Equity Research Report
Student Investment
Management
July 2013
Recommendation:
BUY
Price Target:
Current Price (July 16):
Upside Potential:
Projected Return (incl. div yield.):
62.49$
50.23$
24.4%
26.0%
A
N
F
Martin Perrier
614.648.2380
Perrier_4@fisher.osu.edu
Abercrombie
& Fitch
d
Company Description
Market Data
Market Capitalization
Shares Outstanding
Dividend Yield
Dividend
Beta
52 Week Price Range
Trailing 3 years peak
$3.94B
78.32M
1.6%
0.70$
1.8
28.64$ - 55.23$
$75.77 (2011)
Financial Data (TTM)
Revenue
Revenue Growth
Gross Margin
Operating Margin
Earnings Per Share
Price to Earnings
$4.43B
6.50%
63.7%
8.73%
3.08$
16.20
Abercrombie and Fitch is an international fashion retailer selling apparel, fragrance and luxury products at consumers aged
7 to 25. The brand describes its retailing niche as “casual luxuData !
ry”. The company has a strong brand image based onStock
a provocative communication and a specific in-store experience well
suited to the cool lifestyle it advocates. The company operates
under four different brands and via U.S. based stores, international stores (in Canada, Europe and Asia) and online activities
(Direct-to-Consumer).
Investment Thesis
Within the Consumer Discretionary sector, Abercrombie and
Fitch belongs to the Apparel Retail industry and its stock is
therefore very cyclical. Now, the current phase of the business
cycle (recovery/early expansion) is extremely favorable to consumer cyclicals. Besides, A&F has recently established a dual
strategy towards sales growth (aggressive international expansion in Asia) and profitability increase (stores consolidation in
the US). Both gross and operating margins are increasing, leading to better store productivity, and the company has improved
its historically poor inventory management. In the meantime,
comfortable quick and current ratios show the firm’s ability to
meet its short-term financial obligations. In addition, a Discounted Cash Flow analysis as well as an analysis of A&F’s key
multiples relative to its industry, its sector and the S&P, indicate a weighted upside of 24.4% over the next 52 weeks. Therefore, I recommend a BUY on Abercrombie and Fitch.
Risk of the recommendation
Among reasonable risks to consider, the continued international expansion seen as the key driver of sales growth might not
perform as well as expected, due to different customer tastes
and preferences, exchanges rates fluctuations, local government
policies, etc. In addition, the decrease in the number of US
stores may not reveal sufficient to boost other stores’ sales and
productivity. Finally, the current turmoil over the company’s
exclusionary policy (see insert on Michael S Jeffries) may bring
permanent damages to a brand image crucial to the company’s
results.
ANF: Abercrombie & Fitch – Equity Research Report
Martin Perrier
Table of Contents
A&F - Company Overview ...........................................................................................................................3
Different targets, different brands ...................................................................................................................... 3
Three business segments ...................................................................................................................................... 4
A competitive advantage based on a strong brand image .............................................................................. 4
Recent news and Stock Performance.................................................................................................................. 6
Investment Thesis ..........................................................................................................................................6
Key Fundamentals and Economic Drivers ........................................................................................................ 6
Financials analysis ................................................................................................................................................ 8
Discounted Cash Flow Model ............................................................................................................................. 9
Multiples Analysis .............................................................................................................................................. 10
Risks ...............................................................................................................................................................11
External risks ....................................................................................................................................................... 11
Internal risks ........................................................................................................................................................ 11
Conclusion .....................................................................................................................................................12
Weighted average target price .......................................................................................................................... 12
Abercrombie and Fitch: the Bull, the Bear and the Base case ....................................................................... 12
Recommendation ................................................................................................................................................ 13
Sources ...........................................................................................................................................................14
Appendixes....................................................................................................................................................15
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Summer 2013
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ANF: Abercrombie & Fitch – Equity Research Report
Martin Perrier
Classic, confident, sexy and slightly provocative
are the main characteristics that contribute to
make A&F apparel “always cool”. The original
brand’s core target is usually from 18 to 22 years
old and its products are usually the priciest of the
A&F family. The A&F brand accounts for 38% of
overall sales, with a growth rate of 2.3% in 2012.
Abercrombie Kids
A&F - Company Overview
The original Abercrombie and Fitch was established in 1892 in downtown Manhattan, NYC, as
a sporting and outdoor goods retailer. After filing
for Chapter 11 bankruptcy in 1976, the company
was bought back by Oshman’s Sporting Goods
and later acquired by The Limited in 1988, which
took A&F public on the NYSE in 1996. The nomination of Michael S Jeffries as president in 1992
marked a radical turn towards what the company
and the A&F brand are today.
Twenty years after CEO Michael Jeffries’ nomination, Abercrombie and Fitch is an international
fashion retailer whose apparel, fragrance and
luxury products are mostly aimed at consumers
aged 18 to 25. The company describes its retailing
niche as “casual luxury”. They operate under
different brands for slightly different targets:
Abercrombie and Fitch, Abercrombie Kids, Hollister and Gilly Hicks. They developed their international presence through the opening of
many stores all around the world as well as via
their online shopping website.
Different targets, different brands
Abercrombie & Fitch
According to the company, privilege and casual
luxury are the core foundations of the original
Abercrombie and Fitch brand, aiming to represent youthful all-American lifestyle based on
“East Cost traditions and Ivy League heritage”.
Sales breakdown by brand
SIM Program
Directly aligned with its older sibling, Abercrombie Kids provides younger people (7-14 years old)
with A&F’s “idolized and respected all-American
cool” image through preppy style apparel aimed
at energetic, popular and athletic kids. Abercrombie Kids is the only brand with a negative
growth in 2012 (-3.9%) and represents now 9% of
the company’s total sales.
Hollister
Introduced in July 2000, Hollister is suited for a
more laidback lifestyle with a deep influence
from Southern California’s young and fun beaches. The brand is also aiming at high school students rather than their siblings in college, targeted by A&F. Due to a more affordable line of
products and, therefore, a larger customer base,
Hollister is the brand with the most stores, domestically and internationally as well as the largest share of total sales, with a contribution for the
first time superior to 50%. Its growth rate was
+30% in 2011 and 14.5% in 2012.
Gilly Hicks
Since 2008, Gilly Hicks, an “all-American brand
with a Sidney sensibility”, provides “young,
beautiful and confident girls” with a whole line of
underwear. The newest and smallest brand of the
A&F family, Gilly Hicks has the best 2012 growth
rate (with 50%) but accounts for only 2% of total
sales.
