Description

Overview:

ANF is an unloved retail stock that rightfully traded as a secular-decliner in the 3-5x EV/EBITDA range pre-covid. While we’ve been short it in the past, we think the set-up and asymmetry today is too good to ignore. Despite the stock’s YTD run, the skepticism towards this name and sector is still well-reflected in the price. The St is failing to give ANF adequate credit for near-term FCF generation (nearly 30% of EV by end of 2021), permanent cost savings that will support EBITDA above 2019 levels even if top line reverts back, and the best multi-year outlook the business has had in over a decade. We see manageable downside at these levels (~10%), with a wide range of positive outcomes. We pin our base & upside case to $69 (~55%) & $82 (~80%) over the NTM. 

Note: For purposes of this write up, all comparisons are vs FY19 unless otherwise specified.

Thesis:

Similar to our BIG write-up on 6/25/20, this is in large part a brute force math thesis whereby the St is failing to pro forma the capital structure for near-term FCF; the combination of incorrectly modeled FY21 EBITDA/FCF and low valuation creates a highly asymmetric opportunity.

• We believe ANF will beat 2-4Q21 St numbers substantially:

• The market is applying a simplistic curve of fading demand (given 1Q21’s stimulus benefit) and a corresponding deterioration in operating margin expansion.

• This simplistic consensus fails to recognize several tailwinds ANF still enjoys this year relative to 1Q21. We expect top line trends to modestly improve (vs consensus decelerating) on strong flow-through, driving significant EBITDA upside.

• We expect ANF will generate $600mm of FCF during the rest of FY21 (vs consensus of ~$390mm and EV of $2.2bn). Pro forma for this cashflow, the stock is trading at 2.3x our FY21 EV/EBITDA (vs historical range of 3-5x).

• 3 scenarios (12-month time horizon):

• Base case: Mkt applies current St multiple (4.4x) to our FY21 EBITDA of $700mm = $69 (+54%)

• Downside case: Mkt has line of sight to demand fading to 2019 levels; structural cost savings yield $425mm in EBITDA. Applying trough multiple of 3.0x = $40 (-11%)

• Upside case: Mkt applies 5x (a “full” multiple by historic standards) on FY21 EBITDA of $770mm = $81 (+82%) to reflect ANF’s improved positioning, a positive consumer backdrop & S&P’s all-time high multiple

What happened: COVID ironically created a structurally better business out of ANF

Generational supply & demand reconciliation: The curse of long supply chains (6+ months) in traditional brick & mortar retail ended up saving the day. COVID gave retailers the ability to cancel orders aggressively; as supply was drastically reduced, demand came back in following months much faster than anticipated and faster than the supply chain could catch up to. This resulted in rightsized inventory, thereby ending years of the death spiral of clearance cycles (lower demand, promote, customer learns to shop sales, lower full-priced sell-through, promote, & so on). While not specific to ANF, ANF’s pre-covid position as an ‘incremental’ player with a low margin structure makes the Company a disproportionate beneficiary of this dynamic.

• Implication: ANF sold through old inventory and was able to start fresh. ANF is now putting product on shelves that consumers actually want; this ignites the reverse cycle: higher demand, better brand perception, more full-priced selling, & so on.

• Evidence:  The single best piece of evidence is pricing power. Typically, undifferentiated, secularly declining businesses have little pricing power; however, for the first time in the past decade ANF has been able to consistently raise AURs for an extended period of time. In 1Q21, the Company reported its best Q1 gross margin since 2013.

• “We saw demand outstrip our supply a bit, and that puts us in a nice position to raise AUR and take out markdowns.” – CFO, 3Q20

• “We realized higher year-over-year AUR for the third consecutive quarter driven by on-trend products, lean inventories and lower promotional intensity.” – CEO, 4Q20

• “After many years of hard work, we have made great progress in transitioning our customers away from a wait-for-sale mentality to a buy-it-when-you-see-it one.” – ANF CEO, 1Q21 Earnings call

Ecommerce ramps from ~30% to ~55% of business:

• Implication 1: Mgmt took an axe to underperforming locations; store count reduced from 854 at end of 2019 to 731 today (15% fewer stores / 18% fewer sq ft.) Now, 90% of US stores are in A or B Malls (482 of their 533 US stores). Of the closed stores, ANF took flagships down from 15 in FY19 to 6 today. Cumulatively, the fleet is now of higher quality whilst the company stripped out ~$100mm of occupancy expense.

