|Shares Out. (in M):||69||P/E||17.5||14.0|
|Market Cap (in $M):||1,360||P/FCF||0||0|
|Net Debt (in $M):||-224||EBIT||126||150|
We are long Abercrombie & Fitch (NYSE: ANF, “A&F” or “the Company”), which is a mall-based specialty retailer that operates under the Hollister (60% of sales) and Abercrombie (40% of sales) brands. For additional information, please refer to mack885’s helpful write-up from 2012. Today, A&F has 879 stores globally (547 Hollister and 332 Abercrombie), of which 684 or 78% are in the U.S. and 195 or 22% are international (mostly in Europe, followed by Asia, Canada and the Middle East). The Company’s U.S. store count peaked at 1,082 in 2008 and is currently 684, a 37% decline as management has closed unprofitable stores.
The above article does a good job explaining the transformation A&F has gone through in the past few years. Despite bears insisting that the Company’s turnaround has not worked and the stock is broken, A&F has performed relatively well recently. To summarize the article, Abercrombie is now targeting 21-24 year olds, vs. teens previously, which is the demographic Hollister targets (Hollister has had fewer issues than Abercrombie and has comped better). Mike Jeffries, the Company’s infamous CEO from 1993 to 2014, damaged the Abercrombie brand through his numerous racist and discriminatory comments and actions. With him gone, A&F has slowly begun to repair its image and now employs a much more diverse workforce and has advertisements that represent a broad range of ethnicities (vs. predominantly Caucasians during Jeffries’ tenure). The clothing has also changed, and now features fewer ripped/hole designs and is less revealing and more conservative and tasteful.
Having shopped at Abercrombie on and off for over 15 years, I’ve observed first-hand the positive changes the brand has gone through. When I was a teenager the clothing was expensive (but good quality) and very fashionable for preppy teenagers (i.e. the jocks), and the store demographic was mostly whites (and I grew up in a very diverse city so this is saying something). Over the last few years, I’ve observed that while the clothing has gotten cheaper, it remains high quality and fashionable (not just to teenagers but also to people in their 20s, and I’ve even witnessed people in their 30s and 40s shopping at the store). In addition, I’ve noticed that the demographic of shoppers has shifted towards a much more diverse set of ethnicities. As a result, I think it’s hugely positive for the Abercrombie brand that it’s diversified away from selling primarily to teenagers (which are a fickle demographic, so greater fashion risk) and now sells to a larger population set, which should help increase traffic going forward. I’ve also noticed that most times I go to the store there is some sort of promotion going on, which is somewhat impressive given despite all these promotions the Company is still able to generate 60% gross margins. Once the brand continues to recover, I think it’s possible the promotions lessen either in magnitude and/or frequency (although they won’t go away entirely as the sector will still likely remain highly competitive), resulting in a potential opportunity for gross margins to expand as a result.
Our bullish view is in part driven by the Company’s recent SSS performance. A&F’s most recent quarter (Q3 2018) marked the fifth consecutive quarter of positive comps. Q3 2018 comped 3% on top of 4% the prior year. The 3% comp in Q3 2018 was driven by 4% at Hollister and 1% at Abercrombie. The U.S. in particular was very strong with a 6% comp, offset by the -3% international comp which continues to be a headwind. Annual historical comps for the entire Company are as follows: +3% in 2017, -5% in 2016, -3% in 2015, -8% in 2014, and -11% in 2013. With several years of negative comps, it’s not surprising a lot of investors got fed up with the stock and abandoned it. However, recent positive comps are encouraging, especially in the context of the broader retail environment in which several competitors continue to experience negative comps.
