NYSE: ANF
Abercrombie & Fitch Co.
08 August 2007
Investment Thesis
Abercrombie & Fitch is a leading specialty
retailer for both teens and young adults with
recognized brands such as Hollister and the original
Abercrombie & Fitch. Traditionally strong growth
potential coupled with high margins give ANF a
significant advantage over other specialty retailers,
but soft retail sales have resulted in a current price
that underestimate the profitability of the firm. A
new inventory management system will incite profits
for the upcoming fiscal year ahead of consensus
estimates.
Summary
Abercrombie & Fitch has an intrinsic value of
$94 dollars resulting from the following drivers:
•
•
•
•
•
•
Improved sales, margins, and inventory
turnover due to new inventory management
system
Historically high margins
Continued sales growth in Hollister,
abercrombie, and RUEHL brands
Ability to moderate corporate expenses during
slow growth periods
Favorable employment figures and interest
rates will negate generally slow economic
growth
Encouraging international expansion
Analyst:
Fund
Fund Mgr:
Adam Robertson
Bus Fin 824
Royce West
Fisher College of Business
The Ohio State University
Robertson.225@osu.edu
Stock Recommendation:
BUY
Sector: Consumer Discretionary
Industry: Specialty Retail
Current Price:
Price Target:
Market Cap:
Outstanding Shares:
52 Week High:
52 Week Low:
YTD Return:
Dividend Yield:
$72.22
$94.00
$7,178m
92.3m
$84.92
$49.98
27.6%
. 96%
Abercrombie & Fitch (ANF)
8 August 2007
Company Overview1
Abercrombie & Fitch Co. (“A&F”), incorporated in Delaware in 1996, is a specialty
retailer that operates stores selling casual apparel, such as knit shirts, graphic t-shirts, jeans,
woven shirts and personal care and other accessories for men, women and kids under the
Abercrombie & Fitch, abercrombie, Hollister and RUEHL brands. As of May 2007, the Ohio
based company operated 964 stores in the United States, Canada, and England.
The Abercrombie & Fitch brand was established in 1892 and became well known as a
supplier of rugged, high-quality outdoor gear. Famous for outfitting the safaris of Teddy
Roosevelt and Ernest Hemingway and the expeditions of Admiral Byrd to the North and South
Poles, Abercrombie & Fitch goods were renowned for their durability and dependability. In
1992, a new management team began repositioning Abercrombie & Fitch as a fashion-oriented
casual apparel business directed at 18 to 22 year-old male and female college students with a
product assortment reflecting a youthful lifestyle based upon an East Coast heritage and Ivy
League traditions. In reestablishing the Abercrombie & Fitch brand, the Company’s goal was to
combine its historical reputation for high quality with a new emphasis on casual American style
and youthfulness.
In 1998, the Company launched abercrombie, a brand directed at 7 to 14 year-old boys and
girls, based on the traditions of Abercrombie & Fitch. The Company launched its next brand,
Hollister, in 2000. Hollister is a West Coast oriented lifestyle brand targeted at 14 to 18 year-old
high school aged guys and girls that embodies the laid-back California surf lifestyle. The RUEHL
brand, targeted at 22 to 35 year-old men and women, was launched in 2004. RUEHL’s product
assortment is a mix of casual sportswear and trendy fashion created to appeal to the modernminded, post-college customer.
The Company’s strong brands are undeniably the driver behind its success. Abercrombie
& Fitch Co. has solidified itself as a fashion leader within its target market, relying heavily on
brand reputation for continued growth and profitability. Fashion is a highly cyclical market that
changes market leaders frequently, but A&F has managed to maintain a position as an industry
leader. It will be A&F’s ability to dictate style and fashion coupled with improved distribution
and logistics that will dictate the Company’s success in years to come.
The corporate headquarters, located in New Albany, Ohio, has a unique culture to say the
least. The office more closely resembles the seasonally distributed A&F catalogs than a place of
business. With a distinctly young, hip workforce, A&F undeniably exhibits the fashion and
lifestyle it markets. Clearly, this corporate mentality has helped in the creation and development
of their popular brands.
1
Adapted from 2006 Abercrombie & Fitch Co. 10-k
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Abercrombie & Fitch (ANF)
8 August 2007
Industry Analysis
Industry Characteristics
Specialty retail has matured in recent years to a stable industry with several large players
leading most fashion trends. The changes in market leaders are typically due to the constantly
changing fashion trends, and it is a firm’s ability to create and dictate popular fashion that will
determine sustained success. Many of the top retailers find themselves constantly creating new
brands and reinventing their image in order to drive top line growth in this highly competitive
industry.
