   counts

FYE Jan

FYE Jan

FYE Jan

FYE Jan

FYE Jan

FYE Jan

FYE Jan

FYE Jan

FYE Jan

FYE Jan

 

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

US   stores

                   

Abercromie   & Fitch

340

357

357

360

357

355

352

340

316

280

Hollister  

93

172

256

317

390

447

506

507

502

494

abercrombie   (kids)

164

171

171

164

177

201

210

205

181

154

Gilly   Hicks

0

0

0

0

0

3

14

16

18

18

Total US stores

597

700

784

841

924

1,006

1,082

1,068

1,017

946

                     

International   stores

                   

Abercromie   & Fitch

0

0

0

1

3

4

4

6

9

14

Hollister  

0

0

0

1

3

3

9

18

38

77

abercrombie   (kids)

0

0

0

0

0

0

2

4

4

5

Gilly   Hicks

0

0

0

0

0

0

0

0

1

3

Total international   stores

0

0

0

2

6

7

15

28

52

99

                     

Total   stores

597

700

788

843

930

1,013

1,097

1,096

1,069

1,045

 

US store economics and store closures

ANF targets a minimum threshold of 30% 4-wall profit margins for any new location and builds in a buffer allowing for lower than plan sales when selecting new sites.  Perhaps counter intuitively, Europe has been exceeding these targets for the past few years while the US has lagged, only achieving 17% margins in 2011.  The US has suffered in part due to cannibalization from building out too many stores and in part due to growth in DTC (direct to consumer internet sales).  In response, the company has engaged in a plan of accretively closing underperforming domestic locations to right size the store base. In 2010 and 2011 combined ANF closed 132 stores, primarily consisting of Abercrombie & Fitch and abercrombie (kids) brands.  An incremental 180 stores has been targeted for closure through 2015, primarily by allowing leases to expire.  Closures should bring margins up materially as the top 250 domestic stores maintained 30% or better margins in 2011.  While management hasn’t quantified the benefit, CFO Ramsden stated on last year’s Q1 call (5/18/11):...coming back to domestic closures, we haven't been specific about the margin impact of that, but as you know, we talked in the past about those stores, the 65 or so we closed averaging about $1 million of volume and roughly breaking even or having flat EBITDA across those stores.”  For illustrative purposes, applying the same metrics to the 71 store closures in 2011 and the planned 180 closures implies a 2% increase in US operating margins.  The closures are strictly a US phenomenon where the store base is clearly mature and store rationalization is net present value positive for shareholders both in earnings accretion, margin accretion, and the likely pickup in higher margin DTC sales when a store is closed.

 

International store economics and store closures

While European exposure has recently become a pejorative to investors, for ANF it represents a long term growth opportunity.  ANF opened its first store outside of the US as recently as 2006 and ramped up its roll out dramatically by opening 71 stores in the last two years.  Such expansion was clearly too rapid as they have already experienced declining comparable store sales and some cannibalization.  Combined with the dismal European economy, and additional investor pressure to increase buybacks given the stock price, management will be more prudent with its site locations and growth.  While much of the recent stock decline is attributable to European fears, ANF’s European stores are actually outperforming its domestic ones from a margin standpoint[1].  At the April 6, 2011 investor day, management discussed that FY 2010 4-wall margins in US were 20% vs. 35% in Europe and the trend continued in 2011.  Management has recently articulated some of the salient metrics:

CFO  Jon Ramsden 6/20/12 at a conference: “…when we look at return on invested capital, that we still see strong returns from the stores we expect to open [internationally]. The stores we're still opening today are continuing to do well. We have had two very strong openings in Germany recently. Our French openings have been very good. And if a store hits its approved volume, the payback on that initial investment is very quick.  There was an example I gave a couple of weeks ago about a store we just approved in France outside Paris. We think it's going to do about $8 million. It will be 35% four wall of that or higher EBITDA margin and would pay back all of the upfront investment, CapEx net of allowance, plus other pre-opening costs within about a year and a half. Even if it only does 75% of the targeted volume, it would still do a 30% 4-wall margin. So there is room in the model. And when we hit the approved volumes or even somewhat lower than that, the return on that cash is still extremely strong.


