Description

ANF is a teen retailer that earns 30%+ returns on capital and trades for 8x normal free cash flow.

The company has 2 premium brands: Abercrombie & Fitch and Hollister (each comprising about 45% of sales). There is also a kids' concept called abercrombie (~10% of sales), and a start-up lingerie concept called Gilly Hicks. Within the past few years, ANF has begun to expand internationally, where the A&F and Hollister brands appear to be even more sought-after than they are in the US.

I will argue 3 related points: First, ANF's brand franchises constitute a sustainable moat. Second, the company's normal earnings power is over $3.50 per share. Third, ANF is likely to experience double-digit annual free cash flow growth over the next decade.

BRAND FRANCHISES
It is widely perceived that teen retailing is a bad business. A common assertion in support of this view is that the customer is fickle. No one knows in advance what will be in style next season. Another assertion is that success in fashion begets failure: the more popular a particular brand becomes, the less likely it is to be seen as desirable. Yet another assertion is that there are no barriers to entry: competitors can freely walk through the stores of temporarily successful concepts and copy them. As a result, the argument goes, teen retailing (and fashion retailing in general) is an industry that does not support the existence of enduringly profitable enterprises.

The facts suggest otherwise. The three most prominent teen retailers-Abercrombie and Fitch (ANF), American Eagle (AEO), and Aeropostale (ARO)-have earned returns on invested capital in excess of 30% for nearly 15 years. They have done so while routinely missing fashion trends and suffering the related short-term effects. They have remained highly profitable despite steadily increasing popularity and now near-ubiquity.

The source of competitive advantage that has permitted the long-term success of these teen retailers is their brand franchises. It is true that short-term fashion trends are changeable and hard to predict, but the appeal of particular brands is based on psychological characteristics of the customers that do not change: they aspire toward privilege, prep, and sex. And while it is impossible to get the fashion right every season, established retailers like ANF, AEO, and ARO have a demonstrated ability to get fashion right on average and over time.

In fact, retailers possessing iconic brands can, to an extent, influence or dictate fashion trends as a result of their unique stature. ANF stands alone in this regard, with premium brands that enable the company to charge 100% more than competitors for comparable products. Price increases historically have exceeded the rate of inflation.

Sustaining a brand's franchise value requires discipline, and discipline is a barrier to entry that is seldom discussed. In weak retailing environments, there can be enormous pressure to be promotional in order to clear inventories, buttress same-store-sales trends, and combat potential market share losses. Executives risk losing their jobs by ignoring the concerns of investors and analysts who are worried about the upcoming quarter or year. However, promotional behavior can have the long-term consequence of reducing the stature and the pricing power of the brand. In this way, managing a retail brand is like being a value investor: it can be difficult to stick with the strategy through difficult conditions, but long-term success necessitates doing so.

As regards discipline, ANF also stands alone. The founder, CEO, and Chairman-Michael Jeffries-has created a corporate culture of maniacal protection of brand integrity. Here is an illustrative Jeffries quote from the 2Q08 earnings conference call:

We position our brands to be aspirational. We differentiate our brands by combining the highest            quality, trend right merchandise with an exceptional shopping experience that stimulates the senses and creates an emotional connection with our customer. We are absolutely committed to protecting and enhancing our brands' long-term sustainability.

It is this approach that has allowed us to produce some of the most highly productive and profitable businesses in retail. We do not compete on price or promotion, regardless of macroeconomic conditions, although it may be both easy and tempting to drive short-term sales with pricing and promotional efforts, this approach will diminish the long-term strength and profitability of premium brands.

It is clear to me that our decision back in 2005 to raise retail prices in the Abercrombie & Fitch brand reinforced its aspirational position and contributed to the substantial international appeal and growth prospects that the brand enjoys today.

NORMAL EARNINGS POWER
ANF has an outstanding track record of growth and profitability, dating back to the early 1990s. The table below shows some statistics from 2000-2008. Following the company's own convention, each year represents the fiscal year ending a month later; for example, "2008" represents the fiscal year ended February 3, 2009.

                                          2000    2001    2002    2003    2004    2005    2006    2007     2008
Sales per sq. ft. ($)              354      401      379      345      360      464      500      489      425     
Gross square footage (M)      2.8       3.7       4.4       5.0       5.6       6.0       6.7       7.3     8.0
Revenue ($ M)                     1,238   1,365   1,596   1,708   2,021   2,785   3,318   3,750     3,540
Y/y growth (%)                     20.1     10.3     16.9     7.0       18.4     37.8     19.2     13.0     -5.6      

EBIT ($ M)                           254      268      312      331      348      543      658      740     439     
EBIT margin (%)                  20.5     19.6     19.6     19.4     17.2     19.5     19.8     19.7     12.4

EPS ($)                               1.55     1.62     1.94     2.06     2.28     3.66     4.59     5.20     3.05
ROIC (%)                            45        35        37        36        28        36        37        34      18

Estimating ANF's normal earnings power is challenging because there is a possibility that the company's profitability will be permanently diminished by a change in the behavior of American consumers. That is, if Americans save more, carry less credit card debt, take fewer trips to the mall, and so on, then demand for ANF's wares would permanently decrease. The economy will rebound from recession, but ANF will not rebound to its historical level of profitability or earnings power.

However, it is nonetheless possible to formulate a reasonable "worst-case" normal earnings power by observing how the company performed in 2008. This was a recessionary year, and the seasonally most important fourth quarter coincided with one of the economically scariest environments in history, causing a precipitous drop in consumer confidence and spending. Therefore, even in light of higher future savings rates among Americans, I believe that 2008 would be an understated proxy for ANF's future normal earnings power.