Cyclicality
In terms of the business cycle, retail stocks perform well during times of recovery, and
they continue to outperform as the economy booms. Conversely, retail does tend to
underperform as the economy slows. As shown in the graph below, annual change in retail sales
is quite indicative of the well-being of the entire economy, most notably in the 1999 prosperity
followed by the recession in 2001.
Seasonality
In addition to the cyclicality of this sector, it is also seasonally impacted. In accordance
with spending habits, most individuals will spend drastically more on retail goods during the
winter holiday season, the back-to-school period, and when customers expect annual sales
periods. This is clearly reflected in the sales and performance figures of the industry. Typically,
many investors will become apprehensive regarding retail stocks during these important sales
periods, specifically in December, frequently causing somewhat predictable investing patterns.
It is not uncommon to see a large sell off of retail stocks with repurchases occurring in February
and March when risk is significantly lower.
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Abercrombie & Fitch (ANF)
8 August 2007
Economic Factors
Interest Rates
Historically, retail performance has been closely tied to interest rates, more specifically
changes in The Federal Funds rate, which tend to dictate the overall trend in interest rates. In
accordance with neoclassical economics, as interest rates fall, purchases today become relative
less expense, and vice versa. Additionally, easing of the Federal Funds Rate is generally
warranted in times of poor economic growth. This decrease in rates typically spurs the economy,
which typically causes a quicker progression through the business cycle. Consequently, easing
of the Federal Funds Rate generally indicates oncoming recovery and boom periods when retail
tends to outperform. The opposite is true for times of increasing Federal Funds Rates. As
demonstrated in the graph below, decreases in the Federal Funds Rate are typically followed by
improved specialty retail stock performance, signifying a inverse correlation.
Currently, the Federal Funds Rate is at 5.25% where it has been for over a year. Despite
urging from the market to decrease the Rate, Fed representatives unanimously voted to maintain
the current rate due to inflationary pressure from energy and food pricing. The Fed did however
change its stance on inflation, insinuating that future inflation was becoming less of an issue at
the June meeting. This shift, coupled with increased demand for lower rates, could indicate Fed
action to spur the economy on the forefront, although Chairman Bernanke has been steadfast in
his stance that the Fed will not bail out the Sub-prime market. Given the unlikelihood of
increased Fed Rates, investing in specialty retail is an increasingly attractive proposition in
response to this facet, but it is difficult to gauge if and when the Fed may agree to decrease
interest rates next.
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Abercrombie & Fitch (ANF)
8 August 2007
Unemployment
Specialty retail is closely related to the amount of disposable income available to
customers, and therefore, unemployment figures have significant bearing on retail performance.
Obviously, it is an inverse relationship between unemployment and stock performance since
higher employment increases discretionary income. Periods with low unemployment ordinarily
lead to increased average wages due to the scarcity of quality workers, which amplifies the
increase in disposable income. The chart below express exhibits the inverse relationship
between these variables.
The unemployment rate has been falling for over 4 years, and presently, in a market with
mixed signals, it remains a strong bull market indicator at 4.5%. Additionally, over the past
year, seasonally adjusted average hourly wage has increase by 3.9% to $17.383. These current
conditions bode well for the retail segment, and outward forecasts seem to expect little change in
these factors, largely due to strong production figures.
Additional Economic Drivers
In addition to interest rates and unemployment, there is a notable inverse relationship
between specialty retail stock performance and gasoline prices. Higher gasoline prices serve as a
tax on customers, specifically lower income consumers.
3
Derived from the Bureau of Labor Statistics Website (http://stats.bls.gov/cps/)
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Abercrombie & Fitch (ANF)
8 August 2007
Finally, consumer confidence generally coincides with consumer retail spending.
Consumer confidence has been low, but more recent figures not yet reflected in the graph have
been encouraging (104 vs 112 from June to July).
Industry Multiples
When looking at the industry compared to the S&P 500, it is rather obvious that specialty
retail has gone out of favor with investors in recent months. Price to Sales, Book Value,
EBITDA, and Cash Flow are all currently below their 5 year averages with strong downward
trends. Price to Sales, Price to EBITDA, and Price to Cash Flow are all currently at 5 year lows.