Sales breakdown by segment
Summer 2013
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ANF: Abercrombie & Fitch – Equity Research Report
Three business segments
The company’s activities are usually divided into
three reportable business segments which contribute differently to the overall performance of
A&F: US stores, International stores and Directto-Consumer.
U.S. stores
The U.S. stores segment includes all the in-store
operations within the USA and Puerto Rico. With
912 stores out of the 1,051 operated by A&F at the
end of fiscal year 2012, the US stores segment is
undoubtedly the most prominent one. However,
the US stores sales recently slowed down and
even decreased by 3.53% in 2012. Facing the increasing international and online sales, the segment’s share of total sales dropped from 73% to
58% over the past two years. Besides, these 58%
of sales lead to only 41.1% of total profit.
Under Michael Jeffries’ leadership, the company
has launched an aggressive stores opening policy
that even expanded, until 2008-2009, to lower tier
cities where the demographics were not really
suited for A&F premium products. The following
recession hit quite strongly a cyclical industry
extremely sensible to the evolution of consumer
spending, the newest stores performing very
poorly and proving to be one of the limits of
A&F’s aggressive expansion. This has led to a
store consolidation strategy that partly explains
the recent decrease in US stores sales (more details on page 7).
International Stores
The International stores segment includes the
company’s operations in Canada, Asia and Europe. International stores represent today 139 out
of the 1,051 stores operated by the company for a
share of total sales jumping from 15% to 26% over
the past two years, with an even greater share of
total profit (33.3%).
In coherence with its aggressive domestic expansion, A&F rapidly opened new stores abroad,
starting with Canada in 2006, the UK the following year and Italy and Japan in 2009. Despite an
SIM Program
Summer 2013
Martin Perrier
initial success due to the exclusivity of these first
flagship stores in Europe, a scenario similar to the
one described for US stores happened on the old
continent. In European economies devastated by
the recession, A&F’s premium line of products
was definitely not a priority for the expected potential customers. In Asia, however, where consumer spending in discretionary products is
quickly increasing, A&F has found a key driver of
international and overall sales growth (more details on page 8).
Direct-to-Consumer
Ultimately, the Direct-to-Consumer segment concerns all the on-line operations, whether they are
domestic or international. This segment’s share of
total sales has increased from 12% to 16% between fiscal years 2010 and 2012, with up to
25.6% of total profit. On-line operations are also a
key driver of sales growth, allowing the company
to reach potential customers in area without a
customer base solid enough to open a new store
(i.e. the aforementioned lower tier cities). Besides,
economies realized by the absence of physical
stores’ expenses allow A&F to offer free shipping
and various price discounts without decreasing
profit margins.
A competitive advantage based on a strong brand
image
A&F and its competitors
Whether it is via physical stores or Direct-toConsumer, domestically or internationally, the
apparel industry is highly competitive. With a
considerably large offer and low switching costs,
consumers have a real power over apparel retailers and are consistently looking for the best quality for the cheapest price, unless they consider a
certain loyalty to a particular brand. Therefore,
differentiation is usually sought after in brand
recognition (see below for A&F), price, store location and quality of the products.
A&F’s main competitors are American Eagle Outfitters (AEO), Aeropostale (ARO) or The Gap
(GPS), which are all somewhat cheaper
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ANF: Abercrombie & Fitch – Equity Research Report
alternatives with a less aggressive branding policy (more detailed analysis of A&F’s competitors
in the Peer Comparison section).
A distinct shopping experience and brand image
driving the business
To differentiate from its competitors and obtain a
sustainable advantage, A&F relies on two key
drivers: its brand image and a specifically related
in-store experience.
Martin Perrier
As mentioned before in the brand presentations,
the young all-American cool, classic and sexy
lifestyle is the core of all the company’s products.
Because of the company’s exclusionary customer
policy (assumed or not, see insert Controversy),
A&F customers really identify with the brand and
feel like members of an exclusive group: cool
people.
Controversy: Chairman and CEO Michael Jeffries, awkward public speaker or brilliant marketer?
Michael S Jeffries, emblematic CEO of Abercrombie and Fitch and symbol of the renewed popularity of the brand at the dawn of the 21st century (6th
most popular brand among teenagers at the time),
has been under the spotlight as much for his performance at the head of the Central Ohio-based
fashion retailer as for the controversies he regularly brings over his “casual luxury” apparel retailer.
As the main negative consequences of these controversies, are mostly accusations and lawsuits
leading to the need for official apologies and, at
times, other measures to be taken (fines to pay,
anti-bullying campaign initiative launched in
June 2013, etc…) in order to calm the fire, but
without extinguishing it…
Indeed, these interventions may have a negative
impact on the short-term but reveal brilliant marketing actions down the road, leaving
Upon his arrival in 1992, he admitted
“We want to market
the controversies talk for themselves
wanting A&F to “sizzle with sex”, the
to cool, good-looking
and insure the brand remains in peocornerstone of long series of lawsuits
people.
We
don't
ple’s mind. Making A&F customers
and controversies. The first one commarket to anyone
members of a selected group of popuing with A&F Quarterly, a periodical
other than that.”
lar and successful people increases
magazine aimed at college students to
their loyalty while making even more
vehicle A&F’s lifestyle and which was
Michael Jeffries,
attractive for non-customers the proaccused to promote “soft pornograCEO
spect to get in the “family”. In addiphy” to children.
tion, the considerable size of the apLater, Jeffries confessed in an interview the comparel market allows and requires retailers to depany’s exclusionary policy about its customer
velop a specific positioning to vehicle their identitarget: “In every school there are the cool and
ty to the final consumers.
popular kids, and then there are the not-so-cool
Besides, an obvious parallel can be made with
kids. (…)A lot of people don’t belong [in our
another successful strategy: Apple’s recent marclothes], and they can’t belong. Are we exclusionketing of its computers against rival Microsoft’s.
ary? Absolutely. » These 2006 comments, coherApple, whose main campaign argument was how
ent with the consistent refusal to make any extraMacs were aimed at cool and creative people
large sizes to accommodate a broader customer
while PCs were already from an old age…
base, launched another firestorm of criticism over
the company and its CEO, especially after they
resurfaced in May 2013 in a period marked by
school bullying concerns and an all-time-high
obesity in the USA.