CEO COB Mike Jeffries 5/16/12 Q1 call: “When we look at the current trends in Europe the questions we ask ourselves are -- first, are our stores continuing to stand out from the mall in terms of excitement and energy and in terms of traffic and productivity? Second, are the new store volumes consistent with the volumes at which we approved the deals? Third, are we achieving our annualized target 30% four wall margins at the current trend and after cannibalization? Last, is our international direct-to-consumer business continuing to grow at a healthy rate? Despite the downtrend we have experienced, at this point the answer to all of those questions is yes in aggregate and yes individually for the majority of our European stores. Based on that, while we will continue to review trends closely and be very disciplined in how we approach new store openings, we believe the current economics of our business in Europe strongly affirm our long-term strategy.”

Management believes that Europe can ultimately support 185 Hollister stores and generate $1.25bn in sales (Asia would be incremental) and international Abercrombie & Fitch flagship stores could provide an additional $1.25bn in sales. Combined international sales in FY 2011 were $876mm, leaving a long runway for growth that investors are not paying for at today’s prices. 
 
 

Financial summary

                         
 

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

FYE   Jan

 

1999  

2000  

2001  

2002  

2003  

2004  

2005  

2006  

2007  

2008  

2009  

2010  

2011  

2012  

Revenue

$805  

$1,031  

$1,238  

$1,365  

$1,596  

$1,708  

$2,021  

$2,768  

$3,284  

$3,700  

$3,484  

$2,929  

$3,469  

$4,158  

%growth

 

28.0%  

20.1%  

10.3%  

16.9%  

7.0%  

18.4%  

37.0%  

18.6%  

12.7%  

(5.8%)

(15.9%)

18.4%  

19.9%  

                             

EBIT

$167  

$242  

$254  

$271  

$312  

$331  

$348  

$578  

$698  

$779  

$498  

$104  

$277  

$319  

margin

20.7%  

23.5%  

20.5%  

19.9%  

19.6%  

19.4%  

17.2%  

20.9%  

21.3%  

21.1%  

14.3%  

3.6%  

8.0%  

7.7%  

                             

EBITDA

$188  

$270  

$284  

$313  

$388  

$421  

$453  

$702  

$844  

$965  

$754  

$428  

$506  

$552  

margin

23.3%  

26.2%  

23.0%  

22.9%  

24.3%  

24.6%  

22.4%  

25.4%  

25.7%  

26.1%  

21.6%  

14.6%  

14.6%  

13.3%  

                             

CapEx

$37  

$73  

$153  

$127  

$146  

$160  

$185  

$256  

$403  

$403  

$368  

$175  

$161  

$319  

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

A history of high margins

In the entire decade prior to the global economic meltdown of 2008 and 2009, ANF generated astonishingly consistent 20% EBIT margins with only 1 year below 19.5% while growing revenue at a CAGR of 18.5%.  Such results are particularly impressive for an apparel retailer, but more importantly provide comfort that the power of the brand is very much intact.  As shown in the financial summary chart, there was no margin slippage until the vicious economic turn of events in 2008.  When the economy is not in free fall, ANF should be able to recapture the majority of its past margins.  This is not the story of a broken, waning brand. 

One more wrinkle already ironed out

Operating margins in FY 2010  (FYE Jan 2011) represented a slight recovery to 8% over 2009’s trough 3.6%[1], however margins in 2011 subsequently declined a bit to 7.7%.  The primary cause of margin recovery derailment was a dramatic rise in cotton costs. Cotton had fluctuated between $0.60 and $0.80 per pound (occasionally lower) through the entire decade of 2000 through 2010.  However, between July of 2010 and Mar of 2011, cotton spiked from $0.84 to $2.30.  Cotton has since fallen below $1.00 per pound as of November 2011.  Management state that higher cotton costs contributed the majority of 2011’s gross margin decline of 3.2%.  If we assume that mark downs contributed 40% of the decline and cotton increases the remaining 60%, its striking to have a built-in 2% margin tailwind in a quality branded retailer trading at 3.5x EBITDA.