Price to Year Forward Earnings is only slightly below 5 year averages, but they numbers have
fallen significantly since the beginning of the year when they approached 5 year highs. Overall,
these figures indicate that specialty retail stocks are relatively undervalued and could be a
purchased now at a significant discount, especially if one believes a bull market is on the
forefront.
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Abercrombie & Fitch (ANF)
8 August 2007
Current Industry Analysis
Although forecasting most industries is difficult, this particular segment is especially
unclear due to the mixed economic indicators. Neither the Federal Funds Rate nor
unemployment is expected to significantly change in short-term, though current unemployment
figures are strong. Consumer confidence is down; conversely, there is clear downward pressure
on already high gasoline prices, which could give retail the boost it needs. The entire industry
suffers in circumstances like the current where GDP growth has slowed and energy prices are
squeezing margins. However, due to the cyclicality of the retail industry, it would be
advantageous for investors to maintain sector weightings inline or even slightly overweight the
group. It certainly appears that gasoline prices should fall during the third quarter, and this could
definitely be the catalyst for retail and the economy as a whole. These stocks are clearly
undervalued at the moment, and although the timeline on the upside is unclear, there appears to
be few downward oriented indicators at the moment.
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Abercrombie & Fitch (ANF)
8 August 2007
Drivers
Inventory Improvements
Abercrombie is in the process of implementing a Perpetual Inventory System. Due to
the impact of catalogue and internet sales, many specialty retails have been forced to upgrade
their inventory systems accordingly. Inventory management has been a major knock on
Abercrombie in recent quarters. For fiscal 2006, A&F’s year end inventory was 12.9% of annual
sales, much higher than 9.4% and 11.3% for competitors American Eagle and Gap Stores
respectively. Both of these companies have previously implemented highly comparable Oracle
inventory systems in order to control their inventory levels. The charts below show the
immediate impact of this inventory system on inventory turnover on Nordstrom (JWN) and Gap
Stores (GPS) respectively. The years of implementation are highlighted. Often, companies will
experience improved inventory numbers during times of revenue growth (Nordstrom), but even
while facing very poor sales growth, Gap experienced its best turnover rate in 10 years.
Derived from Baseline
Although the benefits in amount of inventory are immediately obvious, the overall impact
on sales and operating expenses has frequently gone overlooked. Due primarily to less lead
time, Gap and American Eagle both experienced notable margin improvements due to the
improved inventory system. As companies can better asses what is selling, they can improve
ordering, stocking, lead times, etc., which correlates into better sales and better margins. The
tables below demonstrate the impact of the inventory separate from other influencing variables
over a 10 year span. Specifically, the variable labeled “dummy” is a dummy variable given a
value of 1 in the four quarters of implementation and a value of 0 in all other quarters. The
dependant variable was the year to year change in Pre-Tax margin on a year to year basis.
Previous quarter’s pre-tax margin is a significant variable and has a negative coefficient,
implying that it is more difficult to improve on already high margins. Additionally, the year to
year change in revenue was both statistically significant and positive as expected. All percents
are given in basis points.
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Abercrombie & Fitch (ANF)
8 August 2007
Intercept
Previous Quarter’s Pre-Tax Margin
REVENUES YTY % CHANGE
dummy
AEO
Coefficients
56.11
-0.0663
0.03361
49.75
GPS
Coefficients
69.7
-0.0909
0.03941
52.24
Standard Error
42.5
0.03314
0.01077
45.23
t Stat
1.32
-2.00
3.11
2.104
Standard Error
t Stat
38.71
1.80
Intercept
0.02549
-3.56
Previous Quarter’s Pre-Tax Margin
0.009234
4.26
REVENUES YTY % CHANGE
38.06
2.37
Dummy
Derived from StockVal Data
The key point to take away from this regression analyses is that in both cases, the
installation of this inventory system improved pre-tax margin by approximately 50 basis points.
Although Gap’s margins were no where near that of ANF, American Eagle is highly comparable
since it has similar revenue growth and margins. For the purposes of this paper, the 50 basis
point improvement shown by the regressions will be used. It would also be acceptable to use the
regression analyses to create a function and apply Abercrombie’s current financial situation;
nevertheless the resulting expect change in operating margin is about 40 basis points, only 10
basis points less than previously expected.
In August, ANF upped second quarter earnings guidance from 83 cents to 88 cents.