SIM Program
Summer 2013
Ultimately, Jeffries’ controversies make some
noise, no doubt about that, but the impact of this
free advertising on the brand over the mid to
long-term may not reveal as negative as one
might think.
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ANF: Abercrombie & Fitch – Equity Research Report
To reinforce this feeling, the company has developed a very unique in-store experience where
everything reminds the customers of the A&F
lifestyle. All the customers’ senses are called for
by all the features of the stores, from the music to
the odor of the atmosphere, from the visual
presentation of the products to the sales associates who represent the typical A&F family member. Each store’s design and presentation is carefully standardized, allowing a consistent in-store
experience and facilitating new stores openings.
The main A&F stores in Europe are used to raise
expectations by having people queue outside for
up to an hour before actually getting in the store
even though this one is barely full.
Recent news and Stock Performance
Martin Perrier
$51.40 price on July 1, probably more aligned
with the company’s actual value.
Investment Thesis
This paragraph aims to provide a brief overview
of the investment analysis as well as a calculation
of an estimated target price for the A&F stock. In
addition to a brief focus on the Consumer Discretionary sector, I will try to shed the light on the
key fundamentals of A&F’s performance within
the apparel industry. The analysis of the company’s financial statements and ratios will also help
assess the firm’s current situation. Finally, a
weighted average target price for A&F will be
calculated based on a Discounted Cash Flow
analysis and a multiples analysis.
Key Fundamentals and Economic Drivers
ANF: stock performance over the last three months
The last earnings release happened on May 24th,
announcing a first quarter net loss or $7.2 million
and a net loss per share of $0.09. It is, however,
better than the same quarter a year before and
definitely coherent with the seasonality of the
apparel industry (Q3 and Q4 being every year
much more profitable than Q1 and Q2).
However, negative earnings per share are likely
to scare investors away, which partly explains the
stock price drop following the announcement.
The controversy coming from Michael Jeffries’s
2006 comments resurfacing late in May 2013 is the
other explanation of a serious price drop initially
in the end of May but also in the middle of June,
to reach a 20% decrease in 4 weeks down to a
share price of $43.46.
This move was not representative of structural
issues with the company’s operations though,
and it was likely that the price would go back to
its previous level. Indeed, in less than three extra
weeks, the stock increased by 16% to reach a
SIM Program
Summer 2013
The performance of Abercrombie & Fitch depends on several key drivers and industry trends
that affect future growth opportunities. The following paragraphs summarize the most important drivers of the company’s performance. It
is implied, naturally, that this list is not exhaustive and that other factors can affect the company’s performance as well.
Financial and economic conditions
The apparel retail industry, as a part of the Consumer discretionary sector (see below, insert Consumer Discretionary), is a very cyclical industry
that strongly depends on the financial and economic context. Indeed, customers are more likely
to refrain from buying non-necessary goods in a
period of recession than in a thriving economy.
However, the US economy seems to be precisely
leaving a period of recession for expected better
times. The recovery and early expansion phases
of the economic cycle usually offer tremendous
opportunities to invest in consumer discretionary
stocks, because of the expected sales growth in
the upcoming years.
US focus: an effective consolidation strategy
As I mentioned earlier, A&F’s domestic expansion in the mid and late 2000’s hit a wall due to a
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ANF: Abercrombie & Fitch – Equity Research Report
too aggressive strategy along with a bad timing.
The company launched numerous stores in low
tier cities that revealed totally unsuited to the
premium prices of A&F products, which was obviously aggravated by the economic crisis.
Facing dramatic sales decreases, a stubborn Jeffries refused to lower prices for months, while
other apparel stores launched massive promotions in order to limit the damages. The cut in
prices arrived late, mid 2009, with the realization
of the future steps needed to recover from the
economic disaster.
Martin Perrier
In 2010, A&F launched a store consolidation
strategy and started closing under-performing
stores across the country. So far, almost 150 stores
have been closed and an additional 160 will be
closed by the end of 2015. Improved performance
is already showing with a better inventory management and increased net profits in remaining
stores (see financials analysis below).
International opportunities
If the apparel retail industry reached a certain
maturity in the US or in Europe, the situation is
quite different in developing countries. Today,
Asia is the company’s top priority in terms of
international expansion.
The Consumer Discretionary sector: overvaluation or solid performance?
The Consumer Discretionary sector, also referred
to as Consumer Cyclicals, concentrates companies
selling non-necessary goods and services (i.e. automobiles manufacturers, apparel retailers, entertainment providers…). These stocks, by definition very cyclical, perform better than average in
a thriving economy but are weaker during recessions.
Consumer discretionary stocks perform best early
in the business cycle, from the end of the depression phase to the early expansion. This explains
why the sector has consistently outperformed the
S&P 500 for the past three years, showing either
higher gains or lower losses (see data below from
Fidelity.com).
A quick economic analysis shows obvious correlations between the sector’s performance and key
drivers like consumer spending, consumer confidence, disposable income, real GDP or employment. However, the first semester of 2013 has
seen the CD sector record a +20% performance
when none of the aforementioned drivers have
recorded an increase of more than a couple of
percent (see graph on the right for a typical illustration of the pattern).
SIM Program
Summer 2013
This pattern may have two different explanations:
either an increased confidence has led to a serious
overvaluation, or the sector has developed evidence of a sound financial situation.
After running a brief analysis of the sector’s financials, the second option seems to be strongly
supported. Indeed, the sector’s net profit margin
has reached an all-time high (6.4% and 0.7 relatively to the S&P). Earnings per share are in line
with the sector’s historic median in 2012 (10%)
but are expected to rise to 17% by 2014. Besides, a
stable CF/E ratio over 1 is a guarantee of sound
earnings (earnings and cash flows growing at the
same pace). Finally, the sector presents a ROE of
20.3%, higher than the S&P’s since 2011.
In the current phase of the business cycle, the
Consumer Discretionary sector is clearly outperforming the benchmark and is on an upward
trend that is likely to continue for a couple of
years. Therefore, I would recommend a portfolio
manager to overweight their CD stocks on at least
a 1-3 year horizon.
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In the current globalization context, population in
emerging countries benefit from an ever-high
disposable income as well as a solid confidence in
a sustained growth for the years to come. This,
added to the strong cultural influence of the US
and Europe in Asia, offers ideal growth opportunities for a company like A&F.