• Implication 2: ANF is in the strongest negotiating position it has ever been with landlords. As business shifts away from brick & mortar, ANF’s reliance on stores diminishes, whilst REITs face pressure from the combination of 2020 bankruptcies and lower foot traffic. Substantial negotiations took place last year and may continue to take place in coming years as stores continue to come up for renewal (~1/3rd up for renewal in FY21), which will likely result in incremental savings. We have not incorporated further contribution from future rent negotiations in our cases.

• Implication 3: As ecommerce represents a greater share of revenue, business quality improves (revenue trend, asset light, more efficient inventory turns, etc.) As an example, ecommerce 3yr CAGR into COVID was +12% vs brick & mortar -1%.  

What’s Next: 2021 FCF, Structural Cost Savings Buffering Downside and the Outer Years:

2021: St model too conservative: significant cash flow heading shareholders’ way

1. Revenue: St is taking 1Q 2yr revenue stack (+6.5%) and modeling a deterioration for 2Q-4Q (~3% on average). This is because 1Q in the US benefited from substantial stimulus and pent-up demand. However, this fails to appreciate the following:

1. QTD: We believe US 2Q21 QTD (through June) 2yr stack trends are similar to that of 1Q21, despite the lack of stimulus in the quarter and the US largely re-opened.

1. We’re a data-forward fund that uses a large ensemble of alternative data sources (as we reference in some of our previous write ups), including multiple panels of credit cards, debit cards, email receipts, web traffic, geolocation, social media, and multiple promotionality barometers, that cumulatively inform our analysis.

2. July & 2H could improve from 2Q QTD / 1Q21 Trend:

1. The QTD period does not reflect back-to-school, which represents an easier compare than the QTD period because the in-person fall semester was non-existent last year.

2. Further, beginning on July 15th, individuals with income <$75k and households <$150k are eligible for child tax credits that equate to $250 per child for children ages 6-17 ($300 per child

3. Europe is still in recovery, and 2Q & 2H should fare better than 1Q21.

1. 30% of the business was -14% in 1Q21 vs 1Q19, vs US which was +18% in 1Q21 vs 1Q19. While we’re only directionally confident on the rate of improvement here, we think it will be accretive to ANF’s total revenue growth rate for 2-4Q vs 1Q.

2.  EBIT margin expanded ~1100bps in 1Q21 vs 1Q19. The St is modeling 3Q/4Q EBIT margin expansion of only 350bps and 0bps, respectively. We believe this conservatism is a function of lack of mgmt guidance in 2H and historical volatility in operating results.

1. SG&A: In 1Q21, SG&A was -7% vs ‘19. The St is assuming 2Q-4 on average will realize SG&A +2% vs ‘19, which we take the under on given the permanent reduction in fleet & personnel.

2. GM improvement in 1Q21 vs 1Q19 was 285bps and the St models 2H improvement at 216bps. However, our real-time analysis of promotional emails, online pricing, in-store pricing, order values, and item values gives us confidence that GM rate expansion is continuing to accelerate from 1Q into 2Q (we estimate a 375bps improvement vs 2Q19).

Structural cost savings – new run-rate EBITDA substantially above pre-covid levels even if top line were to slow: We acknowledge that each year we look out has less & less visibility. So before discussing 2022 & beyond, it is important to appreciate the structural cost savings that bridge to structurally elevated EBITDA vs pre-covid levels, even on similar demand. This gives us confidence in debunking the bear case of “what if EBITDA goes back to $250-300mm seen in FY19-FY18?”

• Mgmt took out $200mm of structural costs in FY20. While we take this aggregate number with a grain of salt, we estimate that half of this is due to rent reductions ($30mm reported due to closure of 7 flagships alone) which gives us confidence.

•  4+ more flagships closures on the horizon

• In 2019, ANF generated ~$255mm of EBITDA. On the same level of demand, the business would generate ~$455mm of EBITDA today pro forma for mgmt’s stated cost savings. We give $10mm of credit for the next 4 flagships that are destined for closure, $0mm for further rent negotiations, $0mm credit for any potential gross margin (AUR) stickiness, and further haircut this consolidated number by an arbitrary $40mm (20% of the stated structural savings quantum) for conservatism. See table below.