Management

Mike Jeffries is the iconoclastic CEO and COB largely credited with the creation of Abercrombie brand we know today.  Often described as obsessive, meticulous, superstitious and controlling, he embodies the style of a physique of a 25 year old despite his numerical age of 67.  Staunchly against discounting merchandise to maintain the aspiration nature of the Abercrombie brand, he has been known to raise prices in the face of recession.  To create a brand that “sizzles with sex”, he employs shirtless models as greeters to his stores and on more than one occasion has gotten in trouble with parental watchdog groups for producing catalogs deemed too racy and only hiring attractive employees.  He also intentionally doesn’t utilize one of the most valuable pieces of a retailer’s real estate, successfully breaking a cardinal rule of retailing.  Rather than use the front windows for merchandise displays, Abercrombie and Hollister cover their windows with shades to create a club like atmosphere.  Jeffries owns a substantial amount of equity in the form of 1mm shares outright and 7.84mm options with strikes generally ranging from $25-$55.  He clearly has skin in the game, however he has 10b5-1 plan that he has used to sell exercised options though he has not sold any shares since December around $50.   (For a couple of decent profiles on Jeffries see: http://www.businessweek.com/stories/2005-05-29/flip-flops-torn-jeans-and-control  and http://www.salon.com/writer/benoit_denizet_lewis/)

Capital allocation

I would grade management’s historical capital allocation a B- (maybe worse), however they seem to have gotten religion and are moving firmly into the A range.  Like most retailers, they have sunk capital into money losing concepts including RUEHL, abercrombie (kids) and potentially Gilly Hicks (the jury is still out on this one).  They were also too aggressive at store expansion in the US in the early 2000s, and as discussed above, they were a bit too aggressive in European expansion over the last 2 years.  Today, capital is generally spent on new A&F/Hollister stores in Europe, share buybacks and dividends.  Given the decline in share price, management is correctly most focused on share repurchases.  Over the last two years ANF has repurchased 5mm shares (6% of the company) for $273mm.  With its first quarter earnings in May, ANF authorized an additional 10mm shares brining the current authorization to 12.9mm, or 15% of the company.  CFO Jon Ramsden further articulated his thoughts on capital allocation 3/7/12 stating, “Our basic parameters on use of cash are the same. We want to maintain that trough cash cushion of around $350 million. Beyond that, we will be in the market making repurchases when we think it's opportune to do so from a market standpoint. And obviously based on our overall view of the business and market conditions, the term loan we locked into last week was basically a very inexpensive facility we've set up, which gives us flexibility if we want to go out go after buybacks more aggressively. That would really be the only reason we would dip into it.  Apparently, investor pressure is only increasing as a recent New York Post article that claims that ANF is planning a very large repurchase effort partially funded by trimming its 2012 European expansion plans and its related $400mm 2012 CapEx budget. (http://www.nypost.com/p/news/business/le_preppy_pe_yew_CYG7XhnaYYfeq4aFMwu0PN).  ANF also pays a $0.70 annual dividend, which means the stock currently yields better than 2%, which handily beats a ten year treasury. 

Other opportunities

ANF’s direct to consumer has tripled in the last 5 years to $552mm in FY 2011 and management believes it will grow to $1bn over time.  Not surprisingly, DTC sales are the highest margin activity at the company at over 50% operating margins.  Management has indicated that DTC sales also benefit from store closures, though they have not quantified the effect.

