Description

We are long Abercrombie & Fitch (NYSE: ANF, “A&F” or “the Company”), which is a mall-based specialty retailer that operates under the Hollister (60% of sales) and Abercrombie (40% of sales) brands. For additional information, please refer to mack885’s helpful write-up from 2012. Today, A&F has 879 stores globally (547 Hollister and 332 Abercrombie), of which 684 or 78% are in the U.S. and 195 or 22% are international (mostly in Europe, followed by Asia, Canada and the Middle East). The Company’s U.S. store count peaked at 1,082 in 2008 and is currently 684, a 37% decline as management has closed unprofitable stores.

https://www.fastcompany.com/40511151/inside-abercrombies-plot-to-win-over-gen-z-where-everyones-a-cool-kid

The above article does a good job explaining the transformation A&F has gone through in the past few years. Despite bears insisting that the Company’s turnaround has not worked and the stock is broken, A&F has performed relatively well recently. To summarize the article, Abercrombie is now targeting 21-24 year olds, vs. teens previously, which is the demographic Hollister targets (Hollister has had fewer issues than Abercrombie and has comped better). Mike Jeffries, the Company’s infamous CEO from 1993 to 2014, damaged the Abercrombie brand through his numerous racist and discriminatory comments and actions. With him gone, A&F has slowly begun to repair its image and now employs a much more diverse workforce and has advertisements that represent a broad range of ethnicities (vs. predominantly Caucasians during Jeffries’ tenure). The clothing has also changed, and now features fewer ripped/hole designs and is less revealing and more conservative and tasteful.

Having shopped at Abercrombie on and off for over 15 years, I’ve observed first-hand the positive changes the brand has gone through. When I was a teenager the clothing was expensive (but good quality) and very fashionable for preppy teenagers (i.e. the jocks), and the store demographic was mostly whites (and I grew up in a very diverse city so this is saying something). Over the last few years, I’ve observed that while the clothing has gotten cheaper, it remains high quality and fashionable (not just to teenagers but also to people in their 20s, and I’ve even witnessed people in their 30s and 40s shopping at the store). In addition, I’ve noticed that the demographic of shoppers has shifted towards a much more diverse set of ethnicities. As a result, I think it’s hugely positive for the Abercrombie brand that it’s diversified away from selling primarily to teenagers (which are a fickle demographic, so greater fashion risk) and now sells to a larger population set, which should help increase traffic going forward. I’ve also noticed that most times I go to the store there is some sort of promotion going on, which is somewhat impressive given despite all these promotions the Company is still able to generate 60% gross margins. Once the brand continues to recover, I think it’s possible the promotions lessen either in magnitude and/or frequency (although they won’t go away entirely as the sector will still likely remain highly competitive), resulting in a potential opportunity for gross margins to expand as a result.  

Our bullish view is in part driven by the Company’s recent SSS performance. A&F’s most recent quarter (Q3 2018) marked the fifth consecutive quarter of positive comps. Q3 2018 comped 3% on top of 4% the prior year. The 3% comp in Q3 2018 was driven by 4% at Hollister and 1% at Abercrombie. The U.S. in particular was very strong with a 6% comp, offset by the -3% international comp which continues to be a headwind. Annual historical comps for the entire Company are as follows: +3% in 2017, -5% in 2016, -3% in 2015, -8% in 2014, and -11% in 2013. With several years of negative comps, it’s not surprising a lot of investors got fed up with the stock and abandoned it. However, recent positive comps are encouraging, especially in the context of the broader retail environment in which several competitors continue to experience negative comps.

While we think it’s positive that company-wide SSS has recently been positive, it’s helpful to frame the current performance of the Company relative to its historical performance:

·       Sales: Currently $3.6bn and peaked at $4.5bn in 2012. Analysts forecast $3.6bn in 2019E and $3.7bn in 2020E, reflecting low growth expectations

·       Sales/sq ft: Currently ~$360, peaked at $503 in 2007, bottomed at $339 in 2009. Since Mike Jeffries’ departure, part of the turnaround strategy has been to lower prices and offer more frequent promotions, which we think has been necessary to regain traffic, but which has lowered sales/sq ft. While we don’t think sales/sq ft gets back to $500 any time soon, we believe there’s more upside to this metric than downside, as once the turnaround strategy stabilizes, management may reduce the frequency and/or magnitude of promotions, which could increase the average order value and thereby sales/sq ft

·       Online sales: $974mm in 2017 (28% of total sales), compared to $700mm in 2012 (16% of total sales) and $260mm in 2007 (7% of total sales). The Company has done a nice job of expanding its online business, and nearly a third of sales coming from direct-to-consumer is a healthy mix which is likely to continue to increase. We like that unlike other retailers like HIBB, ANF is not struggling to increase its online presence (2/3 of the online sales are coming from mobile which is positive)

·       Gross margin: Currently 60% (lowest in past 15 years), peaked at 67% in 2007. Analysts forecast GM remaining flat at 60% in 2019E and 2020E. Cotton prices are down over 10% in the last few months, which could provide a short-term boost to gross margins. Longer term, if promotions reduce in frequency and size, gross margins could increase.