• This informs our downside case EBITDA assumption.

Outer years – best multi-year outlook in the past decade: We believe there’s a good chance demand remains elevated vs 2019 levels for several years to come. These concepts are more nebulous, harder to diligence with certainty and harder to translate into a financial model, so we’ll keep it brief.

1. 2022: Some offsets to stimulus & pent-up demand in 2021

1. If 2Q demand remains healthy despite little stimulus in the quarter, that will be the first big proof point that ex-stimulus the business can retain a higher level of demand above FY19. We believe this is the case and the market will realize upon earnings. We acknowledge there is likely still some pent-up demand contribution in 2Q, but expect it to be materially less than that of 1Q.

2. Europe, the UK in particular, was still in partial lockdown during 1Q21, resulting in revenue -14% vs 2019. We’ll see how this number improves throughout the year. While clearly the US has surpassed FY19 levels, if Europe were to only return to its FY19 level, it would contribute ~5% to 1Q22’s YoY growth.

3. Next year will be a fully re-opened year in the US. Most tangibly, in 1Q21, most K-12 schools did not have an in-person spring semester. This represents an easy compare for next year.

2. 2023 & 2024: We do not purport to know quantitatively how these tailwinds will net out against the headwinds of lapping significant stimulus and pent-up demand in 2021. However, there are enough independently good reasons to believe there’s reasonable probability that demand will be at or above 2019 for the foreseeable future:

1. The covid-driven supply-demand reconciliation previously discussed viciously accelerated Abercrombie’s rebranding/repositioning that was slowly taking place over the past few years. The brand’s evolution from large bold company lettering to more on-trend fashion with subtle branding has improved the brand perception. Several articles have been published this year commenting on the revitalization of the brand (just google). While we are no fashion experts, a simple glance through Abercrombie’s website & Instagram seemingly corroborates what the experts are reporting on. While we don’t underwrite fashion turnarounds via brand health, we acknowledge this contributes to a more optimistic outlook than in the years preceding covid. 

1. https://www.businessinsider.com/abercrombie-and-fitch-is-back-how-af-became-cool-again-2021-4

2. Strong inventory position today increases the probability of healthier inventory positions in the future.

3. New denim & silhouette cycle:

1. The last “fit shift” (skinny jeans in late 2000s) lasted 5-10 years. Now mgmt teams across the board are referring to a potential new denim cycle (wider leg / higher waist) alongside a new silhouette (tight- and loose-fitting tops). This could drive a multi-year replacement cycle. Abercrombie is a key beneficiary with a substantial denim business (~LSD % share of US denim market).

2. “We are in the early stages of a new denim cycle that could drive revenue and profit growth for the next 5 years (at least).” – LEVI Q2 2021 Earnings Call

3.  Refer to any recent transcript of a specialty apparel retailer; most mgmt teams are discussing the cycle, and some have already updated their long-term algos to implicitly reflect it. This is challenging to reflect in a financial model, but it is nonetheless real.

4. Ecommerce is now 55% of the business:

1.  Over the past 3 & 5 years prior to covid (ending FY19), online revenue CAGRd at +12% & +8% respectively, whilst brick & mortar CAGRd at -1% & -4% respectively. We believe online growth is likely to continue to fare better, and now that it’s a greater % of the biz we believe the business in aggregate has a better shot at combating secular threats.

5.  New brand launch - Social Tourist: The biggest TikTok stars, Charlie & Dixie D’Amelio, partnered with Hollister to launch this fashion-forward brand. The sisters have a combined following of ~165 million people on TikTok alone, and have their own reality TV show coming to market (think Kardashians). Mgmt is clearly serious about it, as indicated by airtime on transcripts, presentations, press releases etc. We aren’t attempting to model this precisely, but it could be a further multi-year demand driver with gross margins similar to rest-of-chain according to mgmt. The following are proof points we’ve noticed that Social Tourist is being taken seriously and finding early success:

1. Charlie & Dixie are wearing Social Tourist apparel with large obvious logos in nearly every recent post for several weeks.