Though 2 to 3 cents were attributed to lower tax rates, the additional improvement were not
specified. Recent sales have not been above expectations, implying that growing margins are the
likely cause. This could certainly be a sign of the impact of this inventory system.
Strategic Positioning
As previously mentioned, Abercrombie & Fitch originally focused on the teen segment,
and although it has expanded its range to try and maintain customer relationships (RUEHL), it’s
still overwhelmingly driven by its teen apparel lines. In a recent MarketWatch article, Jennifer
Waters noted:
According to results compiled by Thomson Financial, teen-oriented retailers as a
group ranked as the strongest in terms of same-store sales performance for June,
cumulatively tallying growth in sales at stores open longer than a year of 2.7%.
That easily exceeded analysts' average expectation calling for an anemic monthly
gain of 0.7%.4
4
Waters, Jennifer. “Those teens and their money”. Marketwatch.com. Jul 12, 2007
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Abercrombie & Fitch (ANF)
8 August 2007
It appears that teenagers are less cyclical in comparison to the entire industry, and more
specifically, these teenage shoppers are not strongly impacted by the poor housing market and
high food and energy costs. The strong unemployment and continually increasing average wage
figures, largely due to an increase in minimum wage, appear to have bolstered this segment’s
performance. The same Waters’ article noted that A&F’s same store comparable growth was
approximately 2% company wide, a stark improvement from the 2.8% decrease expected by the
market, indicating that A&F is still a fashion leader as well. At the current time, there is no
reason to expect that teen retailers will not continue to outperform within specialty retail, due
largely to the previously mentioned strong unemployment and increasing minimum wage.
Strong Revenue Growth Opportunities
Abercrombie & Fitch has several sources of revenue growth for the upcoming years.
Although the original A&F brand still has a strong revenue stream, the firm finds most of its
growth prospects in its newly developed lines. First, Hollister has been the primary driver in
ANF’s success of the past few years. In 2006, the brand’s revenue grew over 36% in 2006, with
5% coming from comparable store growth. Hollister’s comparable store sales became flat during
early 2007, but July’s figures are a positive 2%, rebounding with improved economic strength to
outperform expectations. At the end of the first quarter, there were 399 Hollister stores with 66
more expected to be completed by the end of the year. The company estimates around 60 more
each other next two years, though these figures will be highly sensitive to comparable store
results in the months to come.
A&F has been pushing RUEHL, a line designed for college graduates in an attempt to
keep current customers as they become older. Comparable growth has averaged over 11% per
quarter, but it has been around 0 in recent months due to the economic slowdown. Although
RUEHL’s potential is nowhere near that of Hollister or Abercrombie, it should provide revenue
growth and reasonable profits in the upcoming quarters.
A&F’s brand aimed at 14-18 year olds, abercrombie, had about 18% growth in 2006,
with a surprising 11% comparable store increase. With its recent success, ANF has planned 29
more locations for the 2007 year, and more could be in the pipeline due to 6% comparable
growth number so far this summer. .
Abercrombie & Fitch recently has started looking for international growth options. It
currently has 3 stores in Canada, which have performed similarly to traditional American stores,
but it is the recently added project store in London that has beaten expectations. Although A&F
has not provided figures, the Company has indicated it is highly encouraged by initial figures to
explore similar options in this region and other major cities within Japan, Italy, France,
Germany, Spain, Denmark and Sweden.
Pricing
In order to alleviate some seasonal volatility, Abercrombie & Fitch has eliminated as
much discounting as possible to maintain price premiums and avoid drastic swings in sales. This
pricing strategy coincides with its positioning as a “Casual Luxury” retailer. Frequently,
specialty retailers will conduct annual sales to reduce inventory and push sales, and customers
tend to expect and modify purchasing habits to coincide with these sales. It is these trends that
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Abercrombie & Fitch (ANF)
8 August 2007
A&F’s discounting policy should moderate. A&F has managed to maintain strong revenue
growth, while not succumbing to discounting trends.
Corporate Management
Abercrombie & Fitch has a strong management team led by Michael Jefferies. He was
introduced as the CEO in 1992 when the company repositioned itself to focus on young adults,
and he has also severed as Chairman of the company since 1998. He has a strong reputation
throughout the industry for his ability to develop new brands. Additionally, former Apple
Computers executive Michael Kramer has served as Chief Financial Officer since 2005.