After adjusting for items that do not reflect the underlying earnings power of the business, I estimate ANF's normal EPS to be $3.70:

                                                                             Comment
Sales per sq. ft. ($)                          425                  = 2008
Gross square footage (M)                  8.4                   Estimated year-end 2009
Revenue ($ M)                                 3,580

EBIT margin                                    12.4%              = 2008
EBIT ($ M)                                      444

($ M)
Plus: RUEHL losses / impairment     58                      A loss-making concept shut down in 2009
Plus: Other impairment charges        9                      Impairments taken to stores
Plus: Pre-opening rent                    30                    Rent paid for non-producing stores
EBIT as adjusted                            541                 
EBIT margin as adjusted                 15.1%

Less: Taxes @40%                         216
Net income                                    325                  Excludes interest income / expense
Diluted shares (M)                          88
EPS                                               $3.70

A word about depreciation and maintenance capex: I define maintenance capex as all capex not related to increases in gross square footage (so, maintenance capex includes the cost of store remodels). The company does not report maintenance capex, but it is possible to make an estimate by calculating the cost of square footage growth, based on historical PP&E per square foot statistics. I subtract this "growth capex" figure from total capital spending to arrive at maintenance capex. Based on this analysis, I do not believe there is an appreciable difference between maintenance capex and depreciation. Therefore, I consider net income an appropriate proxy for free cash flow.

VALUATION
At $28 per share, ANF stock is trading for 8x normal free cash flow per share of $3.70.

I believe this is cheap because of the long-term sustainability of ANF's brands and the long-term opportunity to increase square footage. Based on the company's view of store count potential, I estimate square footage could increase by 60% globally (excluding the unproven Gilly Hicks concept). If this is true, then ANF would be able to increase square footage at 5% annually for the next decade, though it is likely that the growth will be more rapid.

One way of estimating future free cash flow growth is to calculate the reinvestment rate and the incremental return on capital. This necessitates an estimate of store-level economics, which is presented below. Sales per square foot is normalized per the above calculations, while other per-square-foot statistics are historical averages from 2005-2008.

Gross square feet (000)                                  8,000

Inventory / sq. ft.                                            $56
Inventory ($ 000)                                            445

PP&E / sq. ft.                                                  $169
PP&E ($ 000)                                                 1,349

Invested capital ($ 000)                                  1,794  

Sales / sq. ft                                                    $425
Revenue ($ 000)                                             3,400

Gross margin %                                              66.7%
Gross profit ($ 000)                                        2,267

Stores and distribution expense / sq. ft.         $94*
Stores / dist. expense ($ 000)                         754

EBIT ($ 000)                                                   1,514

Less: Taxes @40% ($ 000)                            606                                         
NOPAT ($ 000)                                              908

ROIC                                                               50%

* On the 2Q09 conference call, ANF indicated that about ½ of stores and distribution expense is fixed. Therefore, for calculating store-level economics I use 50% of the historical per-square-foot figure of $188.

The incremental ROIC, then, is roughly 50%. The reinvestment rate assuming 5% annual square footage growth would be about 30%, as per the following calculation:

(a) Est. 2009 year-end square footage (M)                        8.4                   Assumption
(b) Annual incremental sq. ft. (5% growth) (M)                   0.420               a * 5%
(c) PP&E per square foot                                                  $169                Assumption
(d) Inventory per square foot                                           $56                  Assumption
(e) Investment in new stores ($ 000)                                94,000             (b * c) + (b * d)
(f) Normal free cash flow ($000)                                       325,000           Assumption
Reinvestment rate                                                           30%                 e / f                             

Multiplying the incremental return on capital of 50% by the reinvestment rate of 30% produces annual free cash flow growth of roughly 15%. A company that will grow free cash flow at 15% annually for the next decade is worth no less than 20x free cash flow. At that valuation, the stock would trade at $74 per share, representing 165% upside to the current share price.                

It is unlikely that ANF will fetch the valuation it deserves before the economy recovers (or is expected to). Therefore, it makes sense to consider what the normal earnings power will be at a time when a recovery can reasonably be expected to occur-say, 3 years from now. If ANF grows square footage at 5% annually over that period, then, per the above calculation, earnings power would increase at 15% annually. At the end of 3 years, normal free cash flow would be about 50% higher than it is today, equal to $5.55 per share. Applying a multiple of 15-20x, the stock would trade for between $85-110 per share. The 3-year compound annual return from today's stock price would be 45-60%.

A WORD ABOUT OPERATING LEASES
Like most of the specialty retail industry, ANF rents its stores and accounts for its leases as operating leases. Sometimes this accounting is criticized as overstating returns on capital and understating financial leverage. Indeed, if one were to capitalize ANF's leases, ROIC would decrease to a mid-teens range, and interest expense would increase from a de minimis level to nearly $300 million.

In my view, there are two important observations about operating versus capital leases. The first is that this is an accounting distinction and, as such, does not affect cash flow or valuation. The level of normal free cash flow to equity is the same under either accounting regime, as rent expense is merely exchanged for interest expense. The incremental ROIC is viewed as being lower with leases capitalized because the business is more capital intensive, but the reinvestment rate is commensurately higher because the business is more capital intensive. Therefore, the growth rate of free cash flow is unaffected.

A second observation is that if ROIC under operating lease accounting is viewed as being "inflated" by "hidden" leverage, the key question is whether the leverage is sustainable. In ANF's case, I think it clearly is. This year-in conditions so unfavorable they may never be experienced again-ANF is likely to generate over $50 million in net income, even while making significant investments in international expansion. Moreover, there is $650 million of net cash ($750 million of cash and $100 million of debt) on the balance sheet. This $7.40 per share of net cash was not included in the valuation calculations presented above.

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