Valuation

After declining 60% from its October high of nearly $77 to its current price of $32.50, ANF has a fully diluted market cap of $2,800mm and an enterprise value of $2,510mm after backing out nearly $300mm of net cash.  Consensus EBTIDA for 2012 is $715mm providing for a very inexpensive 3.5x.  That still only represents 10% operating margins versus its long running historical 20% average.  While comps have been challenging, the company should be able to achieve its targeted 2.5% margin increase over 2011 with the tailwinds of cotton price declines, accretive store closures, and previously opened European stores ramping up.  Share repurchases will also be very accretive to value though not margins.  While CapEx has averaged $285mm over the last 5 years due to store builds and DTC investments, CFO Jon Ramsden estimates maintenance CapEx runs below $100mm implying  TEV/EBITDA-maint capex of 4x and after tax adjusted free cash flow of $385mm for a 6.5x multiple. Management’s most recent 2012 EPS guidance of $3.50 to $3.75 implies 8x backing out $3.40/share in net cash.  By any metric ANF is cheap. Over time, margins should trend back toward 20% and, if management is ballpark accurate with its long term European store estimates, it is possible to envision over $7bn in total company sales and $1.75bn in EBITDA.  While this is simply an illustration of potential earnings power rather than an estimate, investors need not believe in such lofty targets to make money at current prices.

 



[1] Excluding an $85mm non cash impairment charge for exiting the RUEHL concept operating margins would have been 6.5%



[1] For anecdotal evidence of retailing Euro-fear in retail look to watch and accessories company Fossil.  On May 8 FOSL announced a less than stellar first quarter due to a soft European environment. Not only did Fossil lose 40% of its market cap that day, but it also sparked a panic sell off across all European exposed retailers (http://articles.marketwatch.com/2012-05-08/industries/31620274_1_asia-warnaco-group-sales).  I have no opinion on FOSL’s stock, but I view the reaction to its Q1 as the metaphorical bath plug being pulled with ANF playing the role of baby in the bathwater.  Note that Fossil’s business is larger outside of the US than domestically, with Europe comprising 35% of its wholesale business.  It was also trading at a lofty 13.6x EBITDA and 23.6x P/E versus ANF’s modest multiples.     

 

Catalyst

  • Declining cotton costs flowing through in the back half of the year
  • Increased share repurchases
  • Margin accretive store closures
    sort by   Expand   New

    Description

    Abercrombie & Fitch Co. (ANF)

    Abercrombie & Fitch is a premium priced, mall-based teen apparel retail brand currently valued at a rock bottom 3.5x EBITDA multiple on near trough 10% EBIT margins. As a result of sky high prior year cotton prices and overreactions around European exposure, ANF offers investors a compelling opportunity to buy a very high ROI business at a bargain bin discount price.  Further, management sees the undervaluation and the company has been aggressively repurchasing stock.

    Business basics:

    ANF operates two primary brands consisting of Abercrombie & Fitch with 280 US based stores and 14 international stores and Hollister with 494 US based stores and 84 international stores.  Abercrombie is positioned as Rooted in East Coast traditions and Ivy League heritage, Abercrombie & Fitch is the essence of privilege and casual luxury.” It is priced at a premium to its own Hollister brand as well as American Eagle, Aeropostale, Banana Repbulic, JCrew, and most other comparables.  Hollister is positioned as “the fantasy of Southern California. It’s all about hot lifeguards and beautiful beaches” and is priced at a modest discount to Abercrombie. (For more entertaining hyperbolic descriptions of the brand see the 10-K)

     Abercrombie also operates 21 Gilly Hicks stores, which is their intimates brand comparable to Victoria Secret Pink and American Eagle’s aerie.  ANF is still internally debating how, or if to expand the concept and whether or not to move forward with stand-alone stores or as stores-within an existing Abercrombie & Fitch.

     Abercrombie also operates abercrombie kids, however it has shrunk its store count from 205 to 159 in the last 3 years and will continue to close stores going forward. The children segment has been an unsolvable puzzle for teen retailers further evidenced by competitor American Eagle’s recent exit from its comparable concept AE77 Kids.

