The Case for Optimism at Abercrombie
Shawn is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Anyone who has shopped at Abercrombie & Fitch (NYSE: ANF), the well known maker of specialty apparel, knows the company has a knack for receiving premium pricing on clothes that are remarkably similar to their direct competitors. This pricing power can be seen in the company’s gross margins, or the difference between total sales and the cost of the products, which are in their own stratosphere compared to their direct competitors, American Eagle (NYSE: AEO), and Aeropostale (NYSE: ARO).
Consistently higher than average gross margins is a positive characteristic when looking to invest in a company as it demonstrates a competitive advantage inherent in their business model. It becomes problematic, however, when the consistently higher margins become not so consistent, as analysts, money managers and other wall street professionals find it difficult to adjust when assumptions change. Higher than expected price discounting and higher input costs has translated into a decline of 30% in ANF’s shares since its high in October, including a recent pre-earnings announcement this past Thursday that sent shares down 13%.
Investors have reasons to be optimistic and could find ANF’s shares undervalued at current prices. Gross margins indeed have been under pressure over the past few quarters but have been generally resilient since 2004. Any uptick in economic performance could reduce the pricing pressure that the company is experiencing.
Input costs, particularly cotton, have also declined significantly since reaching their high this past spring. High cotton costs have affected margins because the company was required to purchase the commodity in preparation for the fall/winter season when it was at its all-time high. The company should begin to realize lower input costs as their seasonal apparel purchased during the spring is sold and replaced with new apparel manufactured with cotton at much lower prices.
Gross margin pressure has received the most attention recently, but operating costs conveniently have significant room for improvement. The rise in operating costs (Store and Distribution Expense plus Marketing, General and Administration) since 2008 (see chart below) have mostly been the result of non-standard issues such as expenses associated with the closure of the failed RUEHL brand, minimum wage increases and increased spending to expand their headquarters.
Oh and there was the gem found in the 2010 proxy statement that the company paid $4 million to CEO Michael Jeffries for compensation to not use the company’s private jet for personal use. Besides not providing Mr. Jeffries compensation for not using a corporately owned item, the company must figure out ways to reduce operating costs to pre-2008 levels. The company could slow down expansion of new stores, leverage their scale to renegotiate store rent, slow down short-term compensation, or even cut down on the amount of cologne sprayed outside the stores as patrons walk by (this is somewhat in jest, but seriously you can smell the cologne as you walk by ... it can’t be cheap.) If ANF could revert back to historical operating levels, the company could reduce annualized costs by about $50 million, or roughly $0.60 per share.
Investors shouldn’t expect any positive news when Abercrombie releases earnings on Feb. 13 given ANF’s most recent dismal pre-earnings announcement. But investors who have the patience to last through ANF’s seasonally slower quarters could be in for better times in the second half of this year if the company can keep costs under control.
Here are some links (positive and negative calls) from fellow Fool.com blog writers regarding ANF:
http://beta.fool.com/dividendkings/2012/01/23/abercrombie-risky-stock-has-terrible-earnings-pros/1111/
http://beta.fool.com/vatalyst/2012/01/23/5-likely-apparel-buyout-targets/1159/
http://beta.fool.com/iumfool/2012/01/26/6-potential-takeover-targets-2012/1251/
Finally, I will be placing this pick as a “outperform” in my CAPS index, given Fool.com’s co-founder David Gardner’s CAPScall described here.
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The Motley Fool owns shares of Aeropostale and has the following options: long JAN 2014 $10.00 calls on Aeropostale, long JAN 2014 $15.00 calls on Aeropostale and long JAN 2014 $20.00 calls on Aeropostale. ShawnRobinson has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
