To The Moon

Another week of rising treasury yields pushed stocks to their third straight week of losses. The best-performing concepts are Internet & Direct marketing retail, apparel retail and passenger ground transportation.

Considering the different perceptions of the stock, this time TigerPicks choose $Abercrombie & Fitch(ANF)$ to have a fundamental highlight to help users understand it better.

$Abercrombie & Fitch(ANF)$

The story of Abercrombie & Fitch Co. serves as a poignant reminder that the path of entrepreneurship often diverges from the original plan. If David T. Abercrombie, the founder, were alive today, he would be astounded by the brand's transformation. What began as a high-end sporting goods store catering to elite outdoorsmen has evolved into a luxury clothing brand favored by affluent teenagers.

Abercrombie & Fitch’s stock has performed exceptionally well in recent months increasing by around 65% year-to-date. This is particularly impressive considering the relatively poor performance of other stocks in the consumer discretionary sector which has been plagued with concerns over declining sales in several core customer segments. The company has largely bucked this trend and reported strong sales growth in its core Abercrombie business, notwithstanding a sales decline in its Hollister’s business.

The retail market and Abercrombie & Fitch’s sales

The rise of inflation has had a negative impact on US retail sales with people spending less on non-essential clothes and being more careful with their money. This is hitting mid-priced stores the hardest, as more shoppers are going to cheaper stores for clothes. These factors have contributed substantially to the decline in sales witnessed at many of Abercrombie’s competitors in recent months. However, as Seeking Alpha analyst LEL Investment LLC notes:

Contrary to reports of consumer weakness from other retailers, ANF anticipated an acceleration in sales for the second quarter. Management expected the growth trend of Abercrombie to continue, while Hollister is projected to demonstrate sequential progress.

In the first quarter of 2023, the company reported its highest Q1 sales level for the Abercrombie brand in a decade. In my view, this served as an important signal that the company has exited the transformation phase of its turnaround strategy and is now firmly focused on growth under its “Always Forward” plan. Management is currently targeting sales between $4.1 billion and $4.3 billion by 2025. This is up between $400 million and $600 million from their current sales levels.

Analysts have also expressed confidence in Abercrombie’s management and their ability to execute on the Always Forward plan. Analysts from Global Data recently noted that:

The question as to why Abercrombie & Fitch has performed where others have not is an important one. And, at a high level, the answer can be found in the skills and attitude of management. Executives are very focused on the consumer and are ever keen to understand what they want. Once they have discerned this, they know how to go about delivering this in an efficient and effective way….Management’s skills are one of the reasons why, over the longer term, Abercrombie has been a retail turnaround success story.

I agree with these sentiments particularly in relation to management’s key-focus on understanding the consumer. A core part of the “Always Forward” plan is indeed the “know them better” initiative through which Abercrombie seeks to obtain an ever-improving understanding of its customers and their needs. This also involves continued investment in customer analytics systems.

Abercrombie’s strong fundamentals

In addition to a more positive sales outlook than many of its peers, Abercrombie has also maintained a strong balance sheet with low leverage levels. In early 2022 Moody’s commented on Abercrombie’s strong balance sheet by noting its “solid credit metrics compared to retail peers, low levels of funded debt relative to cash balances, and very good liquidity.” The company has maintained this strong credit profile with a net debt to earnings before interest, taxation, depreciation and amortization (EBIDTA) ratio of around 2.53 which is the second lowest of the retailers considered in the peer comp charts below.

Peer comp chart showing Net Debt to EBIDTA

Retailers Net Debt/EBIDTA (Author created based on data from EquityRT)

Furthermore, Abercrombie has seen a consistent decline in its total liabilities in recent years. This trend also continued in the first quarter of 2023 when its total liabilities declined by more than $150 million quarter-over-quarter or by around 7.9% Q-o-Q. This together with its low levels of short-term financial debt further demonstrates the company’s strong balance sheet.