     

    Store   counts

    FYE Jan

    FYE Jan

    FYE Jan

    FYE Jan

    FYE Jan

    FYE Jan

    FYE Jan

    FYE Jan

    FYE Jan

    FYE Jan

     

    2003

    2004

    2005

    2006

    2007

    2008

    2009

    2010

    2011

    2012

    US   stores

                       

    Abercromie   & Fitch

    340

    357

    357

    360

    357

    355

    352

    340

    316

    280

    Hollister  

    93

    172

    256

    317

    390

    447

    506

    507

    502

    494

    abercrombie   (kids)

    164

    171

    171

    164

    177

    201

    210

    205

    181

    154

    Gilly   Hicks

    0

    0

    0

    0

    0

    3

    14

    16

    18

    18

    Total US stores

    597

    700

    784

    841

    924

    1,006

    1,082

    1,068

    1,017

    946

                         

    International   stores

                       

    Abercromie   & Fitch

    0

    0

    0

    1

    3

    4

    4

    6

    9

    14

    Hollister  

    0

    0

    0

    1

    3

    3

    9

    18

    38

    77

    abercrombie   (kids)

    0

    0

    0

    0

    0

    0

    2

    4

    4

    5

    Gilly   Hicks

    0

    0

    0

    0

    0

    0

    0

    0

    1

    3

    Total international   stores

    0

    0

    0

    2

    6

    7

    15

    28

    52

    99

                         

    Total   stores

    597

    700

    788

    843

    930

    1,013

    1,097

    1,096

    1,069

    1,045

     

    US store economics and store closures

    ANF targets a minimum threshold of 30% 4-wall profit margins for any new location and builds in a buffer allowing for lower than plan sales when selecting new sites.  Perhaps counter intuitively, Europe has been exceeding these targets for the past few years while the US has lagged, only achieving 17% margins in 2011.  The US has suffered in part due to cannibalization from building out too many stores and in part due to growth in DTC (direct to consumer internet sales).  In response, the company has engaged in a plan of accretively closing underperforming domestic locations to right size the store base. In 2010 and 2011 combined ANF closed 132 stores, primarily consisting of Abercrombie & Fitch and abercrombie (kids) brands.  An incremental 180 stores has been targeted for closure through 2015, primarily by allowing leases to expire.  Closures should bring margins up materially as the top 250 domestic stores maintained 30% or better margins in 2011.  While management hasn’t quantified the benefit, CFO Ramsden stated on last year’s Q1 call (5/18/11):...coming back to domestic closures, we haven't been specific about the margin impact of that, but as you know, we talked in the past about those stores, the 65 or so we closed averaging about $1 million of volume and roughly breaking even or having flat EBITDA across those stores.”  For illustrative purposes, applying the same metrics to the 71 store closures in 2011 and the planned 180 closures implies a 2% increase in US operating margins.  The closures are strictly a US phenomenon where the store base is clearly mature and store rationalization is net present value positive for shareholders both in earnings accretion, margin accretion, and the likely pickup in higher margin DTC sales when a store is closed.

     

    International store economics and store closures

    While European exposure has recently become a pejorative to investors, for ANF it represents a long term growth opportunity.  ANF opened its first store outside of the US as recently as 2006 and ramped up its roll out dramatically by opening 71 stores in the last two years.  Such expansion was clearly too rapid as they have already experienced declining comparable store sales and some cannibalization.  Combined with the dismal European economy, and additional investor pressure to increase buybacks given the stock price, management will be more prudent with its site locations and growth.  While much of the recent stock decline is attributable to European fears, ANF’s European stores are actually outperforming its domestic ones from a margin standpoint[1].  At the April 6, 2011 investor day, management discussed that FY 2010 4-wall margins in US were 20% vs. 35% in Europe and the trend continued in 2011.  Management has recently articulated some of the salient metrics:

    CFO  Jon Ramsden 6/20/12 at a conference: “…when we look at return on invested capital, that we still see strong returns from the stores we expect to open [internationally]. The stores we're still opening today are continuing to do well. We have had two very strong openings in Germany recently. Our French openings have been very good. And if a store hits its approved volume, the payback on that initial investment is very quick.  There was an example I gave a couple of weeks ago about a store we just approved in France outside Paris. We think it's going to do about $8 million. It will be 35% four wall of that or higher EBITDA margin and would pay back all of the upfront investment, CapEx net of allowance, plus other pre-opening costs within about a year and a half. Even if it only does 75% of the targeted volume, it would still do a 30% 4-wall margin. So there is room in the model. And when we hit the approved volumes or even somewhat lower than that, the return on that cash is still extremely strong.