Precisely, in addition to the current 139 international stores and despite closing many of its US
stores, A&F plans to open two additional flagship
stores in Seoul and Shanghai as well as 20 international Hollister stores in 2013, including first
stores in Australia and Dubai.
In parallel, the “Casual-luxury” retailer will slow
down its expansion plans in Europe, where most
local economies are still struggling to regain a
positive growth and where has already started a
tendency to self-cannibalization between the few
existing stores.
Demographics
Michael Jeffries and A&F’s consistent refusal to
extend their lines to larger sizes deprives them of
a huge potential customer base in the US (with
about 70% of overweight people, including 35%
of obese people1). However, as discussed earlier,
this exclusionary policy is an essential component
of the brand identity and even a factor of attraction for non-customers.
Besides, A&F is not the only retailer to defend
such a policy: Spanish company ZARA, world’s
largest apparel retailer, operates 1,700 stores
worldwide but only 45 in the US, while currently
opening a record three stores per week in China.
The reason? “People don’t fit in the clothes”.
The market size of the apparel industry is large
enough for any retailer to restrict its target to one
specific segment, as long as the targeted customers can identify to the company’s brand.
Is Sex still selling?
other industries. With the era of smartphones and
internet making it much easier for teenagers to
have access to nudity- and sexuality-related content, sex has become less and less taboo and lost
part of its provocation. However, an extreme position leading to another, as the taboo is disappearing, it is replaced by a growing openmindedness about sexuality and a desire to know
and experience more about it.
Therefore, I personally expect A&F’s “libertine”
marketing strategy to keep seducing teenagers
and college students, even though it contributed
to shifting the very reason for this attractiveness.
Besides, no matter the imitations, over the past
two decades A&F has made its mark in people’s
mind as one of the sexiest apparel brands on the
market, and each and every in-store experience
reminds it to the customer.
Financials analysis
A copy of the total pro forma income statement
for segment data as well as the consolidated income statement can be found in appendix 1 on
page 15. The following paragraphs present and
explain the various assumptions used for the calculations as well as the main takeaways from the
analysis.
Revenues
In coherence with the store consolidation strategy
implemented since 2010, A&F will keep closing
under-performing stores in the US until 2015,
which is likely to further decrease the segment’s
sales until they stabilize. International stores’
opening, however, is one of the priorities for fiscal year 2013, driving a sales growth likely superior to 20%. Direct-to-Consumer sales are also
likely to keep increasing due to the ever-growing
popularity of online shopping as well as the reduction of the number of physical stores in the
US.
Cost of Revenues and Operating Expenses
If A&F has been a pioneer in using Sex as a core
element of its communication, it has been imitated by several competitors and companies from
1
Martin Perrier
Historically, A&F has had some trouble managing inventories. However, the current strategy
focuses on improving margins by cutting nonessential costs. Through a decrease in average
According to the Center for Disease Control & Prevention
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ANF: Abercrombie & Fitch – Equity Research Report
unit cost, the company managed to improve its
gross margin by 1% in 2012 and will likely do the
same over the upcoming years.
Stores and distribution expenses also dropped by
1% of net sales and should keep on the same
trend over the next three years due to the numerous store closings.
Michael Jeffries also expressed the desire to decrease Marketing and communication expenses
which I think reasonable for a brand already extremely famous worldwide and whose in-store
experience and periodic controversies are the best
advertisement media. The recent turmoil over
Jeffries’ “not-so-cool kids” comments, however,
has already incurred some extra marketing cost
for 2013, with the express development of a major
anti-bullying campaign.
Share buyback strategy
Last year, in an effort to appease discontent
shareholders, A&F launched a massive share
buyback operation. They actually repurchased
some of their shares in 4 out of the latest 5 quarters, decreasing the number of outstanding shares
from 89 to 78 million. Besides, the board of directors authorized a total of 18 million additional
shares to be repurchased. The volumes of future
share buybacks are relatively hard to predict
though, since they usually depend on the quarterly earnings the company is about to release.
Peer Comparison
Metric (ttm)
Market Cap:
Employees:
Revenue:
Gross Margin:
EBITDA :
Op. Margin:
Net Income:
EPS:
P/E:
ANF
3.94B
10,000
4.43B
0.64
615M
0.09
251M
3.08
16.32
AEO
3.62B
7,000
3.45B
0.4
559M
0.12
248M
1.1
17.03
ARO
1.12B
4,205
2.34B
0.32
121M
0.02
12M
0.14
98.82
GPS
20.89B
136,000
15.89B
0.4
2.63B
0.13
1.24B
2.57
17.38
Source: Yahoo! Finance, 7/16/2013.
Aeropostale (ARO), American Eagle Outfitters
(AEO) and The Gap (GPS) are A&F’s main competitors on the high-school/college students’ casual apparel. As I mentioned earlier, A&F’s differ-
SIM Program
Summer 2013
Martin Perrier
entiation comes from its specific brand image and
related in-store experience.
Now, in terms of financials, A&F’s most similar
competitor is American Eagle Outfitters which
has a market capitalization of $3.62B for revenues
of $3.45B, against $3.94B and $4.43B for the Ohiobased company. Other characteristics are relatively similar as well: A&F has a significantly higher
gross margin (64% vs 40%) but has a lower operating margin (9% vs 12%). Finally, A&F also has
larger EPS and offers a lower P/E ratio than any
of these three competitors.
Profitability analysis
As mentioned before, Abercrombie’s gross margin is higher than its main competitor’s, but its
operating margin however, tends to be smaller.
Higher stores-related expenditures and marketing expenses might be the main two reasons for
this difference.
A&F’s Return On Equity is 13% for Fiscal year
2012 (up to 14.3% for the trailing twelve months),
which is still below the sector’s and industry’s
returns but on an upward trend.
A DuPont analysis allows the investor to better
understand a stock’s ROE based on a breakdown
of the company’s profitability, operating efficiency and financial leverage. In Fiscal 2012, a profit
margin of 5.25%, an asset turnover of 1.51 and an
equity multiplier of 1.64 lead indeed to a ROE of
13%. Abercrombie’s equity multiplier has been
relatively constant over the past couple of years,
making the other two ratios responsible for the
increasing ROE.
Liquidity analysis
A current ratio of 1.89 for Fiscal 2012 tends to
show A&F as relatively liquid and able to meet its
short-term financial obligations. Even despite the
company’s poor track record in terms of inventory management, its quick ratio of 1.28 is still comfortable.
