8/18/2010
By Brian Sozzi, Research Analyst

"As we said at the beginning of the year, we are willing to tolerate some gross margin erosion in the near-term." –CEO Mike Jeffries

That comment, as well as a bulge in inventory, all but sealed the fate for Abercrombie & Fitch (ANF) shares on its August 17 earnings release day.  There is a sense in the market that Abercrombie & Fitch, once hands down a premium player in the mall, is pulling out all the stops to bring footsteps to its non-tourist domestic stores.  Average unit retail prices (AUR) declined 15% in 2Q10, mostly from Hollister promotions (competing more effectively with Aeropostale), but also within Abercrombie & Fitch brand.  In order to drive the 5% reported comparable store sales (comp), therefore, Abercrombie & Fitch had to register increased transactions, which it got as a result of improved merchandise offerings (women's in particular).  As I have indicated in prior months, Abercrombie & Fitch has removed quality from its product chain-wide, reflecting an attention on obtaining advantageous costs to counteract the AUR pressure.  It's a chief reason Abercrombie & Fitch did not report greater gross margin erosion (150 bps y/y) than it did; the volume existed to raise the level of gross profit dollars.

I appreciate the increased granularity on domestic store closures; 110 will have been shuttered (weighted towards Abercrombie & Fitch and kids) by the end of 2011 through natural lease expirations and buyouts.  The closings are very necessary to reduce the leverage point of the business in an uncertain consumer spending trend, free up funds for international expansion, and return Abercrombie & Fitch to a true accessible luxury destination over the long-term.  That said, I must voice severe disappointment in the judgment by CEO Mike Jeffries as it pertains to putting stores in malls that made little economic sense.  Employed at the company since 1998, Mr. Jeffries has raked in roughly $44 million in compensation.  A shareholder would like to think that instead of him chasing the top of the real estate market in 2005-2007 by opening new stores, juicing sales and profits that in the process bolstered his compensation, Mr. Jeffries would have undertaken a more disciplined investment strategy.  Moreover, he further deserves a thumbs down on the ill-timed, poorly conceived concept that was Ruehl, which was closed after the disastrous holiday 2009 season after consistent quarterly losses.  I have to ask, shouldn't this guy's job be in question?

Though there exists valid concerns coming off a report like the one issued, I am a bit more optimistic on the earnings direction of the company than the market.  Abercrombie & Fitch has the potential in FY11 to print 20% plus EPS growth by way of fewer stores in operation that are EBIT unfriendly, assortments that are finally touching trend right status, two years of favorable comp comparisons, and an increased penetration of international stores which appear to be nicely situated from an operating margin perspective from the onset.  The stock is valued at a premium to our teen apparel sector average at a P/E multiple of 15.5x consensus FY11 earnings; I view this as an opportunistic valuation for long-term investors as Abercrombie & Fitch enters a period of international growth and healthier domestic store economics, thereby translating to above industry average EPS appreciation.

Discussion

* Overview: Abercrombie & Fitch reported net sales of $745.8 million (consensus: $745.9 million) , +17.0% y/y, and in line the pre-announcement on July same-store sales day.  The large surprise was on the bottom line, where EPS surpassed consensus by $0.08, owing to a strong quarter on S&D expense control.

* Area of concern: Inventory ballooned 47.5% y/y to $480.0 million.  Management stated it bought inventory to a mid-single digit percentage comp gain, which was somewhat comforting in light of recent monthly trends.  Inventory was also purchased to support strong sales in the DTC channel and internal, where flagships are expected to be opened later this year.  The level of inventory does suggest Abercrombie's gross margin will be constrained in 2H10 especially considering competition amongst mall based peers.  Therefore, it will be imperative for Abercrombie to drive enough transaction growth through planned promotions  to engineer earnings that do not slip below consensus. 

Brian Sozzi
Wall Street Strategies