Description

Investment Thesis

ANF is a best-of-breed company in the specialty retail space, yet it is trading at the LOWEST multiple in the group.  The myopic market is focusing on some weak NT SSS number and potential EPS miss and ignoring a very attractive/sustainable LT story. ANF is a high-quality business with 30%+ after-tax ROIC, strong brand name and pricing power, 10%+ square footage growth, and arguably the best mgmt in the industry. Yet it is trading at 13x ’07 and 11x ’08 EPS. At $68, I believe ANF has less than $10 downside and $30 upside in the next 12 months. For investors with a 2+ year horizon, I see a potential double in 3 years (based on 15x 2010 EPS + cash) and minimal risk of permanent capital loss as the company continues to grow and build value.

Brief Company Description

ANF was founded in 1892 as an outdoors apparel company. The brand was transformed under current CEO Mike Jeffries in the 90’s and was spun off from LTD in late 90’s. The company sells casual (preppy) apparel and operates 4 mall-based concepts: Abercrombie & Fitch (350 stores), Hollister (396 stores), abercrombie (180 stores), and Ruehl (16 stores). ANF operates in an ultra-competitive teen apparel retail industry. Closest competitors include American Eagle Outfitters (AEO, 925 stores), Aeropostale (ARO, 800 stores), and Pacific Sunwear (PSUN, 960 stores).

ANF has been a terrific business with store economics at/near the top of mall-based apparel retailers. In the last 10 years as a public company, Sales, EPS, and stock price have compounded at 26%, 30%, and 21% respectively, despite wild fluctuations in same store sales (SSS).  

Why is ANF a best-of-breed specialty retail company?

·         Sustainable business model and margins. The bear story on ANF has always been that the company is at peak margins and earnings will crumble eventually. Yet the most under-appreciated part of the story is that margins have been very stable and I believe margins are sustainable going forward. Since 1999, average op margin is 20% with trough margin at 18%.

Many mall-based retailers have reached or exceeded the magical 20% op margin number, but NONE has shown ANF’s consistency, especially in tough times when companies miss fashion and SSS (inevitable in this industry). I’d wager that few retailers (if any) in history had managed to maintain operating margin near peak 20% level and ROIC at 40%, after having NEGATIVE SSS for 4 consecutive years and store productivity (sale/sqft) fallen by 30%. Yet that was precisely what ANF had accomplished from ’00 to ’04. You may wonder how ANF managed to pull this off. The answer is that the strong brands allowed them to raise prices even in tough times (true signs of a franchise-type of business), and ANF’s mgmt did a better job controlling markdowns and variable costs (such as store payroll) better than anyone in the industry.

I will readily admit that going forward, ANF may not have much room for further merchandise margin improvement – they can only raise price so much and ANF’s initial mark-up (IMU) is already at the top of industry, although they managed to surprise everyone in the latest quarter again. But ANF does have some room in the SG&A line if needed – mgmt had chosen to reinvest in stores in the good times in the last 2 years and payroll as % of sales went up 300 bps, so they do have some flexibility if sales trend weaken again – i suppose the shopping environment should not suffer much if they choose to have 4 hot looking associates rather than 6. In addition, they hired a very good CIO last year and we are just starting to see some benefits of the IT investments flowing through the bottom line. For reference, a big part of AEO’s big jump in operating margin from 10% to 21% was from improved efficiencies due to more sophisticated IT systems, something that ANF had sorely lacked in the past (imagine doing planning & allocation of thousands of SKUs over a simple spreadsheet. Opening the spreadsheet alone took over 20 minutes).

ANF’s CFO (formerly CFO of Apple stores) believes 20% operating margin should be a floor rather than a ceiling, and he believes it is not unreasonable to assume 100bps improvement every year in the next 5-10 years. I am not as optimistic as he is, but shareholders should be rewarded even if the margins just hold up.

·         Above average growth driven by visible and high quality 10%+ sqft growth. Among the 3 proven concepts, Abercrombie & Fitch (college), Hollister (teens), abercrombie (kids), ANF can grow 100+ stores annually from a current base of 950 stores. Also the growth is high quality, as most of the new stores are Hollister stores, which has a higher sales productivity than chain average ($568/sqft vs. $500). So the sqft growth will generate similar sales growth, unlike many other companies opening bigger stores at 60% of sales productivity (ala CHS/LTD). Combined with low-mid single digit SSS, ANF should deliver low-mid teens top line growth for years to come.

·         Multiple potential growth vehicles: International, Ruehl and Concept 5. Ruehl, the 4^th concept, is still a work-in-progress but has seen steady improvement and has a potential of 250 stores. International store is a real growth vehicle – Canadian stores are 2x as productive as US stores, and the new London Flagship store (equivalent to 10+ regular A&F stores) is an absolute homerun. Mgmt has indicated intention to slowly but surely expand overseas through more flagship stores overseas as well as regular stores in Canada (slow because of high standards on real estate).