Discounted Cash Flow Model
Appendix 2 (page 17) is a Discounted Cash Flow
model based on A&F financial statements (balance sheet, consolidated income statement and
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statement of cash flows) as well as the assumptions presented in the previous section.
Despite a certain conservatism in the calculations
(discount rate of 10.5%, terminal FCF growth rate
of 2.5%...), the final target price offered by the
model reaches $63.80, representing a potential
27% upside.
Appendix 3 (page 18) reports a sensitivity analysis run to come up with a target price range. Using discount rates ranging from 9.5% to 11.5%
and terminal FCF growth rates from 1.5% to 3.5%,
the final target price range goes from $ 53.83 to $
79.98.
Multiples Analysis
The purpose of this analysis is to determine
whether the A&F stock is currently undervalued,
fairly valued or overvalued. To do so, I compared
the current value of common multiples of A&F
vis-à-vis the S&P, the Consumer Discretionary
sector and the Apparel Retail industry. Data from
this section comes from Thomson Reuters Baseline and are based on a 10-year period.
A&F Valuation relative to the S&P 500
All the current multiples presented are close to
their 10-year median value but slightly inferior,
this could mean ANF is traded at a discount relative to the S&P.
Relative to
S&P
P/Trailing E
P/Forward E
P/B
P/S
P/CF
High
Low
3.4
1.7
3.0
2.1
1.8
0.32
0.61
0.5
0.5
0.4
Median Current
1.1
1.0
1.2
1.2
1.1
1.0
1.0
0.9
0.6
0.8
A&F Valuation relative to the Sector
The same analysis works for the stock valuation
compared to the Consumer Discretionary sector.
ANF stock seems to be in line with its historical
average, with the same three multiples indicating
a possible discount on ANF stock.
SIM Program
Summer 2013
Martin Perrier
Relative to
Sector
P/Trailing E
P/Forward E
P/B
P/S
P/CF
High
Low
2.9
1.6
3.8
3.5
1.9
0.1
0.4
0.4
0.6
0.4
Median Current
0.8
0.8
1.3
1.8
1.3
0.8
0.8
0.5
0.7
0.7
A&F Valuation relative to the Industry
Once again, ANF stock seems priced in line or
possibly at a discount relative to the Apparel Retail industry.
Relative to
Industry
P/Trailing E
P/Forward E
P/B
P/S
P/CF
High
Low
3.5
1.8
2.5
3.7
1.7
0.46
0.57
0.3
0.5
0.5
Median Current
0.97
0.94
0.9
1.7
1.1
0.86
0.9
0.4
0.7
0.6
A&F Multiples Evaluation
The relative valuations seem to indicate that
A&F’s stock is either fairly valued or slightly undervalued. Now, based on ANF current multiples
(on an absolute basis) and forecasted target values per share, I have arrived to the following calculation of a target price for ANF:
Absolute
valuation
High
Low
Median Current
Target E,
Target
Target
S, B... per
multiple
price
share
P/Forward E
26.1
8.2
14.6
15.4
P/B
9.3
0.8
3.3
2.2
P/S
3.2
0.4
1.7
0.9
P/CF
19.4
2.7
11.1
8.4
P/EBITDA
14.4
1.79
8.33
6.58
Average of target prices
Average of target prices (excluding P/Forward E multiple)
Upside/Downside potential over Current stock price ($50.23)
16
2.6
1
9
7.5
3.2
23.21
58.17
6.74
7.8
51.20
60.35
58.17
60.66
58.50
57.78
59.42
18.3%
The overall target price range goes from $51.20 to
$60.35. However, the target price coming from the
P/E multiple is much smaller than those obtained
with the other 4 multiples (which have an overall
spread of only $2.16). Therefore, it makes sense to
exclude it from the final calculation, ultimately
leading to a target price of $59.42 with a potential
18.3% upside compared to the current price of
$50.23.
Page 10/18
ANF: Abercrombie & Fitch – Equity Research Report
dise from approximately 155 vendors in more
than 20 countries over the world.
Risks
Obviously, one should keep in mind that this
valuation is only based on estimates and assumptions and that for many reasons, reality may differ from the expected scenario. Some risks exist,
both internally and externally, that could explain
a radically different evolution of the company’s
results and/or stock price.
External risks
Negative changes in the economic and financial
conditions can impact dramatically the company’s results. In particular, the apparel industry
supplies discretionary goods and immediately
suffers from a decrease in consumer spending.
For existing international stores, especially in Europe, the ongoing economic context could adversely impact the stores’ productivity and the
potential new openings projects.
In addition, A&F’s international expansion strategy depends on the accessibility of new markets,
which can be limited by factors like higher exchange rates or local government policies. Indeed,
A&F’s international subsidiaries usually operate
with currencies other than USD, requiring a translation from one to another for all revenues and
expenses realized overseas. Consequently, the
risk of currency fluctuation increases when international expansion increases.
Moreover, the apparel industry is extremely dependent on fashion trends and consumer preferences, which tend to change more and more rapidly, making it relatively challenging to keep anticipating the consumer’s preferences. Once
again, the company’s international expansion
leads to a broader customer base and therefore
increases the risk of not meeting some of the customers’ expectations (due to different tastes and
cultures in different locations).
Finally, fluctuation in the cost, availability and
quality of raw materials can also increase costs
and cause manufacturing issues. It has to be noted, though, that the company is relatively hedged
against a major supplier problem as it has not
sourced more than 10% of its merchandise from
any single player in 2012. A&F sources merchan-
SIM Program
Martin Perrier
Summer 2013
Internal risks
Among the internal risks threatening the company, the main one is the potential loss of A&F’s
competitive advantage: the A&F brand image. As
I explained earlier, all the controversies related to
nudity, sexuality, exclusionary targeting may in
the end benefit the company but that still has to
be proven, while the consistent criticism remains
against the brand. The next controversy might
simply be the one from where one can’t come
back…
But even without the event of additional controversies, consumer preferences change and it is
likely that at some point, A&F communication
based on “sexy” and nudity will not have the
same impact it has had for the past 20 years. The
smartphones and internet era dramatically facilitates the access to nudity and what was yesterday
some sort of mystery for teenagers has become
today relatively banal for their younger siblings.
In addition, CEO Michael Jeffries is emblematic to
the brand and a symbol to the company. The loss,
for any hypothetical reason, of such an inspirational leader could adversely impact the company’s image and operations.