Chart showing decline in liabilities

Author created based on company fillings and data from EquityRT

Abercrombie currently has short term financial debt totaling just below $190 million which is well below the company’s total cash on hand which exceeds $400 million. In its most recent earnings call management has also indicated that:

As we look to the second quarter and the rest of 2023, we expect to continue to manage a strong liquidity position as we work through this period of macro uncertainty to help ensure we can invest for the long-term through any cycle.

Therefore, it seems like management will continue to take a cautious approach to further expenditure and new debt despite its current growth focus. In my view, this is a prudent approach given the current uncertainty over the risk of a recession and stubborn inflation levels.

What to look out for in upcoming earnings?

Abercrombie will report second-quarter earnings later this month. Investors will likely be interested in the extent to which management has achieved the sales growth forecasted earlier this year. The recent rise in consumer spending and early indications of easing inflation may bode well for these projections and broader sales growth prospects throughout the year.

The slight increase in consumer spending has not, however, equally translated into an increase in consumer discretionary spending such as on clothing. Analysts have indicated that the lowered levels of inflation were expected to drive an increase in consumer discretionary spending. However, consumers have remained cautious, and this uptick has not materialized. I am of the view that the recent trend of lowering inflation is unlikely to meaningfully benefit Abercrombie at this stage. I will be closely monitoring managements statements on sales growth when its 2nd quarter earnings call is released. A miss on sales growth estimates would pose a material risk to the investment thesis in Abercrombie in the short term.

Valuation Assumptions Reflect Management's Projection

A quick examination using the DCF model revealed that the stock is now trading at a level that is consistent with the outcome if the management's FY2023 prediction is included as a model assumption input. (Sales: $3.7 billion, 5-6% operating margin) We also use the following assumption:

1. WACC: 20%

2. Terminal growth rate: 3%

3. Net debt:149 million (Q12023 data)

4. Shares outstanding: 51 million (Q12023 data)

Sensitivity analysis (2023 projection)

Sensitivity analysis (2023 projection) (LEL Investment)

As a result of this finding, we reran the model with management's FY 2025 prediction as the model input. The revised analysis indicated a remarkable upside potential of 149% from the current stock price. Hence, the stock is likely to reprice as a result when management provides more data points or the company continues to meet the guidance goal.

Sensitivity analysis(2025 projection)

Sensitivity analysis(2025 projection) (LEL Investment)

Management's FY2025 projection encompasses ambitious targets, including a revenue increase from $3.7 billion to $5 billion, representing a CAGR of 16% over the next two years. Additionally, the projection entails enhancing the operating margin from its current level of 5% to 8%.

We assess the viability of the plan's breakdown by opportunity for margin expansion and growth driver as follows:

Abercrombie Returned to Growth

Hollister and Abercrombie, two distinct brands under Abercrombie & Fitch Co., have strategically targeted different consumer groups. Hollister caters to the teenage demographic, while Abercrombie focuses on millennials. In the first quarter, Abercrombie & Fitch's sales surpassed those of Hollister and accounted for 52% of the company's total sales, indicating the early success of the brand's transformation.

Revenue by brands

Revenue by brands (ANF)

Contrary to reports of consumer weakness from other retailers, ANF anticipated an acceleration in sales for the second quarter. Management expected the growth trend of Abercrombie to continue, while Hollister is projected to demonstrate sequential progress.

According to the management, the women's business had played a pivotal role in the company's turnaround, with double-digit increases for 11 consecutive quarters. The men's business has also exhibited growth. One factor contributing to Abercrombie's success has been the expansion of its product range beyond jeans and t-shirts, encompassing dresses and clothing for various occasions. YPB, the active brand introduced by the company, celebrated its first anniversary and has expanded into the men's segment, offering non-denim products. Leveraging Abercrombie's reputation for soft and comfortable materials, YPB aims to capitalize on the trend of shifting from denim to non-denim and the preference for comfortable workwear, influenced by the work-from-home culture.

The company's shift toward more comfortable and casual clothing aligns with the increasing consumer demand for practicality and comfort, as observed in the successes of brands like Hoka and Lululemon. According to Grand View Research, the athleisure market is expected to reach $662.5 billion by 2030, presenting Abercrombie with an opportunity for growth if it continues to innovate and introduce new products in this space.

