Laggard Retail Stock More Attractive Than 2 Expensive Peers
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Poor job figures compounded with intense price competition has put the clothing industry under a bit of pressure. At the same time, investors have still pushed stocks like American Eagle Outfitters (NYSE: AEO), Gap (NYSE: GPS), and Abercrombie & Fitch (NYSE: ANF) to abnormally high multiples. In my view, now is a compelling opportunity to sell American Eagle and Gap as the market moves towards higher-risk producers, like A&F. Over the last six months, American Eagle and Gap have appreciated to stratospheric levels - rising 41.5% and 37.3%, respectively. During the same time period, A&F has lost more than a quarter of its value.
While American Eagle trades at a respective 24.3x and 15.5x past and forward earnings, the corresponding figures for Gap are 19.7x and 14.7x - not much lower. In my view, American Eagle merits this premium due to a strong balance sheet with no long-term debt and a current ratio of 3.5. In addition, American Eagle is less volatile and offers a ~50-bps greater dividend yield at 1.9%.
However, both are at too much of a premium to the market at large. The S&P 500 currently trades at 16.6x past earnings, which is at also at a slight premium to the historical 15.5x mean. The key to the firm's justifying their expensive price tag will come from strong returns during a full recovery. At the current moment, consumers have uncertain incomes that they don't want to spend. But brands, like American Eagle, will likely resonate under an attitude interested in lifestyle clothing. By contrast, mall traffic has been weak for A&F.
To address business woes, A&F has brought in Goldman Sachs for advisory. While analyst Hedgeye floated the idea that shareholder activism could move the stock, the reality is that A&F is too risky. Why would an investor launch an expensive proxy contest for board control if there is a little margin of safety? On the other hand, it does have a low forward multiple that stems from strong future growth forecasts.
Indeed, analysts anticipate A&F to grow EPS by 18.3% annually over the next 5 years. This implies 2016 EPS of around $5.13. At a 15x multiple, this translates to a future stock value of $76.95. Discounting backwards by 10% yields a present value of $47.78. However, the stock has yielded low single-digit ROA, ROE, and ROI while failing to meet investor optimism. Should the company fall short on expectations (not unlikely given the high bar that has been set), the stock will fall even more. Even still, debt is low and management is taking the appropriate steps to cut costs and grow margins. As a result, I believe that the downside is more limited against the upside and that this will induce investor entry around the full recovery. American Eagle and Gap have already delivered impressive fundamentals - these stocks are more ideal during macro uncertainty and less ideal during bull runs. That is because investors tend to prefer riskier assets during recoveries.
Moreover, as much as market commentators says American Eagle is safe, the company has merely performed in-line with expectations during the last two quarters. The other three featured 1 in-line report, 1 beating expectations by 2.9% and 1 missing expectations by 9.1%. During the same time period, shareholder value has gone up dramatically. A&F, however, has beaten expectations in 3 of the last 5 quarters by an average of 12.1%. As this demonstrates, the perception can be very different from the reality.
All things considered, it is an attractive time to buy retail stocks from forecasts of greater retail holiday traffic for the first time since 2007. ShopperTrak is anticipating domestic retail sales to rise 3.3% y-o-y, which is strong enough to merit some exposure. I would steer away from investing in American Eagle and Gap so that more of your portfolio could be locked up into "surprise earnings" stocks, like A&F.
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