Abercrombie and Fitch: An Attractively Valued Stock For The Long Term
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Recently, Abercrombie and Fitch (NYSE: ANF) reported 2Q12 results and provided guidance. The results were mostly in line with its preannouncement two weeks ago. However, we are encouraged by the increased buyback authorization and a slight improvement in same store sales (SSS) trends in August. The management is cautious and will not be making aggressive use of the large buyback authorization until business stabilizes and free cash flow improves. After hitting a 52-week low earlier this month a recovery in stock prices was expected (See: Abercrombie & Fitch: Most of the negatives are already priced in) and the stock prices have reacted positively to the recent announcements.
Going forward, we expect European SSS to remain negative, but show some improvement as the slower unit expansion lowers cannibalization and compares get easier. There is less visibility into the U.S. improvement as it is more a merchandising issue which takes longer to fix; initiatives include a new loyalty program, speeding up product development, better inventory planning & allocation, customer research, etc.
Something to cheer about
The second quarter brought a gale of negativity as slowing demand worldwide pressured sales. Too much inventory hindered company’s ability to look for best sellers as it sold down heavy inventory. However, we are now seeing some improvements in the inventory levels. Inventory at the end of Q2 was up 20%, ahead of LSD-MSD sales growth estimates for Q3 but much improved from Q1's up 44%. Thus, inventory levels are coming down and more flexibility in mix should improve into 4Q. Stabilized cotton prices will improve IMU and help restore more normalized average retail selling prices. Thus, we expect to see improvement in 3Q earnings, accelerating into 4Q given very easy year ago comparisons. Moreover, new stores should contribute about $450 million in sales in FY13.
New 10 million Share Buyback Authorization
Despite a more difficult top-line environment, the company increased the share repurchase authorization by an incremental 10 million shares resulting in a net of 22.9 million shares authorized for repurchase. Although the company did not repurchase shares in Q2, we believe the company can begin to repurchase shares as early as 4Q given material free cash flow gains from lower inventory in 2HFY13 and reduced capital expenditure needs in FY14. We believe the share repurchase will provide a slight EPS upside in Q4 and a significant upside in FY14. If we assume a 5 million reduction in share count for FY14, FY14 EPS will be seeing a ~$0.20 upside.
Hong Kong off to a great start
Abercrombie & Fitch’s new Hong Kong flagship has generated $1million in sales in its first 5 days. The Hollister Festival Walk store is one of company’s best-performing international stores. Moreover, Abercrombie & Fitch flagships are planned for Seoul in spring 2013 and Shanghai in fall 2013. The management remains focused on driving brand awareness in China and believes that the Abercrombie & Fitch’s Hong Kong flagship store will help accomplish this goal. Also, the Abercrombie & Fitch flagship in Singapore is performing solidly.
The company is trading at a forward P/E of 11.2 which is at a 21-25% discount to American Eagle Outfitters Inc (NYSE: AEO) and Gap Inc (NYSE: GPS). Though it deserves to be trading at a significant discount to Gap, given Gap’s strong SSS momentum and better inventory management, but a 21% discount to American Eagle looks somewhat exaggerated. While Abercrombie & Fitch is struggling this year but it has a better expected EPS growth of 23.5% in FY14 as compared to American Eagle’s 12.1%.
The company still faces a lot of challenges including hazy macroeconomic outlook, cannibalization in Europe and lower operating margins due to diminished brand appeal. However, in long term we believe improved domestic productivity (enhanced by the continued closings of underperforming stores), increased international sales due to store openings, declining sourcing cost pressures, growth in the direct channel and share repurchasing will pay off with increased sales and improved earnings; making it a good long term investment.
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