While we think it’s positive that company-wide SSS has recently been positive, it’s helpful to frame the current performance of the Company relative to its historical performance:
· Sales: Currently $3.6bn and peaked at $4.5bn in 2012. Analysts forecast $3.6bn in 2019E and $3.7bn in 2020E, reflecting low growth expectations
· Sales/sq ft: Currently ~$360, peaked at $503 in 2007, bottomed at $339 in 2009. Since Mike Jeffries’ departure, part of the turnaround strategy has been to lower prices and offer more frequent promotions, which we think has been necessary to regain traffic, but which has lowered sales/sq ft. While we don’t think sales/sq ft gets back to $500 any time soon, we believe there’s more upside to this metric than downside, as once the turnaround strategy stabilizes, management may reduce the frequency and/or magnitude of promotions, which could increase the average order value and thereby sales/sq ft
· Online sales: $974mm in 2017 (28% of total sales), compared to $700mm in 2012 (16% of total sales) and $260mm in 2007 (7% of total sales). The Company has done a nice job of expanding its online business, and nearly a third of sales coming from direct-to-consumer is a healthy mix which is likely to continue to increase. We like that unlike other retailers like HIBB, ANF is not struggling to increase its online presence (2/3 of the online sales are coming from mobile which is positive)
· Gross margin: Currently 60% (lowest in past 15 years), peaked at 67% in 2007. Analysts forecast GM remaining flat at 60% in 2019E and 2020E. Cotton prices are down over 10% in the last few months, which could provide a short-term boost to gross margins. Longer term, if promotions reduce in frequency and size, gross margins could increase.
· SG&A: In the mid 2000s, annual SG&A was $1.3bn (47% of sales). As the Company’s store base expanded, SG&A climbed to a peak of $2.4bn (54% of sales) in 2012. Since 2012, SG&A has declined to $2.0bn LTM but has increased as a percentage of sales from 54% in 2012 to 56% LTM as the Company’s sales declined from $4.5bn in 2012 to $3.6bn LTM. As a result, SG&A as a percentage of sales has increased from 47% in 2005 to 56% LTM, a 9% absolute difference, explaining much of the Company’s margin erosion over the past several years
· EBITDA margin: Currently 9%, peaked at 26% in 2007 and bottomed at 6% in 2016. Analysts forecast 8% in 2019E and 7% in 2020E, reflecting expectation for margin compression
As a result, despite the Company’s recent strong performance, the Company’s profitability is still well below historical levels based on several metrics, which we believe represents upside for the stock.
A&F screens cheap on both an absolute and relative EBITDA basis (the Company currently trades at 3.4x LTM EBITDA, which is ~35% below A&F’s 10-year average trading multiple). The stock screens expensive on an absolute P/E basis but cheap relative to its historical average multiple (currently trading at 27.6x LTM P/E, which is 48% below the 10-year average multiple). While bears will argue the Company is expensive on a P/E basis, we don’t think P/E is an appropriate metric given over the last five years, A&F’s net income margin has ranged between 0% and 2%, and therefore the P/E multiple appears overly inflated off of a small net income. Backing out the Company’s LTM legal expenses of $6.6mm (hopefully non-recurring) and asset write-downs of $14.4mm (non-cash), LTM net income would increase from $52mm (27.6x LTM P/E) to $73mm (19.6x LTM P/E), which we think is a more reasonable multiple, although still inflated due to the low margin.
We therefore believe EBITDA and FCF are better metrics on which to value the Company. A&F is currently trading at 3.7x 2019E EBITDA / 17.5x 2019E P/E and 4.2x 2020E EBITDA / 14.0x 2020E P/E. In addition, the Company is trading at a 16% levered LTM FCF yield, which we view as attractive both on an absolute basis and relative to comps (American Eagle and Urban Outfitters trade at an 8% levered LTM FCF yield, BKE trades at an 11% yield, and Gap trades at a 6% yield). Furthermore, all of these comps trade above 5x forward EBITDA vs. just ~4x for A&F. Granted, some of these peers are larger and higher margin than A&F and therefore should trade at a premium, however we do not think some of the peers trading at double A&F’s FCF multiple is warranted. For example, BKE is a comp that has performed significantly worse (SSS of -14% in 2016 and -7% in 2017) yet trades at an 11% LTM FCF yield vs. 16% for A&F.
Our model has sales growing 2% annually in 2019E and 2020E (3% SSS offset by 1% net store closures) to $3.8bn in 2020E (vs. consensus of $3.7bn) and 30 bps of EBITDA margin expansion from 2018E to 2020E, resulting in 2020E EBITDA of $370mm (vs. consensus of $260mm, low in part due to the consensus assumption of 200 bps EBITDA margin compression which we think is overly punitive). Based on $145-150mm of annual capex, we project levered 2020E FCF of $233mm, which at a 10x multiple (i.e. 10% yield) would value the equity at $2.3bn at the end of 2020, representing a 12/31/2020 target share price of $33.70 and 70% upside. Including our cumulative projected $456mm of levered FCF generated in 2019E-2020E would add $6.61 of value per share, for total value per share at 12/31/2020 of $40.30, representing 104% upside and a 43% IRR. Our 10x FCF valuation implies an LTM EBITDA multiple (at 12/31/2020) of 4.4x, which we think is conservative. Bears may counter that while A&F currently trades at a 16% LTM levered FCF yield, to the extent consensus projects EBITDA to decline, then the forward levered FCF yield is probably more like 10% (i.e. a 10x multiple), and therefore the stock is not cheap. Our higher valuation is therefore not based on assigning A&F a higher multiple but rather on our projections, which are much higher than consensus.