2. Most of the ~50 SKUs started running out of popular sizes online within days of launch

6. Competitor bankruptcies & competitive store closures:

1. 2020 represented the largest number of retail bankruptcies since 2009. Similar to ANF, other retailers took the opportunity to right-size their fleet. The below list is by no means comprehensive.

Financials:

We’ve highlighted in green the major divergences on key line items from consensus:

For ease of reference, we illustrate the FCF contribution to EV that creates the stock at 2.3x our FY21 EBITDA.

Valuation:

Traditional framework of base, down & up scenarios:

• Base case ($69, +54%): St applies current market multiple (4.4x) to our EBITDA

• Downside case ($40, -11%): Demand reverts to 2019 levels; market applies lower-end of historical range multiple to business (3.0x)

• Upside case ($81, +82%): Gross margins outperform whilst operating costs are better managed than we anticipate. St applies high-end of historical multiple range to stock (5.0x)

• All scenarios assume we are directionally correct about 2-4Q21 FCF generation, and therefore reflect a pro forma-ed capital structure.

Illustration of outcomes:

We acknowledge that pin-pointing outer year EBITDA is challenging, let alone pin-pointing over the next 12 months what the St is going to conclude is go-fwd EBITDA. If we are correct on near-term numbers (ie ANF generates ~$600mm of FCF from now through year-end), we believe a more appropriate way of assessing the investment is to analyze the range of outcomes were the St to conclude certain run-rate EBITDAs & apply various multiples to it.

The overwhelming takeaway is that there are very few scenarios where you are materially worse off, and many scenarios where the return is adequately attractive. 

Retail peak earnings risk vs non-trough create bear case:

• There of course is the risk of buying a stock that could be at peak earnings creating at non-trough valuation. While we think the pro-forma-ing of the cap table for near-term FCF combined with structural cost savings adequately protects downside as illustrated in our downside case, we also note that there is an added layer of protection: if this narrative gains traction, most US apparel retailers are mispriced.

• In the table below, you’ll see creates on FY21 vs avg 1yr fwd EV/EBITDA multiples from ’15-’19 (ie pre-covid baseline). Peers like AEO & GPS are trading at substantial premiums to baseline valuation (35+%) vs ANF in our base case trading at a 40% discount.  

• If the ‘peak earnings’ narrative were to play out, we believe ANF will outperform its peer group significantly, and suggest that investors who are concerned about this risk consider hedging it out with any one of the many alternatives.

Risks:

• Demand fades sooner and/or more aggressively than we expect

• This could certainly happen, but it’s unlikely at least through Q3 given the trends we are seeing in our data ensemble and any such slowdown still won’t un-do the benefits of structural cost reductions and significant cash flow generated this year.

• Return of lockdowns

• So far it seems that existing vaccines are effective against the delta variant, which should prevent the markets which are important to ANF (North America / Europe) from going back into lockdown

Catalyst

• 2Q/2H results illustrate the FCF generation, at which point the St will be obligated to reflect in its EV calculation

• Returning capital to shareholders. ANF currently has a cash balance of $900mm (vs historical cash balance of ~$600mm when it had a higher fixed cost structure) and has net cash of $565mm ($9/sh). Pro forma for $600mm of cash they’ll generate during the remainder of the year, the Company will have $1.5bn of cash / $1.1bn of net cash ($19/sh) which we believe will be in part returned to shareholders in the form of dividends and/or buybacks.

• We believe PE could be attracted to this given the high cash balance, lack of leverage on the business, and exorbitant FCF generation during the remainder of the year. Our LBO model suggests a sponsor could write a ~$1bn equity check after paying a 33% premium, recoup ~60% of their investment by the end of the year, and generate a >50% IRR over a 2-3 year period.

Disclaimer: At the time of publication, the author of this article holds a long position in ABERCROMBIE & FITCH CO. This article expresses the opinions of the author. The author has no business relationship with any company whose stock is mentioned in this article.

The author of this article has a long position in the company covered herein and stands to realize gains if the price of the stock increases. Following publication, the author may transact in the securities of the company, and may be long, short or neutral at any time.  The author of this report has obtained all information contained herein from sources believed to be accurate and reliable.  The author of this report makes no representation, express or implied, as to the accuracy, timeliness or completeness of any such information, or as to the results to be obtained from its use.  All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this article or any of the information contained herein.  This is not an offer to sell or a solicitation of an offer to buy any security.