Earnings
Abercrombie should beat earnings expectations for 2007. Although market analysts have
lowered retail sales expectations across the board, the company has managed to maintain
reasonable growth during this period of slow retail growth. However, it will be the previously
explained improvement to margins that will provide stronger than expected earnings ($5.35
versus $5.21 consensus estimate for 2007 diluted EPS) as demonstrated by the DCF model in
Appendix A. As previously mentioned, second quarter EPS guidance was raised, which will
subsequently lead to higher year-end estimates holding all else constant.
Risks
Fashion Trends
One of the primary concerns within specialty retail is the constantly changing fashion
trends. Though Abercrombie has strong brand reputation and several new and growing brands,
there is always the risk that ANF brands will fall out of favor with fashion conscience
consumers. Comparable same store sales generally are the best gauge for popularity, and A&F
has managed to maintain consistently positive same store sales, even during the currently soft
retail market. Traditionally, following a period of extremely strong comparable store sales
growth, a firm will be unable to maintain high growth numbers. Nevertheless, A&F has
managed to keep relatively strong growth figures, especially when compared to its direct
competitors. Moreover, ANF has several up and coming brands, where as AEO has all of its
growth and success tied into one brand. CEO Michael Jefferies has a reputation throughout the
industry for his ability to create new, popular brands, and so these joined factors tend to mitigate
the chance of ANF falling out of popular trends.
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Abercrombie & Fitch (ANF)
8 August 2007
Increase in Comparable Store Sales
2006 2005
-4%
18%
Abercrombie & Fitch (brand)
10% 54%
abercrombie
5%
29%
Hollister
14%
n/a
RUEHL
GAP
AEO
-7%
12%
-5%
16%
Economic Downturn
Generally, specialty retailers will be more strongly impacted by poor economic
conditions. As previously discussed, this industry is reliant on discretionary spending, which is
curtailed during times of poor conditions. Currently, the economy is a period of strong
uncertainty due largely to a weak housing market and the current lending hardship. However,
generally it is unemployment and interest rates that are the most indicative of specialty retail
performance. Currently, unemployment figures remain strong, and there is growing pressure for
the FED to lower the federal funds rate to improve the housing market. Although slowed GDP
growth tend to discourage retail spending, ANF’s current position leaves it less susceptible to
economic cycles when compared to the rest of the sector.
Brand Development
Michael Jefferies, CEO and Chairman of ANF, has become well known throughout the
industry for his ability to create strong, profitable brands. Nevertheless, there is obvious risk that
his latest brand, RUEHL will not progress as planned despite encouraging preliminary figures
(most notably comparable store sales). Few expect RUEHL to approach the success of A&F and
Hollister, but future growth is dependant on some discernable growth from this brand.
Additionally, Concept 5 has yet to be unveiled, and so there is obvious risk involved with the
long-term potential of this brand.
Similarly, ANF is trying to expand internationally after the early success of a pilot store
in London. Different cultures obviously have different tastes, and so it is essential that ANF
modify not just the fashion but the physical stores to appeal to the regional preferences.
Inventory Improvement
As previously mentioned, the inventory improvements in progress should have a
noticeable effect on the firm. There is however a chance that the results at ANF will not mirror
that of Gap, American Eagle, and Nordstrom’s for better or worse. Inventory management is
currently a weakness through the company, and if this new perpetual inventory system does not
produce results, the inventory situation will continue to hinder the entire company. The
similarities between not just the inventory systems but the companies themselves lead one to
expect similar results, but it is unclear from this external vantage point if this will be the
subsequent result.
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Abercrombie & Fitch (ANF)
8 August 2007
Over Expansion
When investing in new stores, there is always the potential to over invest. Due to the
lead time in building new stores, there is always a possibility to invest in a brand that has
decreasing sales and popularity. Additionally, firms may stretch to find new locations, which
might not be as profitable. In order to guard against these tendencies, ANF has created an
objective valuation of possible locations (generally malls), and has only invested in locations
with what they consider an A rating. Moreover, there is a clear and discernable pattern between
falling comparable store sales and curtailing of new stores for ANF. All the same, there will
always be a definite risk of overinvestment since there is no way to seamlessly match downward
trending stores with decreasing investment and capital expenditure.