    CEO COB Mike Jeffries 5/16/12 Q1 call: “When we look at the current trends in Europe the questions we ask ourselves are -- first, are our stores continuing to stand out from the mall in terms of excitement and energy and in terms of traffic and productivity? Second, are the new store volumes consistent with the volumes at which we approved the deals? Third, are we achieving our annualized target 30% four wall margins at the current trend and after cannibalization? Last, is our international direct-to-consumer business continuing to grow at a healthy rate? Despite the downtrend we have experienced, at this point the answer to all of those questions is yes in aggregate and yes individually for the majority of our European stores. Based on that, while we will continue to review trends closely and be very disciplined in how we approach new store openings, we believe the current economics of our business in Europe strongly affirm our long-term strategy.”

    Management believes that Europe can ultimately support 185 Hollister stores and generate $1.25bn in sales (Asia would be incremental) and international Abercrombie & Fitch flagship stores could provide an additional $1.25bn in sales. Combined international sales in FY 2011 were $876mm, leaving a long runway for growth that investors are not paying for at today’s prices. 
     
     

    Financial summary

                             
     

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

    FYE   Jan

     

    1999  

    2000  

    2001  

    2002  

    2003  

    2004  

    2005  

    2006  

    2007  

    2008  

    2009  

    2010  

    2011  

    2012  

    Revenue

    $805  

    $1,031  

    $1,238  

    $1,365  

    $1,596  

    $1,708  

    $2,021  

    $2,768  

    $3,284  

    $3,700  

    $3,484  

    $2,929  

    $3,469  

    $4,158  

    %growth

     

    28.0%  

    20.1%  

    10.3%  

    16.9%  

    7.0%  

    18.4%  

    37.0%  

    18.6%  

    12.7%  

    (5.8%)

    (15.9%)

    18.4%  

    19.9%  

                                 

    EBIT

    $167  

    $242  

    $254  

    $271  

    $312  

    $331  

    $348  

    $578  

    $698  

    $779  

    $498  

    $104  

    $277  

    $319  

    margin

    20.7%  

    23.5%  

    20.5%  

    19.9%  

    19.6%  

    19.4%  

    17.2%  

    20.9%  

    21.3%  

    21.1%  

    14.3%  

    3.6%  

    8.0%  

    7.7%  

                                 

    EBITDA

    $188  

    $270  

    $284  

    $313  

    $388  

    $421  

    $453  

    $702  

    $844  

    $965  

    $754  

    $428  

    $506  

    $552  

    margin

    23.3%  

    26.2%  

    23.0%  

    22.9%  

    24.3%  

    24.6%  

    22.4%  

    25.4%  

    25.7%  

    26.1%  

    21.6%  

    14.6%  

    14.6%  

    13.3%  

                                 

    CapEx

    $37  

    $73  

    $153  

    $127  

    $146  

    $160  

    $185  

    $256  

    $403  

    $403  

    $368  

    $175  

    $161  

    $319  

     

     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     

    A history of high margins

    In the entire decade prior to the global economic meltdown of 2008 and 2009, ANF generated astonishingly consistent 20% EBIT margins with only 1 year below 19.5% while growing revenue at a CAGR of 18.5%.  Such results are particularly impressive for an apparel retailer, but more importantly provide comfort that the power of the brand is very much intact.  As shown in the financial summary chart, there was no margin slippage until the vicious economic turn of events in 2008.  When the economy is not in free fall, ANF should be able to recapture the majority of its past margins.  This is not the story of a broken, waning brand. 