The Company’s net cash position and strong FCF generation mitigates risk. A&F has $296mm of debt (~1x leverage) and $521mm of cash, representing a $224mm net cash position. While we think management is being overly conservative with their cash holdings, we would rather see a retailer be in a large net cash position than having too much debt, especially given the Company has $1.5bn of total future lease obligations, of which ~$360mm are due in under a year.
In addition, A&F generated $212mm of LTM levered FCF, of which $15mm was used to pay down debt, $69mm was used to buyback stock, and $54mm was used for dividends. The stock is currently trading at a 16% levered LTM FCF yield and we think management is allocating capital in shareholder friendly ways.
The fact that the Company only has 5% of its total store base (i.e. 48 stores) in Asia (of which just ~3% are in China) also mitigates risk to the extent there is a prolonged slowdown in Asia.
Continued positive comps
Continued strong growth of higher-margin online sales could increase overall company margin
Lower cotton prices (down >10% in last few months) could boost margins in the short-term
Net cash position and strong FCF generation could result in management increasing the dividend (4% yield currently) and/or announcing a large buyback
|Subject||I doubt they will be able to pull back in promotions|
|Entry||01/04/2019 12:58 PM|
I am hard pressed to think of any specialty mall-based retailer that has been able to pull back on promotions sustainably in the last 10 years. Can you name some?
Also, while your sales projections seem conservative in that they are low single digit and assume they never get back to peak productivity, I don't think lsd growth is a lay up here. First on comps, they are mostly in malls which have low to mid single digit negative traffic, almost no one in the mall is not experiencing negative transactions. They can somewhat offset this with online growth, but online has a much higher return rate, and may be dilutive to margins. Do you have any sense of what their capacity is in online...would growth in that area eventually require more investment (and reduce cash flow) or do they have tons of capacity? Beyond the traffic overhang, if they can't reduce promotions, they won't be able to get unit pricing up either. So they will be dependent on share gains and/or basket size. Plus if consumer spending goes down, the hurdles to event 1-2% growth just become larger - pie gets smaller, traffic goes down, promotions even less likely to go down...it all comes down to taking sustainable share. Comparing themselves to their past is largely irrelevant, because the second they abandoned their previous positioning of accessible luxury that almost never went on sale, they gave up hope of ever getting back to their prior sales/sqf productivity and margins. I don't think you are suggesting they can ever get back there - but you are showing them as a sign there is room for margin growth. I think it is apples and oranges.
I agree the FCF yield is compelling, but I am seeing that yield several places in the consumer space - with better topline prospects. I am wary of betting on margin expansion because of my view on promotions as a secular trend, and I can't get to numbers over the street's.
I am intrigued though by the yield though as well as the fact they effectively increased their TAM by not being racist jerks and getting rid of Jeffries. If they would only walk down the road and enlighten the folks at Victoria's Secret....who would greatly benefit from a similar moment of wokeness ;)
|Subject||Re: I doubt they will be able to pull back in promotions|
|Entry||01/04/2019 03:51 PM|
Thanks for your thoughtful response.
As evidence by the ratings, this is clearly a contrarian idea and there are a lot of bears out there. To the extent my thesis plays out as I think it will (definitely far from certain), given the number of bears out there I think the stock has a lot of upside, especially if the turnaround strategy works well enough to get the Company’s multiple re-rated towards the rest of the comp set (i.e. ~5x EBITDA and 8-10% levered FCF yield (10-12.5x levered FCF multiple).
Unlike the tags suggest, I don’t think this is a dying business and believe that under reasonable assumptions ANF can maintain its current earnings level if not grow it slightly in the coming years. This means generating normalized EBITDA over $300mm and normalized levered FCF over $200mm to your question agape.