·       SG&A: In the mid 2000s, annual SG&A was $1.3bn (47% of sales). As the Company’s store base expanded, SG&A climbed to a peak of $2.4bn (54% of sales) in 2012. Since 2012, SG&A has declined to $2.0bn LTM but has increased as a percentage of sales from 54% in 2012 to 56% LTM as the Company’s sales declined from $4.5bn in 2012 to $3.6bn LTM. As a result, SG&A as a percentage of sales has increased from 47% in 2005 to 56% LTM, a 9% absolute difference, explaining much of the Company’s margin erosion over the past several years

·       EBITDA margin: Currently 9%, peaked at 26% in 2007 and bottomed at 6% in 2016. Analysts forecast 8% in 2019E and 7% in 2020E, reflecting expectation for margin compression

As a result, despite the Company’s recent strong performance, the Company’s profitability is still well below historical levels based on several metrics, which we believe represents upside for the stock.

A&F screens cheap on both an absolute and relative EBITDA basis (the Company currently trades at 3.4x LTM EBITDA, which is ~35% below A&F’s 10-year average trading multiple). The stock screens expensive on an absolute P/E basis but cheap relative to its historical average multiple (currently trading at 27.6x LTM P/E, which is 48% below the 10-year average multiple). While bears will argue the Company is expensive on a P/E basis, we don’t think P/E is an appropriate metric given over the last five years, A&F’s net income margin has ranged between 0% and 2%, and therefore the P/E multiple appears overly inflated off of a small net income. Backing out the Company’s LTM legal expenses of $6.6mm (hopefully non-recurring) and asset write-downs of $14.4mm (non-cash), LTM net income would increase from $52mm (27.6x LTM P/E) to $73mm (19.6x LTM P/E), which we think is a more reasonable multiple, although still inflated due to the low margin.

We therefore believe EBITDA and FCF are better metrics on which to value the Company. A&F is currently trading at 3.7x 2019E EBITDA / 17.5x 2019E P/E and 4.2x 2020E EBITDA / 14.0x 2020E P/E. In addition, the Company is trading at a 16% levered LTM FCF yield, which we view as attractive both on an absolute basis and relative to comps (American Eagle and Urban Outfitters trade at an 8% levered LTM FCF yield, BKE trades at an 11% yield, and Gap trades at a 6% yield). Furthermore, all of these comps trade above 5x forward EBITDA vs. just ~4x for A&F. Granted, some of these peers are larger and higher margin than A&F and therefore should trade at a premium, however we do not think some of the peers trading at double A&F’s FCF multiple is warranted. For example, BKE is a comp that has performed significantly worse (SSS of -14% in 2016 and -7% in 2017) yet trades at an 11% LTM FCF yield vs. 16% for A&F.

Our model has sales growing 2% annually in 2019E and 2020E (3% SSS offset by 1% net store closures) to $3.8bn in 2020E (vs. consensus of $3.7bn) and 30 bps of EBITDA margin expansion from 2018E to 2020E, resulting in 2020E EBITDA of $370mm (vs. consensus of $260mm, low in part due to the consensus assumption of 200 bps EBITDA margin compression which we think is overly punitive). Based on $145-150mm of annual capex, we project levered 2020E FCF of $233mm, which at a 10x multiple (i.e. 10% yield) would value the equity at $2.3bn at the end of 2020, representing a 12/31/2020 target share price of $33.70 and 70% upside. Including our cumulative projected $456mm of levered FCF generated in 2019E-2020E would add $6.61 of value per share, for total value per share at 12/31/2020 of $40.30, representing 104% upside and a 43% IRR. Our 10x FCF valuation implies an LTM EBITDA multiple (at 12/31/2020) of 4.4x, which we think is conservative. Bears may counter that while A&F currently trades at a 16% LTM levered FCF yield, to the extent consensus projects EBITDA to decline, then the forward levered FCF yield is probably more like 10% (i.e. a 10x multiple), and therefore the stock is not cheap. Our higher valuation is therefore not based on assigning A&F a higher multiple but rather on our projections, which are much higher than consensus.

The Company’s net cash position and strong FCF generation mitigates risk. A&F has $296mm of debt (~1x leverage) and $521mm of cash, representing a $224mm net cash position. While we think management is being overly conservative with their cash holdings, we would rather see a retailer be in a large net cash position than having too much debt, especially given the Company has $1.5bn of total future lease obligations, of which ~$360mm are due in under a year.

In addition, A&F generated $212mm of LTM levered FCF, of which $15mm was used to pay down debt, $69mm was used to buyback stock, and $54mm was used for dividends. The stock is currently trading at a 16% levered LTM FCF yield and we think management is allocating capital in shareholder friendly ways.

The fact that the Company only has 5% of its total store base (i.e. 48 stores) in Asia (of which just ~3% are in China) also mitigates risk to the extent there is a prolonged slowdown in Asia.

Catalyst

Continued positive comps

Continued strong growth of higher-margin online sales could increase overall company margin

Lower cotton prices (down >10% in last few months) could boost margins in the short-term

Net cash position and strong FCF generation could result in management increasing the dividend (4% yield currently) and/or announcing a large buyback