Financials
Income Statement Analysis
Abercrombie posted strong 2006 results, with revenues over 3.3 billion, a 19% increase
from 2005. The company was able to improve net income by 26% to 422 million dollars. This
26% increase in net income versus 19% revenue increase was due in large part to a favorable tax
rate and increased interest income. Even without the impact of two factors, income still would
have been up 20%, indicating a slight improvement in margins. Gross margins have improved
by about 10 basis points each of the last two years. Operating margins were up approximately 30
basis points for the year as well due stagnant or slightly improving percentages across the board.
Traditionally, ANF has very high margins in comparison to the rest of the sector. The
company has tried to eliminate as much discounting as possible, which has helped maintain
margins. Additionally, the firm has no long-term debt, which tends to squeeze margins through
interest expense. Similarly, ANF holds more marketable securities than traditional retailers as a
nest egg against borrowing. These investments have provided a solid boost to profitability. This
policy may however lead to ANF not falling into the share repurchase trend.
The most recent quarter for ANF was very much inline with previous performance.
Revenues grew by 13% over first quarter 2006, despite soft retail markets. Expenses are actually
the same or lower on a percentage basis (compared to revenues), with the exception of stores and
distribution expense, which is 160 basis points higher due to the perpetual inventory installation.
This expense was largely offset by a 150 basis point decrease in the marketing, general, and
administrative expense versus quarter 1 2006. ANF has impressed investors by exhibiting an
ability to limit expenses during slow growth periods like the present. In anticipation of slowing
sales, ANF management successful maintained profit growth through improved margins.
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Abercrombie & Fitch (ANF)
8 August 2007
Balance Sheet Analysis
Abercrombie’s balance sheet is highly favorable to investors, most notably in the absence
of long-term debt. During 2006, ANF managed to grow Cash and Equivalents from 50 to nearly
82 million. The company has an impressive 448 million in marketable securities, a 9% annual
increase. The only cause for concern was an 18% increase in inventories. Nevertheless, the
company was able to grow current assets much more quickly than current liabilities, resulting in
an impressive current ratio of 2.14. Current liabilities were inline with previous figures, with no
strong outliers. Finally, ANF was actually able to increase shareholders’ equity by over 40%
with 28% of which being attributed to retained earnings growth. Traditionally, ANF’s balance
sheet has been a source of investor confidence, and the firm has and will continue that trend.
Cash Flow Statement Analysis
ANF has customarily relied on its operations as its primary source of cash, generally
through income. During times of low investment, the firm tends to hold excess cash in
marketable securities, which are sold when income is not sufficient. These figures tend to be the
largest and most volatile in the statement, which has been rather stable. In 2004 and 2005, ANF
had sizeable stock repurchases, but no stock was repurchased in 2006. Currently, this treasury
stock is being used as a form of share-based compensation.
DuPont Analysis
The DuPont analysis provides a useful model to examine not just operating profits but
also the asset and capital structure of the company. For this analysis, marketable securities and
their subsequent profits were removed from the data. The rationale behind this was the view that
ANF only holds these securities as a short-term alternative to holding cash. These securities are
sold whenever funds are needed, and the amount has become slightly exaggerated in recent years
in an attempt to avoid any long-term debt. Specifically, in 2004 all of these securities
(approximately 464 million) were sold to finance store growth and share repurchases. This 1
year of drastically lower assets skewed the results, and so this analysis is an analysis of the core
retail business.
DuPont Analysis
Profit Margin (Net Income / Revenues)
Total Asset Turnover (Rev. / Avg Total Assets)
Return on Investment(PM * TAT)
Equity Multiplier (Avg Total Assets / Avg Total Equity)
Return on Equity
2004
10.5%
1.47
15.5%
2005
11.8%
1.46
17.3%
2006
12.5%
1.75
21.8%
1.522
1.661
1.324
23.6%
28.8%
28.9%
The analysis reveals that profit margins, asset turnover, return on investment, and most
importantly return on equity is increasing on an annual basis. The 2006 increase in return on
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Abercrombie & Fitch (ANF)
8 August 2007
investment is especially impressive due to the lower equity multiplier that was the consequence
of the previously mentioned strong retained earnings growth of 2006.
The chart below contains the return on equity for not just ANF but its closest competitors.
In this case, marketable securities were included in order to ensure a like comparison between
the firms. The only stock with better return on equity is Aeropostale, which is a relatively new
competitor, with considerably lower earnings, but a faster growth rate. In either case, both ROEs
are well above the average for specialty retail.
