A history of high margins

One more wrinkle already ironed out

Operating margins in FY 2010  (FYE Jan 2011) represented a slight recovery to 8% over 2009’s trough 3.6%[1], however margins in 2011 subsequently declined a bit to 7.7%.  The primary cause of margin recovery derailment was a dramatic rise in cotton costs. Cotton had fluctuated between $0.60 and $0.80 per pound (occasionally lower) through the entire decade of 2000 through 2010.  However, between July of 2010 and Mar of 2011, cotton spiked from $0.84 to $2.30.  Cotton has since fallen below $1.00 per pound as of November 2011.  Management state that higher cotton costs contributed the majority of 2011’s gross margin decline of 3.2%.  If we assume that mark downs contributed 40% of the decline and cotton increases the remaining 60%, its striking to have a built-in 2% margin tailwind in a quality branded retailer trading at 3.5x EBITDA.

Management

Mike Jeffries is the iconoclastic CEO and COB largely credited with the creation of Abercrombie brand we know today.  Often described as obsessive, meticulous, superstitious and controlling, he embodies the style of a physique of a 25 year old despite his numerical age of 67.  Staunchly against discounting merchandise to maintain the aspiration nature of the Abercrombie brand, he has been known to raise prices in the face of recession.  To create a brand that “sizzles with sex”, he employs shirtless models as greeters to his stores and on more than one occasion has gotten in trouble with parental watchdog groups for producing catalogs deemed too racy and only hiring attractive employees.  He also intentionally doesn’t utilize one of the most valuable pieces of a retailer’s real estate, successfully breaking a cardinal rule of retailing.  Rather than use the front windows for merchandise displays, Abercrombie and Hollister cover their windows with shades to create a club like atmosphere.  Jeffries owns a substantial amount of equity in the form of 1mm shares outright and 7.84mm options with strikes generally ranging from $25-$55.  He clearly has skin in the game, however he has 10b5-1 plan that he has used to sell exercised options though he has not sold any shares since December around $50.   (For a couple of decent profiles on Jeffries see: http://www.businessweek.com/stories/2005-05-29/flip-flops-torn-jeans-and-control  and http://www.salon.com/writer/benoit_denizet_lewis/)

Capital allocation

I would grade management’s historical capital allocation a B- (maybe worse), however they seem to have gotten religion and are moving firmly into the A range.  Like most retailers, they have sunk capital into money losing concepts including RUEHL, abercrombie (kids) and potentially Gilly Hicks (the jury is still out on this one).  They were also too aggressive at store expansion in the US in the early 2000s, and as discussed above, they were a bit too aggressive in European expansion over the last 2 years.  Today, capital is generally spent on new A&F/Hollister stores in Europe, share buybacks and dividends.  Given the decline in share price, management is correctly most focused on share repurchases.  Over the last two years ANF has repurchased 5mm shares (6% of the company) for $273mm.  With its first quarter earnings in May, ANF authorized an additional 10mm shares brining the current authorization to 12.9mm, or 15% of the company.  CFO Jon Ramsden further articulated his thoughts on capital allocation 3/7/12 stating, “Our basic parameters on use of cash are the same. We want to maintain that trough cash cushion of around $350 million. Beyond that, we will be in the market making repurchases when we think it's opportune to do so from a market standpoint. And obviously based on our overall view of the business and market conditions, the term loan we locked into last week was basically a very inexpensive facility we've set up, which gives us flexibility if we want to go out go after buybacks more aggressively. That would really be the only reason we would dip into it.”  Apparently, investor pressure is only increasing as a recent New York Post article that claims that ANF is planning a very large repurchase effort partially funded by trimming its 2012 European expansion plans and its related $400mm 2012 CapEx budget. (http://www.nypost.com/p/news/business/le_preppy_pe_yew_CYG7XhnaYYfeq4aFMwu0PN).  ANF also pays a $0.70 annual dividend, which means the stock currently yields better than 2%, which handily beats a ten year treasury. 

Other opportunities

ANF’s direct to consumer has tripled in the last 5 years to $552mm in FY 2011 and management believes it will grow to $1bn over time.  Not surprisingly, DTC sales are the highest margin activity at the company at over 50% operating margins.  Management has indicated that DTC sales also benefit from store closures, though they have not quantified the effect.

Valuation

After declining 60% from its October high of nearly $77 to its current price of $32.50, ANF has a fully diluted market cap of $2,800mm and an enterprise value of $2,510mm after backing out nearly $300mm of net cash.  Consensus EBTIDA for 2012 is $715mm providing for a very inexpensive 3.5x.  That still only represents 10% operating margins versus its long running historical 20% average.  While comps have been challenging, the company should be able to achieve its targeted 2.5% margin increase over 2011 with the tailwinds of cotton price declines, accretive store closures, and previously opened European stores ramping up.  Share repurchases will also be very accretive to value though not margins.  While CapEx has averaged $285mm over the last 5 years due to store builds and DTC investments, CFO Jon Ramsden estimates maintenance CapEx runs below $100mm implying  TEV/EBITDA-maint capex of 4x and after tax adjusted free cash flow of $385mm for a 6.5x multiple. Management’s most recent 2012 EPS guidance of $3.50 to $3.75 implies 8x backing out $3.40/share in net cash.  By any metric ANF is cheap. Over time, margins should trend back toward 20% and, if management is ballpark accurate with its long term European store estimates, it is possible to envision over $7bn in total company sales and $1.75bn in EBITDA.  While this is simply an illustration of potential earnings power rather than an estimate, investors need not believe in such lofty targets to make money at current prices.