I also have high hope for the upcoming Concept 5 debutting in Jan ’08. It will be an intimates business right down the power alley of ANF’s “Sexy” expertise, most likely competing against Victoria Secret/PINK and AEO’s Aerie. Normally I won’t pin high hope on a new concept, but this may be an exception – in numerous conversations with ANF mgmt, they mentioned they feel better about this concept than Ruehl and Hollister at the same stage and believe the concept will make money sooner. We are also hearing buzz from mall landlords about a potential of 800 stores. Interestingly, LTD, owner of Victoria Secret, apparently felt the threat was so real that they terminated all relationship of their sourcing business (MAST) with ANF, at the cost of losing $200M+ revenue.

·         Strong brands and loyal customers lead to industry leading margins and ROIC: Despite some ebb and flows, A&F and Hollister have been consistently the top brands among teenagers and 20 something young adults. For more details, there are a series of Piper Jaffray surveys of thousands of teenagers over the years to prove the brand popularity. This has in turn led to pricing power and industry leading operating margin of 20% and 30%+ ROIC/ROE.

·         Under-rated CEO: CEO Mike Jeffries is subject to much controversy, but he is unquestionably one of the best merchants and CEOs in the industry. During the last 15 years, Jeffries successfully transformed the A&F brand, maintained the brand cache and pricing power despite facing a fickle customer base, and developed the hugely successful Hollister concept without cannibalizing the core brand too much. Also under-appreciated was his ability to manage the business and cost structure through tough times (discussed above). Many attributed the margin stability in tough time to then CFO Seth Johnson. However, judging from the margin implosion at PSUN shortly after Johnson took over as CEO, I think it is clear that Jeffries should get much of the credit. Most importantly, Jeffries has a LT vision, and will not sacrifice the brand to meet ST goals of sales/EPS, despite repeated disagreement/attacks from the street. Clearly, ANF has the management team that one wants to bet on.

How about some numbers?

After a recent 20% pullback, ANF is trading at 13x ’07 and 11x ’08 EPS estimate, or 7.8x EV/EBIT and 6.8x on ‘07/’08 numbers, both the LOWEST in the specialty apparel retail group. My current estimate is essentially inline with the street. Even if we assume ANF takes a drastic 20% margin hit to 16% op margin, company will still earn $4.75 in ’08, stock will still be trading at 14x EPS. For reference, most “turn-around” retailers are currently trading at over 17-18x forward multiple.

Historically, ANF had typically traded between 12x and 20x forward earnings (higher when SSS is strong). For a company of this quality, I believe it should not trade at 11x next year earnings. 15-16x looks more appropriate. In terms of 12 month target, I see downside to $60, 10x ’08, and upside to $100, 15x ’08 + cash (or 10-11x EV/EBIT). Price target could be higher if one uses ’09 numbers.  

For investors with a 2+ year horizon, ANF should earn close to $8 EPS in 2010 based on growth from proven growth vehicles and 3% SSS and flat op margin. A 15x forward multiple + cash generated in the next 3 years will yield a stock price of $130 sometime in 2009/2010, almost a double from here. Worst case we have dead money here.

For people preferring cash flow, ANF currently has around $6B market cap and generated $582M op cashflow in ’06. Taking out cash, ANF is trading at under 10x trailing op cashflow. FCF yield is low due to growth capex. Adjusting for new store capex, I estimate the company could generate $5-$5.5 in sustainable FCF/share in ‘07/’08.

ANF has a clean balance sheet with $4 in cash/share and no debt (operating leases notwithstanding). Company had always generated healthy operating cash flow, much of which was plowed back into opening new stores, which is highly attractive based on the ROIC.

Why has the stock fallen?

The market (myself included) had hoped for ANF to show positive SSS after lapsing the strong denim sales in ‘05/’06. It had not panned out, as SSS had stayed negative despite easier comparisons. Recent store checks by sell-side analysts have shown continued weak sales trends and higher promotion. Suddenly, investors are fretting about possible NT EPS downward revisions and ignoring the attractive LT story here. Ironically, ANF posted a positive SSS in June to the surprise of everyone (whisper number was -10%), but my guess is that NT results could still be choppy.

NT, stock may not work given the anemic SSS and perceived earning risks. But I would point out historically, 10x next year earning is often a good time to buy specialty retailers. The most recent examples are ANF this time last year and AEO in Dec 2005. I cannot tell you when SSS will turn positive, but I can guarantee that PE will be at least 15x when SSS does turn.

Risks

·         Fashion and margin risks: Despite their past track record and strong brands, it would be naive for me to assume that ANF is immune to the fashion risks. The strong preppy trend from 2004 to 2006 had definitely benefited them. ANF has missed fashion before, but I believe the brand gives them staying power to correct mistakes.

·         Deteriorating inventory turns: Inventory turns had steadily declined from 4.2x in 2002 to a recent 2.7x, which in turn had led to a small decline in ROIC and ROE. This is one question that I have not got satisfactory answers from the mgmt team. There is a conspiracy theory that ANF does a lot of “pack-away” (i.e. storing excess inventory in warehouses for resale next year), and there will be a “judgment day” when they have to liquidate inventory. I don’t think it carries much merit, but inventory situation is definitely worth monitoring.

·         Personnel Risk: Mike Jeffries is the key reason behind ANF’s success, as he continues to oversee almost all aspects of various brands. He is 62 years old, and losing him will be a devastating loss (see GPS after departure of Mickey Drexler).

Catalyst:

·         Return to positive SSS

·         Successful launch of Concept 5

Catalyst