Return on Equity
ANF
33.2%
GPS
14.2%
AEO
29.5%
ARO
38.7%
Industry Average
14.3%
Ratio Analysis
When comparing ratios to competitors, ANF is very much inline with their direct
competitors but ahead of industry averages in all categories except for margins, where is
significantly outperforms averages.. American Eagle, Aeropostale, and Abercrombie all do not
rely on long-term debt, though the average specialty retailer has a LT-Debt/Equity of about 14%.
The only cause for concern is the poor inventory turnover previously addressed. However, it is
reassuring that Gap and American Eagle both have strong inventory turnover, since ANF is after
all installing an inventory system that mirrors both GPS and AEO. ARO is not as comparable in
this case since it has not progressed as quickly into online and catalogue sales like the other 3
firms, which traditionally makes inventory management drastically more difficult. The high
margins at ANF are due to a variety of strategic factors, most notably no price discounting and
commitment to being a “casual luxury” clothing provider.
Days to Collect
Inventory Turnover
LT-Debt/ Equity
Pretax Margin
Net Profit Margin
ANF
4.8
2.8
0
20%
13%
GPS
5.5
5.3
3.60%
7%
5%
AEO
3.4
6.4
0
23%
14%
ARO
5.6
8.7
0
13%
7%
Industry Average
6.6
n/a
14%
7%
4%
Earnings Estimates
ANF should beat market earnings estimates for the 2007 year. Although retail sales are
down, the market has long since priced in these expectations. 2007 and 2008 sales should be
inline with market estimates; it won’t be until international sales expand that estimates may be
revisited. The increase in earnings will be due to margin improvement. ANF has been criticized
for increasing distribution costs, but this is directly due to the inventory system installation. This
increase in expense will only be a short-term effect, and the subsequent quarters should show
improvement once the system is fully operational. The market expects an EPS of $5.21 for
2007, but with improving margins and consistent sales, $5.35 EPS seems more likely. For the
same reasons, 2008 EPS should exceed estimates by about 19 cents ($6.00 versus $6.21).
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Abercrombie & Fitch (ANF)
8 August 2007
Stores
Currently, ANF has 954 stores with the majority concentrated in A&F and Hollister (the
breakdown is included in Appendix B. Using announced locations and analyst expectations, it is
reasonable to expect about 114 more locations being opened by the end of the fiscal year, more
than half of which being Hollister stores. The poor comparable store sales of Hollister is the first
quarter of this fiscal year does cause concern since 72 new stores were expected in 2007 alone.
Traditionally, ANF focuses its strategy more directly on the sales per square foot data.
As shown in the table below, ANF has strong Sales per square foot performance when compared
to its direct competitors. Additional data on stores and square footage is available in Appendix
B.
Percent Increase in Sales Per Square Foot
2006
2005
7%
17%
Abercrombie & Fitch (Brand)
12%
60%
abercrombie
16%
38%
Hollister
40%
n/a
RUEHL
GAP
AEO
ARO
-2.8%
11%
6.1%
-3.4%
22%
4.1%
Actual Sales Per Sq Ft
2006
2005
$ 483
$ 451
$ 538
$ 482
$ 556
$ 480
$ 337
$ 240
$ 416
$ 540
$ 538
$ 428
$ 487
$ 507
Valuation
Price Multiples
Absolute
The table below demonstrates how ANF has become relatively inexpensive compared to
its 10 year averages for Price to Year Forward Earnings, Price to EBITDA, Price to Sales, and
Price to Cash Flow. Generally in the retail sector, Price to Sales and Price to EBITDA are
considered the most informative ratios, both of which are significantly under their mean
averages. This may also indicate that the market has factored in its expectations for lower sales
and earnings at the present time. Using these current valuations and 10 year averages, price
targets were created. In most cases, a slight premium was put on the target multiple primarily
due to strong margin improvement beyond consensus estimates. Using these figures, price
targets of $88 to $93 are obtained. These target values indicate 22% to 29% upside value.
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Abercrombie & Fitch (ANF)
8 August 2007
Absolute
Valuation
High
Low
Mean
Current
Target
Multiple
Per Share
Target
Target
Price
P/Forward E
P/EBITDA
P/S
P/CF
34.5
36
6.19
44.4
5.4
3.2
0.85
5.1
14.6
8.9
2.17
13.2
13.3
8.2
1.95
11.9
16.5
9.2
2.25
13.5
5.35
9.75
41.2
6.5
$88.28
$89.70
$92.70
$87.75
Retail & S&P500 Comparison
The two tables below exhibit the current valuations relative to the retail sector and S&P
500 on a 10 year basis. Once again, ANF is inexpensive when compared to its peers. ANF’s
low Price to Sales ratio is especially surprising considering their historically high margins. As
shown below, only American Eagle has comparable margins, which is actually in part a positive
since AEO has already experience the margin expansion due to the perpetual inventory system.