Under the new CEO's strategy, the company has closed old-format stores while increasing the presence of new-format stores and introducing new brands. This initiative led to a decrease in the store count from 355 to 233. However, it also significantly improved the average revenue per store, nearly doubling from $4.2 million per store to $7.6 million in 2022. This shift reflects the company's efforts to optimize store performance and adapt to changing consumer preferences.

Store count and Rev per store

Store count and Rev per store (ANF)

Overall, Abercrombie has transformed its approach from exclusively targeting a particular consumer group to attracting customers from diverse backgrounds and catering to different occasions, including office wear. However, this broadening of the customer base comes with the risk of losing differentiation. This worrying trend nevertheless vanished in 2021, when the brand's growth resumed.

Margin Expansion

Since 2017, ANF has lowered its SG&A expense percentage by 300 basis points. However, with a current SG&A expense ratio of 54%, which is higher than the industry average, there is still room for expense reduction.

Margin and expense % of revenues

Margin and expense % of revenues (ANF)

Margins

Margins (Seeking Alpha)

We are particularly interested in the cost-cutting initiatives being implemented at Hollister, although it appears that the company is still in the testing phase. The new store formats have increased in number, with 342 locations, while legacy stores have been reduced to 167. While they aim to leverage the success of the Abercrombie brand, progress seems limited.

We think one of the reasons is that Hollister primarily targets teenagers, whereas Abercrombie focuses on millennials. Therefore, certain factors contributing to Abercrombie's success, such as the work-from-home trend, may not be as applicable to the teen demographic.

Hollister store count

Hollister store count (ANF)

Through its marketing expenditures, we can assess its performance in another way. According to Banknotes, the company invested heavily in social media and celebrity collaboration. ANF launched its IGTV series, In the Living Room. The brand also teamed up with soccer star Megan Rapinoe on a seven-part interview series. These initiatives aimed to gain more influence among audiences.

Google search trends showed Abercrombie interests were increasing and outweighing Hollister in recent years.

Google search

Google search (Google trend)

While we believe there is potential for margin expansion, the progress at Hollister appears to be slow and impeding overall performance. Spending on marketing is a hit-or-miss situation. We remained cautious on this margin improvement target.

Historical Valuation Multiple

From a valuation perspective, ANF's stock historically traded within a range of 0.5x to 0.3x the P/S ratio before the pandemic. However, the company's Abercrombie brand has gained significant momentum since 2021, leading to a higher P/S ratio of 0.6x to 0.8x.

Historical P/S ratio

Historical P/S ratio (YChart)

Compared to peers like LULU, a couple of stocks, including Abercrombie's stock, are currently trading at a stressed multiple of a P/S ratio below 1x. We think the market perceives these as relatively weak fundamentals. If ANF successfully leverages the momentum of the Abercrombie brand and achieves its sales and margin targets, there is potential for the stock to undergo valuation multiple expansion.

Valuation multiple

Valuation multiple (Seeking Alpha)

Summary

Since the stock trades at a low P/S ratio, the downside risk of the stock appears limited based on our valuation multiples and the DCF model analysis. While Abercrombie presents an appealing proposition in the growing athleisure market, caution is advised regarding its margin expansion initiatives and potential challenges from the Hollister brand. As such, we consider ANF's stock a short-term opportunity rather than a long-term investment, given its attractive risk and reward profile. We have assigned a "Neutral" rating to the company.

Stock Price Forecast:

Here are the target price forecast for the future 12 months from analysts on CNNMoney.com.

The 6 analysts offering 12-month price forecasts for Abercrombie & Fitch Co have a median target of 45.00, with a high estimate of 47.00 and a low estimate of 18.00. The median estimate represents a +4.14% increase from the last price of 43.21.

Resource:

https://seekingalpha.com/article/4624397-abercrombie-and-fitch-best-of-the-retailers

https://seekingalpha.com/article/4607610-abercrombie-and-fitch-growth-in-athleisure-challenges-remain

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