Description

Abercrombie & Fitch

Price $27 2003E
Shares Out 96.5m P/E 10.3
Market Cap 2,600 EV/EBITDA 5.7
Debt 0
FCF Yield (ex Growth Capex) 12%
Cash 432
EV 2,174

Description: ANF is a mall-based vertically integrated apparel retailer focused on the teen/college age consumer. The company operates 357 Abercrombie & Fitch stores, 173 abercrombie (kids apparel) stores and 164 Hollister stores.

Abercrombie & Fitch is an ¡§aspirational¡¨ brand with high prices ($70 jeans) and infrequent promotional activity. It targets 18-22 year olds. The business is 2/3 womens¡¦, 1/3 men¡¦s. A&F is a relatively mature concept, with potential for 400 stores nationwide according to mgmt. Mgmt believes the kids¡¦ business can grow to 300-400 stores over time, but it is lower ROI than Hollister and therefore not a priority.

Hollister is a lower priced California-inspired concept, targeting 14-18 year olds. It is the company¡¦s primary growth vehicle with estimated potential for 600-800 units. Like A&F, Hollister¡¦s business is 2/3 women¡¦s.

ANF is planning to introduce a new concept in spring 2004, which is rumored to be designed for the 25-35 demographic. The company has disclosed very little about this effort.

ANF is a turnaround story. The valuation is very attractive, but sales at the A&F concept need to stabilize (and hopefully grow) for cash flow to grow.

What is wrong with A&F?
1) The fashion has gotten stale with the same ¡§look¡¨ for 4 years. This has been exacerbated by the rise of low-priced imitator American Eagle.
2) The fit in the men¡¦s business is off ¡V made to fit models vs. normal people. A homoerotic association with the brand may also exist. The women¡¦s fit may also be too skewed towards perfect bodies.
3) The marketing has gotten stale & confusing. Image of sexy naked teenagers doesn¡¦t fit with product (drab colors, distressed finishes, etc) & doesn¡¦t appeal to regular college kids shopping for casual clothes.
4) The design and merchandising team, which is controlled by Mike Jeffries, lacks talent.
5) The company thinks its core customer is 18-22, but the brand rates most highly among younger teenagers.

How Will Management Fix It?
Management has been in denial. First they attributed negative comps to unsustainably high productivity levels reached in 1999. Then they thought it was the weakening economy. Then industry-wide weakness in men¡¦s apparel spending.

Finally, it appears that management now understands something is wrong with the product & marketing. The ¡§magalog¡¨ was cancelled in December, and management expects to announce a new strategy on the Q403 conference call in February. Given how recently this change in thinking has occurred, changes won¡¦t be visible in the stores until 2004 Fall / Holiday season. It is unclear if ANF will recruit new merchant talent as part of its revamping.

Investment Thesis
1) Good business that generates high returns (among the best in specialty apparel, despite 3 years of negative comps) - see exhibit B
ƒ{ 22% ROA, 28% ROE, 45% pretax ROIC (excluding off balance sheet leases)
ƒ{ Strong productivity, high margins and low expenses result in significantly higher EBIT / square foot than competitors
ƒ{ 4 wall cash on cash returns = 60%

2) Despite poor sales performance, the company has a strong brand that draws customers in the door
ƒ{ Brand ranks #1 with teens in surveys
ƒ{ Evidence that it rates lower with college-age consumers.

3) The company is managed for shareholders, with mgmt focused on cash flow and equity returns rather than top line growth (Exhibit A)
ƒ{ 45 consecutive quarters of EPS growth despite negative comps at A&F store (driven by labor hour reductions, IMU improvement & growth of Hollister)
ƒ{ Mgmt has refused to become promotional to drive sales growth, despite increased competition from lower-priced retailers (AEOS, PSUN, ARO, GPS)
ƒ{ ANF is using excess cash to buy back shares (2.5m further shares authorized under current plan)
ƒ{ Jeffries owns 3.6m shares of stock, including 1m shares that vest in 2008

4) Hollister is an attractive growth vehicle
ƒ{ Only 164 stores ¡V potential for 600-800. ANF plans 15% annual square footage growth, driven by Hollister
ƒ{ 35%-40% cash-on-cash 4 wall returns
ƒ{ Recent negative comp resulted from fashion misstep & bad weather, according to mgmt

5) Attractive valuation & good risk/reward
ƒ{ 10 P/E (ex cash) vs. 15-30 for peers
ƒ{ 12% free cash flow yield (ex. growth capex)
ƒ{ Clean balance sheet with $5 per share in cash by year end
ƒ{ Valuable embedded option on the new concept
ƒ{ 2-3x ROI upside if ANF comps stabilize, square footage grows at 15% driven by Hollister and new concept is successful

Risks / Issues

1) Continued deterioration of A&F concept. Mgmt finally appears to have acknowledged its problem. It remains to be seen what they will do about it.

2) Competition: The teen space is probably the most competitive in apparel retail and ANF has clearly lost share to lower-priced competitors/imitators. Mall traffic is also declining as more off-mall concepts (e.g. Old Navy) get traction.

3) Mgmt selling stock: Jeffries sold over 1m shares in 2003. He owns a lot but he sells a lot.

4) Legal issues: the risk of the employee lawsuits & parent group protests.

Catalyst

Stabilization in the business