    One more wrinkle already ironed out

    Operating margins in FY 2010  (FYE Jan 2011) represented a slight recovery to 8% over 2009’s trough 3.6%[1], however margins in 2011 subsequently declined a bit to 7.7%.  The primary cause of margin recovery derailment was a dramatic rise in cotton costs. Cotton had fluctuated between $0.60 and $0.80 per pound (occasionally lower) through the entire decade of 2000 through 2010.  However, between July of 2010 and Mar of 2011, cotton spiked from $0.84 to $2.30.  Cotton has since fallen below $1.00 per pound as of November 2011.  Management state that higher cotton costs contributed the majority of 2011’s gross margin decline of 3.2%.  If we assume that mark downs contributed 40% of the decline and cotton increases the remaining 60%, its striking to have a built-in 2% margin tailwind in a quality branded retailer trading at 3.5x EBITDA.

    Management

    Mike Jeffries is the iconoclastic CEO and COB largely credited with the creation of Abercrombie brand we know today.  Often described as obsessive, meticulous, superstitious and controlling, he embodies the style of a physique of a 25 year old despite his numerical age of 67.  Staunchly against discounting merchandise to maintain the aspiration nature of the Abercrombie brand, he has been known to raise prices in the face of recession.  To create a brand that “sizzles with sex”, he employs shirtless models as greeters to his stores and on more than one occasion has gotten in trouble with parental watchdog groups for producing catalogs deemed too racy and only hiring attractive employees.  He also intentionally doesn’t utilize one of the most valuable pieces of a retailer’s real estate, successfully breaking a cardinal rule of retailing.  Rather than use the front windows for merchandise displays, Abercrombie and Hollister cover their windows with shades to create a club like atmosphere.  Jeffries owns a substantial amount of equity in the form of 1mm shares outright and 7.84mm options with strikes generally ranging from $25-$55.  He clearly has skin in the game, however he has 10b5-1 plan that he has used to sell exercised options though he has not sold any shares since December around $50.   (For a couple of decent profiles on Jeffries see: http://www.businessweek.com/stories/2005-05-29/flip-flops-torn-jeans-and-control  and http://www.salon.com/writer/benoit_denizet_lewis/)

    Capital allocation

    I would grade management’s historical capital allocation a B- (maybe worse), however they seem to have gotten religion and are moving firmly into the A range.  Like most retailers, they have sunk capital into money losing concepts including RUEHL, abercrombie (kids) and potentially Gilly Hicks (the jury is still out on this one).  They were also too aggressive at store expansion in the US in the early 2000s, and as discussed above, they were a bit too aggressive in European expansion over the last 2 years.  Today, capital is generally spent on new A&F/Hollister stores in Europe, share buybacks and dividends.  Given the decline in share price, management is correctly most focused on share repurchases.  Over the last two years ANF has repurchased 5mm shares (6% of the company) for $273mm.  With its first quarter earnings in May, ANF authorized an additional 10mm shares brining the current authorization to 12.9mm, or 15% of the company.  CFO Jon Ramsden further articulated his thoughts on capital allocation 3/7/12 stating, “Our basic parameters on use of cash are the same. We want to maintain that trough cash cushion of around $350 million. Beyond that, we will be in the market making repurchases when we think it's opportune to do so from a market standpoint. And obviously based on our overall view of the business and market conditions, the term loan we locked into last week was basically a very inexpensive facility we've set up, which gives us flexibility if we want to go out go after buybacks more aggressively. That would really be the only reason we would dip into it.  Apparently, investor pressure is only increasing as a recent New York Post article that claims that ANF is planning a very large repurchase effort partially funded by trimming its 2012 European expansion plans and its related $400mm 2012 CapEx budget. (http://www.nypost.com/p/news/business/le_preppy_pe_yew_CYG7XhnaYYfeq4aFMwu0PN).  ANF also pays a $0.70 annual dividend, which means the stock currently yields better than 2%, which handily beats a ten year treasury. 

    Other opportunities

    ANF’s direct to consumer has tripled in the last 5 years to $552mm in FY 2011 and management believes it will grow to $1bn over time.  Not surprisingly, DTC sales are the highest margin activity at the company at over 50% operating margins.  Management has indicated that DTC sales also benefit from store closures, though they have not quantified the effect.

