A&F: Most of the Negatives Already Priced In
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Abercrombie & Fitch’s (NYSE: ANF) shares touched its 52-week low of $31.27 after a disappointing first quarter and the shares have only begun to bounce back. In the first quarter though the company posted a 10% increase in revenue backed by 42% international sales rise and higher than expected EPS ($0.03). But declining same store sales causes the major concern. US same-store sales grew 4%, but the weakness abroad contributed to an aggregated same-store sales decline of 5%.
Since the end of October, the company's share price has dropped from a high of $78.25 to its current price of just around $36. As per the company’s 2012 guidance, the firm expects to earn $3.50-$3.75 per share, implying that the shares are trading at just less than 10x current year’s expected earnings. We find this valuation attractive as the stock prices have a solid upside potential due to the following reasons.
Closing unproductive units a welcome move: ANF has identified 180 stores, or 19% of the US fleet of 942, to be closed over the next few years. Abercrombie and its child company Hollister are essentially saturated in the U.S. market. Thus, the plan to close unproductive stores that have come under pressure from cheaper fast-fashion competitors is a welcome move. The company has a large store base and closing unproductive stores will certainly help the bottom line.
Success with direct to consumer platform: ANF has experienced robust sales growth in DTC, registering nine successive quarters of over 25% growth. ANF, with its portfolio of brands including Abercrombie & Fitch, Hollister Co, Abercrombie kids and Gilly Hicks, is growing its e-commerce and cross-channel operation dramatically in the coming years. ANF is working with IBM to transform its online business across all its brands and continues to work to increase efficiency in the international DTC business. The company is now able to fulfill European DTC orders from its distribution center in the Netherlands, and is already shipping to over 100 countries. The DTC model should continue to be important for both domestic and international operations as the business has higher margins than brick and mortar stores.
Problems more macro than micro: We believe the problems the company is facing are driven more by macroeconomic environment than microeconomic issues. Economic slowdown in Europe and slowing growth in Asia (especially China) has affected ANF a great deal due to its large presence in these markets. But not just ANF, its peer group of Fossil Inc (NASDAQ: FOSL), Warnaco Group Inc (NYSE: WRC) and Deckers Outdoor Corp (NASDAQ: DECK) have also struggled with unfavorable macro trends and posted declining same store sales trends in Europe. However, its biggest competitor, American Eagle Outfitters Inc. (NYSE: AEO), benefited from having less risky franchised stores and less exposure to weak European market.
On the positive side, new international store volumes and margins still meet company expectations. Also, the international internet business posted 40% Q1 growth. Thus, we think ANF’s brands still have relevance. When the economic activity in Europe and Asia accelerates, we think Abercrombie & Fitch will benefit tremendously.
Strong balance sheet: ANF ended 1Q12 with $360 million in cash, cash equivalents and marketable securities, representing $4.17 per share or approximately 13% of its market cap. We expect ANF will continue to generate strong free cash flow. In addition, the management has indicated a willingness to turn to slower store growth if the international environment remains challenging. This will result in lower capex spending, yielding improved free cash flow generation and allowing excess cash to be distributed to share holders by share repurchases and dividends.
Going into the remainder of the year, ANF is planning inventory levels based on a negative mid-single-digit SSS assumption through the end of the year. We believe the spike in 1Q12 inventory has been fully discounted in ANF share price and moderating inventory levels over the balance of the year may prove to be a potential catalyst. With ANF’s shifted focus to manage the business to incorporate a significant same store sales decline both internationally as well as within its US tourist store fleet, we see the risk of an earnings miss significantly mitigated. Also, despite macro concerns, international markets continue to represent a strong and profitable growth opportunity for the company in the long term. Thus, we recommend it a buy.
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