Besides, Jeffries is also the main actor of the aggressive expansion of the company (initially in
the US, currently over the world) which obviously presents a major risk: new capital expenditures
are not to be underestimated, as a bad capital
management could lead to serious operating issues for current stores. In fact, when Jeffries
founded another apparel retailer, Alcott & Andrews, in 1984, he got a little carried away by its
initial success and had to file for bankruptcy in
1989 due to overexpansion...
The size and structure of A&F, though, should
definitely help preventing such a mistake. As I
mentioned, following a too dynamic expansion
right before the economic crisis of the late 2000’s,
they have actually already started consolidating
US stores and slowing down the European expansion.
Page 11/18
ANF: Abercrombie & Fitch – Equity Research Report
Conclusion
Weighted average target price
The Discounted Cash Flow model, with a 10.5%
discount rate and a 2.5% terminal FCF growth
rate, indicated a target price of $63.80 (27% upside) while the multiples valuation led to a target
price of $59.42 (18.3% upside).
Due to the (assumed) better accuracy of the DCF
valuation and its already conservative target price
(in the low side of the targeted price range), I
combined the two valuation methods with a
weight of 70%/30% in favor of the DCF analysis
(see details of the calculation in the table below).
Therefore, the final ANF target price supported
in this stock report is $62.49, providing a 24.4%
upside to the current price of $50.23 (July 16,
2013). Including the 1.6% dividend yield, the
total projected return is then 26%.
Calculation of the final
target price for A&F
Current Price
DCF Target price
Multiples Target price
Price
Up/Downside
potential
Weight
$ 50.23
$ 63.80
$ 59.42
27.0%
18.3%
70%
30%
Weighted average Target price
$ 62.49
24.4%
100%
Abercrombie and Fitch: the Bull, the Bear and the
Base case
Let’s use the aforementioned target price as the
Base case. Indeed, although a 24% upside seems
pretty optimistic, assumptions used in net income
forecasts and free cash flow calculations were
relatively conservative. Besides, this prediction
does not seem unreasonable in regard to the previous prices the stock has already reached ($83 in
2007 and, more recently, $75 in October 2011).
However, as reality may at times differ significantly from expectations, it is essential to keep an
open mind concerning the possible evolution of
the company over the near future.
SIM Program
Summer 2013
Martin Perrier
In the Bear case, several assumptions would be
somewhat different. First of all, the expected increase in consumers’ disposable income in a context of economic recovery might fall below expectations, leaving potential customers with smaller
resources as well as a lack of confidence in the
economy, thus leading to the need for even more
store closings. Also, the economic situation in
Europe could remain identical, freezing any potential project of expansion. In parallel, despite
local customers’ high expectations ensuring positive initial results, international openings in Asia
could quickly reveal less productive than they
have been in Tokyo a couple of years ago, for example. Finally, the image and reputation of the
company could very well be eroded by the accumulation of controversies around its communication and strategic positioning. In that scenario, a
much lower target price should be considered,
probably below the targeted range and even below the stock current’s price.
In the Bull case, however, the store consolidation
strategy implemented in the US would reveal
extremely productive, improving stores operating
margins and boosting sales in Q3 and Q4, by far
the two most dynamic quarters for the whole industry. An improvement of the European economy as well as an incredible excitement in Asia
due to the anticipation of stores’ openings would
also be two key factors of international and overall success. Internally, the company would keep
working on the improvement of its operations,
including the establishment of a better inventory
management. Finally, facing the ever-growing
obesity in the country, Abercrombie & Fitch could
become an emblematic leader in a global fight
against this primary society concern. In these
conditions, the actual target price could easily
reach the top of the targeted price range ($80).
If these last two scenarios are probably a bit extreme, I believe they both offer interesting elements to discuss, either in favor or against the
company’s future performance.
Page 12/18
ANF: Abercrombie & Fitch – Equity Research Report
Martin Perrier
anymore, the brand will still keep for a
while its image of sexiness well installed
in public opinion;
Recommendation
To conclude, I do recommend a BUY for this
stock. Indeed:
-
I do believe that A&F is going into the
right direction in terms of internal reorganization of the US stores (closing underperforming stores, improving inventory
management and operating margins);
-
With the unfortunate experience of the
overexpansion to lower tier cities right before the recession, I am convinced the
company is now managing its international expansion much more wisely;
-
-
-
The international growth opportunities,
and precisely in economies where the apparel industry is still far from being mature, are going to play a key role in the
company’s performance;
In its ideal phase of the business cycle, the
consumer discretionary sector is currently
thriving and, in my opinion, this is likely
to continue for an additional couple of
years;
If Abercrombie & Fitch cannot rely on its
(now banalized…) sense of provocation
SIM Program
Summer 2013
-
Finally, facing what is probably one of the
USA’s biggest health problems (obesity),
A&F might indeed find a spot, or create
one, as a dedicated partner of the fight
against this rampant epidemic. However, I
doubt this could ever be initiated under
Michael Jeffries’ management…
As a conclusion, I am not certain I would include
ANF equity in a long-term strategy but I definitely recommend a BUY for a mid-term strategy on a
1 to 3 year horizon.