While bears are often overly focused on the Abercrombie brand's performance, it's worth mentioning that over the past several years Hollister, which has more sales than Abercrombie, has actually performed reasonably well and better than Abercrombie. In the first 9 months of 2018, Hollister comped 4% and Abercrombie comped 2%. In 2017, Hollister comped 8% and Abercrombie comped -2%. In 2016, Hollister comped 0% and Abercrombie comped -11%. In 2015, Hollister comped 0% and Abercrombie comped -6%. As a result of this performance, the sales mix has shifted towards Hollister, with Hollister currently 60% of total sales versus 53% in 2015. Hollister's brand has not been damaged as much as Abercrombie's brand. Since 2015, in a tough retail environment Hollister has managed to comp positively or flatly in every year, while Abercrombie has just recently started to comp positively. We therefore think the market is not ascribing enough value to the Hollister brand, which has performed reasonably well, or the Abercrombie brand, for which the market seems to be pricing in a deteroriation of SSS performance and does not think the brand's recent positive comps will last.
As far as malls, we agree the macro for malls is not great, however it’s also not as bad as some make it out to be. For example, the below CNBC article notes that the 2018 Black Friday and Thanksgiving retail foot traffic dropped just 1% y-o-y. This is hardly an exponential decline (granted it's just one data point). Although online shopping is likely to continue to gain share from brick and mortar, I believe mall traffic's foot traffic decline is potentially decelerating and could flatten over time once the tier C-D mall locations shut down and the tier A-B locations are left. An analog would be how once e-books came out, within a few years they were taking less and less share from physical books which have shown they will always have a place in the market, to the point where in the last few years the e-book/physical share has actually stabilized and e-books are no longer taking share from physical books.
Tier A-B malls continue to perform reasonably well, while tier C-D malls are struggling. It would be an interesting analysis to categorize ANF’s U.S. store base by mall tier to see which types of malls the Company has the most exposure to. It’s also important not to just focus on mall traffic, which while a very important metric needs to be taken in context with other metrics like the intent to buy (i.e. % of mall shoppers who make a purchase) which is higher today than it was 10 years ago. Declining mall traffic would clearly be a larger issue for the Company if it didn’t have a strong online business, which it does with nearly a third of sales coming from online. Importantly, ANF continues to invest in the online business. Management has guided towards $145mm of total capex in 2018, of which $90mm is for new stores and remodels and $55mm is for the continued rollout of omnichannel and CRM capabilities, including investments in the Company’s loyalty programs (which are doing very well), IT and other investments. My FCF projections assume management continues to spend $55-60mm on these efforts, which are important. To your point regarding margins, I’ve assumed online has higher margins than retail, but I actually don’t know that for a fact given the Company does not disclose the margin split (certainly a higher return rate for online would hurt margins).
All this said, I think ANF (in particular the Abercrombie brand) can gain modest share over the coming years as the brand’s reputation and image continue to recover, which, combined with your point that the effective TAM has been increased due to the brands now appealing to a wider age range and demographic base, should help drive SSS growth. Unlike other mall-based retailers like BKE which I think are structurally losing share, ANF’s clothes remain in fashion and are high quality at a reasonable price and as a result I think the Abercrombie brand in particular can start to gain modest share.
As far as the promotions go, in the past few years I have visited Abercrombie stores several times and almost every time there was a significant promotion going on that allowed me to purchase clothing for 50-75% off. And it’s not like I bought weird off-market items, the items I bought were nice and "normal". Being able to buy regular items for >50% off seems like a strong promotion and is one I have frequently encountered at Abercrombie, although perhaps it’s because I usually happen to visit Abercrombie during the summer months or over Thanksgiving/Christmas when I imagine they have their best promotions. And perhaps the magnitude of these promotions is not uncommon for mall-based retailers. While it’s not part of my base case, an upside case could include the ANF promotions either reducing in frequency or in magnitude (even going from offering ~50% discounts to ~40% discounts could boost earnings). My base case assumes only 30 bps of EBITDA margin expansion in the next two years, so my thesis is not fundamentally based on meaningful margin expansion, which in my view is more of an upside case.
I believe the 16% FCF yield is attractive, while recognizing that one could argue that the “true” yield based on dividends and buybacks alone is closer to 9%. Bailey, would you mind sharing where else in the consumer space you are finding ~16% yields with better topline prospects? That would be helpful.
Ultimately this is not a low risk buy and I wouldn’t recommend making it a large percentage of one’s portfolio. That said, I think the risk reward is attractive at the current price.