    Valuation

    After declining 60% from its October high of nearly $77 to its current price of $32.50, ANF has a fully diluted market cap of $2,800mm and an enterprise value of $2,510mm after backing out nearly $300mm of net cash.  Consensus EBTIDA for 2012 is $715mm providing for a very inexpensive 3.5x.  That still only represents 10% operating margins versus its long running historical 20% average.  While comps have been challenging, the company should be able to achieve its targeted 2.5% margin increase over 2011 with the tailwinds of cotton price declines, accretive store closures, and previously opened European stores ramping up.  Share repurchases will also be very accretive to value though not margins.  While CapEx has averaged $285mm over the last 5 years due to store builds and DTC investments, CFO Jon Ramsden estimates maintenance CapEx runs below $100mm implying  TEV/EBITDA-maint capex of 4x and after tax adjusted free cash flow of $385mm for a 6.5x multiple. Management’s most recent 2012 EPS guidance of $3.50 to $3.75 implies 8x backing out $3.40/share in net cash.  By any metric ANF is cheap. Over time, margins should trend back toward 20% and, if management is ballpark accurate with its long term European store estimates, it is possible to envision over $7bn in total company sales and $1.75bn in EBITDA.  While this is simply an illustration of potential earnings power rather than an estimate, investors need not believe in such lofty targets to make money at current prices.

     



    [1] Excluding an $85mm non cash impairment charge for exiting the RUEHL concept operating margins would have been 6.5%



    [1] For anecdotal evidence of retailing Euro-fear in retail look to watch and accessories company Fossil.  On May 8 FOSL announced a less than stellar first quarter due to a soft European environment. Not only did Fossil lose 40% of its market cap that day, but it also sparked a panic sell off across all European exposed retailers (http://articles.marketwatch.com/2012-05-08/industries/31620274_1_asia-warnaco-group-sales).  I have no opinion on FOSL’s stock, but I view the reaction to its Q1 as the metaphorical bath plug being pulled with ANF playing the role of baby in the bathwater.  Note that Fossil’s business is larger outside of the US than domestically, with Europe comprising 35% of its wholesale business.  It was also trading at a lofty 13.6x EBITDA and 23.6x P/E versus ANF’s modest multiples.     

     

    Catalyst

    Messages


    SubjectMaturity Curve, New Entrants
    Entry07/13/2012 01:46 PM
    Memberruby831
    1) Any thoughts on the maturity curve for European stores? I think this has been a crucial point to consider given you wouldn't pay a high multiple for earnings coming from new stores which decline substantially in year 3 and thereafter following the first 1-2 year 'pop'
    2) Looking back on ANF's golden years, ANF didn't have as much competition from J Crew (which I think is more a threat than it was back in mid 2000s) and AEO, which no longer looks like ANF's stepsister. In Europe, ANF faces the new guys Superdry, TopShop which have been very successful (at someone's expense). Is there room for ANF to thrive as it had in the US?
     
    The bear case says a) if they need $350mm in cash to run the business, then your EV calculation should exclude or discount it since shareholders aren't going to see it ever, b) give ANF a low multiple on euro stores since sales from new stores are overstated relative to 'normalized' sales/store, and c) ANF doesn't do well in a promotional environment, which is likely to continue for quite some time as competitors fight for customer loyalty.
     
    I think the stock is cheap, too, but you have to really believe management has learned when a consumer market is saturated and has learned the real life-cycle economics of new stores. As you note, they have made a number of errors in the past by being far too aggressive with their business model assumptions - most recently, lowering EPS guidance significantly more than once within a year while spending tons to open stores they assumed would remain stronger for longer. I want to believe all the bad news is priced in - but one could have thought that when the stock went from $80 to $50, even though it took yet another leg down from $50 to $30. Do you have data (quantitative or qualitative) to help support the argument the brand isn't dead (I assume we could just look at AEO, but ANF value is in Europe too), and that management has a better understanding of new stores' maturity curve and life-cycle economics?
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