Stock: Abercrombie and Fitch
Ticker: ANF
Current Price: $50.23 (July 16, 2013)
Estimated 52-week target price: $62.49
Recommendation: BUY
Analyst: Martin Perrier
Page 13/18
ANF: Abercrombie & Fitch – Equity Research Report
Martin Perrier
Sources
Abercrombie & Fitch Annual Reports 2011, 2012, 2013 (FORM 10-K)
Abercrombie & Fitch Q1 2013 Investor Presentation
Abercrombie and Fitch: www.abercrombie.com
Abercrombie kids: www.abercrombiekids.com
Hollister: www.hollisterco.com
Gilly Hicks: www.gillyhicks.com
Abercrombie – Investors: http://www.abercrombie.com/anf/investors/investorrelations.html
Thomson Reuters Baseline
Bloomberg
Fidelity:
https://eresearch.fidelity.com/eresearch/markets_sectors/sectors/sectors_in_market.jhtml?sector=25&tab=le
arn
Forbes : http://forbes.com; http://www.forbes.com/sites/dividendchannel/2013/05/21/see-how-abercrombiefitch-ranks-among-analysts-top-picks-with-strong-buyback-activity/
Yahoo Finance: http://finance.yahoo.com; http://finance.yahoo.com/news/abercrombie-fitch-may-launchmassive-112954601.html
Google Finance : http://www.google.com/finance
Seeking Alpha: http://seekingalpha.com/article/1460091-abercrombie-fitch-management-discusses-q12013-results-earnings-call-transcript
The Man behind Abercrombie and Fitch: http://www.salon.com/2006/01/24/jeffries/
The Columbus Dispatch: http://www.dispatch.com/content/stories/business/2012/02/18/af-will-shutter180-stores-in-3-years.html
S&P Dow Jones Indices: http://us.spindices.com/indices/equity/sp-500/
BusinessWeek: http://investing.businessweek.com/
SIM Program
Summer 2013
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ANF: Abercrombie & Fitch – Equity Research Report
Martin Perrier
Appendixes
Appendix 1: Income Statement Forecasting
A. Segment Forecast
Segment sales forecast
NET SALES
US Stores
Growth
International Stores
Growth
Direct-to-Consumer
Growth
Total Sales
Total growth
2008
2009
2010
2011
2012
2013 E
2014 E
2015 E
3,219,624
2,566,118
-20.30%
362,508
37.09%
2,546,798
-0.75%
517,005
42.62%
404,974
2,928,626
-15.94%
3,468,777
18.44%
2,710,842
6.44%
894,616
73.04%
552,600
36.45%
4,158,058
19.87%
2,615,138
-3.53%
1,195,016
33.58%
700,651
26.79%
4,510,805
8.48%
2,353,624
-10%
1,493,770
25%
805,749
15%
4,653,143
3.16%
2,188,871
-7%
1,837,337
23%
910,496
13%
4,936,704
6.09%
2,101,316
-4%
2,204,805
20%
1,019,755
12%
5,325,876
7.88%
264,434
3,484,058
B. Consolidated Forecast (details calculations)
Expenses calculation as % of sales
2008
2009
2010
2011
2012
2013 E
2014 E
2015 E
NET SALES
Cost of Goods Sold
3,484,058
2,928,626
1,152,963
33.1%
2,331,095
1,436,363
41.2%
405,248
11.6%
(8,778)
-0.3%
498,262
(11,382)
-0.3%
509,644
201,475
39.5%
1,045,028
35.7%
1,883,598
1,425,950
48.7%
353,269
12.1%
(13,533)
-0.5%
117,912
(1,598)
-0.1%
119,510
40,557
33.9%
3,468,777
1,251,348
4,158,058
1,607,834
4,510,805
1,694,096
4,653,143
1,712,357
4,936,704
1,796,960
5,325,876
1,917,315
36.1%
38.7%
37.6%
36.8%
36.4%
36.0%
2,217,429
1,589,501
2,550,224
1,888,248
2,816,709
1,987,926
45.8%
45.4%
44.1%
400,804
437,120
473,883
11.6%
10.5%
10.5%
(10,056)
3,472
(19,333)
-0.3%
0.1%
-0.4%
237,180
3,362
221,384
3,577
374,233
7,288
0.1%
0.1%
0.2%
233,818
78,109
217,807
74,669
366,945
129,934
33.4%
34.3%
35.4%
308,169
78,953
155,709
143,138
237,011
2,940,786
2,047,383
44.0%
511,846
11.0%
(9,306)
-0.2%
390,864
4,653
0.1%
386,211
134,788
34.9%
251,423
3,139,743
2,172,150
44.0%
493,670
10.0%
4,937
0.1%
468,987
4,937
0.1%
464,050
160,097
34.5%
303,953
3,408,560
2,316,756
43.5%
532,588
10.0%
5,326
0.1%
553,891
5,326
0.1%
548,565
189,255
34.5%
359,310
(35,914)
(78,699)
272,255
254
237,011
251,423
303,953
359,310
% of sales
GROSS PROFIT
Stores and Distribution Expense
% of sales
Marketing, General and Administrative Expense
% of sales
Other Operating Expense (Income), Net
% of sales
OPERATING INCOME
Interest Expense, Net
% of sales
INCOME FROM CONTINUING OPERATIONS
Tax Expense from Continuing Operations
% of income
NET INCOME FROM CONTINUING OPERATIONS
NET INCOME FROM DISCONTINUED
NET INCOME
SIM Program
796
155,709
143,934
Summer 2013
Page 15/18
ANF: Abercrombie & Fitch – Equity Research Report
Martin Perrier
B. Consolidated Forecast
In $ thousands, except share and per share amounts
2008
2009
2010
2011
2012
2013 E
2014 E
2015 E
NET SALES
3,484,058
2,928,626
3,468,777
4,158,058
4,510,805
4,653,143
4,936,704
5,325,876
Cost of Goods Sold
1,152,963
1,045,028
1,251,348
1,607,834
1,694,096
1,712,357
1,796,960
1,917,315
GROSS PROFIT
2,331,095
1,883,598
2,217,429
2,550,224
2,816,709
2,940,786
3,139,743
3,408,560
Stores and Distribution Expense
1,436,363
1,425,950
1,589,501
1,888,248
1,987,926
2,047,383
2,172,150
2,316,756
405,248
353,269
400,804
437,120
473,883
511,846
493,670
532,588
Other Operating Expense (Income), Net
(8,778)
(13,533)
(10,056)
3,472