In either case, it is clear by these measures that ANF is currently inexpensive.
Relative to Retail
P/Forward E
P/EBITDA
P/S
P/CF
High
2.04
4.86
10.38
3.62
Low
0.42
.57
1.83
.67
Mean
.82
1.14
2.89
1.19
Current
.90
1.04
2.36
1.05
Relative to SP500
P/Forward E
P/EBITDA
P/S
P/CF
High
1.39
3.96
2.62
2.76
Low
.22
.32
.37
.31
Mean
.85
1.08
1.34
1.09
Current
.89
1.05
1.26
.99
Pretax Margin
Net Profit Margin
ANF
20%
13%
GPS
7%
5%
AEO
23%
14%
ARO
13%
7%
Industry Average
7%
4%
DCF Model
The best valuation method for Abercrombie & Fitch is the discounted cash flow (DCF)
model. The model used is relatively consistent in structure with standard models, and it is
included in Appendix A. Using historical performance, segmented and full income sheet
performance was projected in detail for 2007 through 2009, and more vaguely through 2017.
Though it was done separate of outside sources, consensus sales estimates are very close to these
projections. The real discrepancies appear in the assumed effects of the perpetual inventory
system. This DCF model reflects improving inventory in terms of a percent of revenue, which is
generally not expected. Moreover, this new system will improve margins as previously
discussed. Quarter 1 saw an stark increase in the cost of distribution, which most analysts took
as a contraction of margins. This was however due largely to the installation of the new
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Abercrombie & Fitch (ANF)
8 August 2007
inventory system that will in time actually significantly lower distribution costs. Even if the new
system does not effect long term margins as expected, this is still a one time installation cost, and
the expense should at worst revert to its average. Additionally, ANF gave guidance for CapEx of
395 to 405 million, which was used in the model. Also, ANF suggested a tax rate of 39%, which
appears to be slightly high by historical standards and forward looking due to international
expansion; however, the value was used since ANF’s guidance is usually quite accurate.
Using these assumptions, ANF’s intrinsic value is actually about $96, a 33%
improvement from the current $72.22 price (as of August 7, 2007). Even without any
improvements due to the inventory system and EPS estimates inline with consensus estimates,
ANF still warrants around $88, which is 23% above the current value. Though there is no reason
not to expect benefits from the new inventory system, if one chooses to ignore its impact, it is
still an undervalued stock with an attractive option (inventory effects) included for free.
Summary
Using the DCF target price of $96 and price multiples target price range of $88 to $93, an
overall price target of $94 is established. Given the current price of $72.22, Abercrombie &
Fitch is an immediate BUY. A shift in fundamentals, a drastic change in management,
exceedingly poor economic conditions beyond current expectations, or a price under $55 for an
extended period would justify a reassessment of this price recommendation.
Strengths
• New inventory system should improve sales, margins, and inventory turnover
• High margins relative to competitors
• Solid growth potential between international stores and growing brands
• Well positioned as a teen retailer within the specialty retail to withstand economic
downturns
• Currently, strong employment figures and low interest rates bode well for upcoming
performance
• Outperforms competitors on a pre-tax margin and sales per square foot basis among other
measures
• Exhibited ability to lower corporate costs during slow sales periods in order to meet
earnings expectations
Weaknesses
• Soft retail sales outlook for upcoming fiscal year
• Closely correlated to GDP, which is currently showing slow growth
• Financial success is directly related to its ability to be a fashion leader
• Poor inventory performance and subsequent reliance on new inventory system to improve
turnover
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Appendix A
DCF Model with effects of new inventory management system
Abercrombie & Fitch (ANF)
8 August 2007
Revenue breakdown by brand
20
Abercrombie & Fitch (ANF)
8 August 2007
Income Statement (with inventory effects)
DCF Model without any effects from new inventory system
21
Abercrombie & Fitch (ANF)
8 August 2007
22
Abercrombie & Fitch (ANF)
8 August 2007
Appendix B
23