(19,333)
9,306
4,937
5,326
OPERATING INCOME
498,262
117,912
237,180
221,384
374,233
390,864
468,987
553,891
Interest Expense, Net
(11,382)
(1,598)
3,362
3,577
7,288
4,653
4,937
5,326
INCOME FROM CONTINUING OPERATIONS BEFORE TAXES
509,644
119,510
233,818
217,807
366,945
386,211
464,050
548,565
Tax Expense from Continuing Operations
201,475
40,557
78,109
74,669
129,934
134,788
160,097
189,255
NET INCOME FROM CONTINUING OPERATIONS
308,169
78,953
155,709
143,138
237,011
251,423
303,953
359,310
INCOME FROM DISCONTINUED OPERATIONS, Net of Tax
(35,914)
(78,699)
NET INCOME
272,255
254
155,709
143,934
237,011
251,423
303,953
359,310
89,291
88,609
89,851
89,537
83,175
78,320
78,320
78,320
NET INCOME PER DILUTED SHARE:
3.05
0
1.73
1.61
2.85
3.21
3.88
4.59
DIVIDENDS DECLARED PER SHARE
$0.70
$0.70
$0.70
$0.70
$0.70
$0.80
$0.80
$0.80
Marketing, General and Administrative Expense
WEIGHTED-AVERAGE DILUTED SHARES OUTSTANDING:
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Summer 2013
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ANF: Abercrombie & Fitch – Equity Research Report
Martin Perrier
Appendix 2: Discounted Cash Flow Analysis
Abercrombie and Fitch (ANF) - Discounted Cash Flow analysis
Analyst: Martin Perrier
Terminal Discount Rate =
10.5%
Terminal FCF Growth =
2.5%
7/15/2013
Year
Revenue
% Growth
Operating Income
Operating Margin
Interest
Interest % of S ales
Taxes
Tax Rate
Net Income
% Growth
Add Depreciation/Amort
% of S ales
Plus/(minus) Changes WC
% of S ales
Subtract Cap Ex
Capex % of sales
Free Cash Flow
% Growth
4,653,143
3.16%
390,864
8.40%
4,653
0.10%
134,788
34.90%
251,423
6%
232,856
5.0%
32,549
0.7%
220,000
4.7%
296,829
3.5%
2014E
4,936,704
6.1%
468,987
9.5%
4,937
0.1%
160,097
34.5%
303,953
20.9%
249,227
5,325,876
7.9%
553,891
10.4%
5,326
0.1%
189,255
34.5%
359,310
18.2%
272,575
2016E
5,645,428
6.0%
592,770
10.5%
5,645
0.1%
202,558
34.5%
384,567
7.0%
270,981
2017E
5,871,245
2018E
6,047,383
4.0%
645,837
11.0%
6,047
6,229
0.1%
0.1%
227,412
234,234
34.5%
34.5%
431,753
9.0%
281,820
685,168
11.0%
34.5%
419,178
3.0%
665,212
0.1%
220,788
6,228,804
3.0%
11.0%
5,871
2019E
444,705
3.0%
3.0%
290,274
298,983
2020E
6,384,524
2.5%
702,298
11.0%
6,385
0.1%
240,090
34.5%
455,823
2.5%
306,457
2021E
6,544,137
2.5%
719,855
11.0%
6,544
0.1%
246,092
34.5%
467,219
2.5%
314,119
2022E
6,707,741
2.5%
737,851
11.0%
6,708
0.1%
252,245
34.5%
478,899
2.5%
321,972
2023E
6,875,434
2.5%
756,298
11.0%
6,875
0.1%
258,551
34.5%
490,872
2.5%
330,021
4.8%
4.8%
4.8%
4.8%
4.8%
4.8%
4.8%
4.8%
4.8%
(16,614)
(7,884)
(11,291)
(11,742)
(12,095)
(12,458)
(12,769)
(13,088)
(13,415)
(13,751)
-0.3%
212,278
4.3%
324,287
9.3%
2,581,929
NPV of terminal value
2,414,654
48%
Projected Equity Value
4,996,583
100%
78,320
2015E
5.0%
NPV of Cash Flows
Shares Outstanding (thsd)
SIM Program
2013E
-0.1%
229,013
4.3%
394,989
21.8%
-0.2%
242,753
4.3%
401,503
1.6%
-0.2%
252,464
-0.2%
4.3%
436,791
-0.2%
260,037
267,839
4.3%
4.3%
449,895
8.8%
463,392
3.0%
3.0%
-0.2%
274,535
4.3%
474,977
2.5%
-0.2%
281,398
4.3%
486,851
2.5%
-0.2%
288,433
4.3%
499,022
2.5%
-0.2%
295,644
4.3%
511,498
2.5%
52%
Terminal Value
Current Price
$
Implied equity value/share
$
Upside/(Downside) to DCF
Summer 2013
6,553,567
50.23
63.80
27.0%
Page 17/18
ANF: Abercrombie & Fitch – Equity Research Report
Martin Perrier
Appendix 3 : Sensitivity analysis
Sensitivity analysis based on the potential target price
Terminal discount rate
Terminal FCF growth
$
50.23
9%
9.0%
9.5%
10.0%
10.5%
11.0%
11.5%
12.0%
12.5%
0.5%
72.48
67.96
63.95
60.37
57.15
54.24
51.60
49.20
47.00
1.0%
75.09
70.17
65.84
61.99
58.55
55.46
52.66
50.13
47.82
1.5%
78.08
72.68
67.96
63.80
60.10
56.80
53.83
51.15
48.71
2.0%
81.52
75.54
70.36
65.84
61.84
58.29
55.12
52.27
49.69
2.5%
85.54
78.85
73.11
68.14
63.80
59.96
56.56
53.51
50.77
3.0%
90.29
82.70
76.28
70.78
66.01
61.84
58.16
54.89
51.96
3.5%
95.99
87.26
79.98
73.82
68.55
63.97
59.96
56.43
53.28
4.0%
102.95
92.73
84.35
77.38
71.47
66.40
62.01
58.16
54.76
4.5%
111.66
99.41
89.60
81.57
74.88
69.21
64.34
60.12
56.42
Sensitivity analysis based on the potential upside (downside)
Terminal discount rate
Terminal FCF growth
$
SIM Program
0.5%
50.23
9%
44.3%
9.0%
35.3%
9.5%
27.3%
10.0%
20.2%
10.5%
13.8%
11.0%
8.0%
11.5%
2.7%
12.0%
-2.1%
12.5%
-6.4%
1.0%
49.5%
39.7%
31.1%
23.4%
16.6%
10.4%
4.8%
-0.2%
-4.8%
1.5%
55.4%
44.7%
35.3%
27.0%
19.7%
13.1%
7.2%
1.8%
-3.0%
2.0%
62.3%
50.4%
40.1%
31.1%
23.1%
16.1%
9.7%
4.1%
-1.1%
2.5%
70.3%
57.0%
45.6%
35.7%
27.0%
19.4%
12.6%
6.5%
1.1%
3.0%
79.7%
64.6%
51.9%
40.9%
31.4%
23.1%
15.8%
9.3%
3.4%
3.5%
91.1%
73.7%
59.2%
47.0%
36.5%
27.4%
19.4%
12.3%
6.1%
4.0%
105.0%
84.6%
67.9%
54.0%
42.3%
32.2%
23.4%
15.8%
9.0%
4.5%
122.3%
97.9%
78.4%
62.4%
49.1%
37.8%
28.1%
19.7%
12.3%
Summer 2013
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