ANF: Denim, T’s, and Polarization
Over the years, Abercrombie has gone from loved to hated to loved and everywhere in between. However, it’s hard to remember a time when investor interest and the company strategy have been more polarized. The smoke has cleared after Tuesday’s EPS, expectations are reset, and the consensus EPS estimate is now $1.66 for 2010.
Over the years, Abercrombie has gone from loved to hated to loved and everywhere in between. However, it’s hard to remember a time when investor interest and the company strategy have been more polarized. The smoke has cleared after Tuesday’s EPS, expectations are reset, and the consensus is now at $1.66 per share. Aside from a slight beat vs. expectations, management provided some longer-term parameters or benchmarks for which they would like to Street to measure against. First and foremost, the company set a goal to return to a 15% operating margin over the next three years. Sounds reasonable when looking at the historical multi-year run of 19+% margins, but the company is now in the midst of more changes than we can remember. If you’re a true optimist then you’re probably focused on CEO Mike Jeffries’ comments which suggested a return to 20% EBIT margins is also still within reach.
As analysts it’s our job to opine on the merits of such a goal and ultimately make a judgment on whether or not this seems reasonable, obtainable, and over what time frame can this realistically occur. Unfortunately, the specifics of such a plan were not entirely quantified, although additional disclosure on underperforming stores (almost 25% of the entire base!) and the international operation was definitely a step in the right direction. But, key questions in our view still remain. Can domestic productivity rebound on store closures alone? Can gross margins return to peak levels while AUR’s continue to decline and macro headwinds (aka traffic) still exist? Can management bring Gilly Hicks into the black while keeping the store base stable and relying on productivity gains? Can all this be accomplished while simultaneously doubling the international store base each year? Furthermore, is aggressive growth outside of the U.S really worth that much if the domestic business continues to shrink a measurable pace?
These questions are what makes Abercrombie so polarized, at least in our view. Each of these factors is critical to realizing the 2012 margin goal of 15%+ ($3.30-$3.40 in EPS assuming flattish sales). With margins finishing 2009 at 6.6%, a rebound of 840 bps is needed over the next 3 years to achieve this goal. Keep in mind that management suggested trends may actually get worse in the near term. Gross margins are expected to remain under pressure as clearance activity and lower AUR’s persist. Additionally, a back-half weighted store opening plan with a substantial international bias will also weigh on results as costs run through the P&L prior to opening. Whether this is conservative positioning remains to be seen, but the reality is we’re now looking at holiday 2010 before we can make a reasonable judgment on the progress of the many initiatives underway. For now, the bar has been set low, with little expected in the near-term as the company begins the three year journey towards a profitable recovery. That keeps us smack of the middle of the debate for now. On one hand it appears that management bought some time here, but on the other hand there are numerous unanswered questions that remain. Before we can get on board and see through the polarization, we need to see more evidence that all these moving parts can in aggregate reverse a declining sales and profit trend that has been in place now for over two years.
Here are some more of our post-quarter thoughts.
- There are 230 A&F, A&F Kids, and Hollister stores with a negative four-wall contribution in aggregate of $36 mm (about $0.27/share) in 2009. The negative contribution is skewed toward A&F and A&F Kids stores and is heavily concentrated in C malls. 95 of the 230 stores are more critically ill, which caused the company to take an impairment charge in the quarter. Looking at the A&F store cannibalization, approximately 16% of the brand’s stores are located within a ½ mile distance from each other.
ANF’s Plan: Cull the store base through natural lease expirations (half of the 230 stores have leases expiring before 2012), rent relief, and early closures where profitability is not achievable. Additionally, management believes productivity (i.e. sales) improvements would boost some locations back to four-wall profitability, but the amount of such stores on the “cusp” is unknown.
Hedgeye: Either way we look at it, almost 25% of the domestic store base is unprofitable and even with a same store sales rebound, total volume is likely to decrease as locations are shed.
- Gross Margins have declined 280 bps since the 2007 peak of 67%, mostly due to increased promotional activity and higher markdown activity. Headwinds will persist in 1H 2010 with lower AUR’s (still expected to be down 7-10%) in the Spring and an expected increase in freight costs. Product costs in 2H 2010 have not been addressed, however many retailers and apparel companies are already planning for increases beyond mid-year.
ANF’s Plan: Management put gross margins first on the list of improvements needed to achieve the goal of 15% operating margin by 2012. The intent to raise gross margins back to peak historical levels of 67% will likely be a difficult task in the near to intermediate term even as the higher-margin international business becomes a bigger part of the equation. Clearly less clearance activity is both a function of better product and more customers walking over the lease line. Both of which are still big unknowns.
Hedgeye: Management maintains that they are able to get back lost gross margins even with lower AUR’s (which have been offset by lower COGS) but this seems like a short sighted view based on a deflationary environment. Additionally, lower volumes on a smaller store base does not suggest economies of scale are improving here. Customer traffic, while barely mentioned on the call, remains a critical element to the “productivity” equation and a factor that will be dictated by the overall economy, merchandising improvements, and the price elasticity of lower prices.
- The intimates concept Gilly Hicks, with 16 stores, remains unprofitable. Management dispelled rumors that the brand would be shut down but noted that the store base will remain essentially unchanged until productivity is improved.
ANF’s Plan: Management calls for Gilly Hicks to break-even or become profitable over the next few years through aggressive goals for increased productivity. However, the steps needed to drive sales and ultimately profits were not articulated. If a successful turnaround is made, the store base will ramp up in 2012. In other words, management just bought three more years for the brand.
Hedgeye: While this is a smaller part of the story at the moment, it still represents the only potential domestic growth strategy for the company as of now.
- Flagships and international stores have considerably higher gross margins and sales volume than domestic stores, especially as the US store base finished the year with a mid-single digit operating margin. The NYC 5th Ave. A&F flagship store contributes $100 mm in revenues a year while London, Milan, and newly opened Tokyo are expected to contribute $200 mm in aggregate to the topline in 2010. Management suggests that close to 20% of the incremental sales added through international store openings will flow through to operating income, which is clearly the reason why store growth is ramping up overseas. UK Hollister stores average 6x more volume than domestic stores, however newer stores are planned to be less productive on average than the malls they are currently in. This sounds like the best locations were already opened.
ANF Growth Plans: Copenhagen, Fukuoka (Japan), and NYC 5th Ave. Epic Hollister store are in the works for opening in Q3 and Q4 of 2010. Paris is in the works for 2011. The international store based will grow from 28 units to 60 with the addition of 30 new Hollister stores in Europe and 2 international A&F flagships. As such capex is expected to grow by 40+% in 2010, to $250-$260 million. That’s a big jump considering at least 100 stores will actually be closed over the same time frame.
Hedgeye: There is no question that the best growth prospects for ANF at the moment are outside of the U.S and what better way to tap into this than opening highly visible, super productive flagship stores. However, we wonder what happens when it comes time for these locations to finally comp against their initially high productivity. Adding stores in a hub and spoke manner is also likely cannibalistic to the flagship, which can’t be good for leveraging high cost real estate. Over the next year or two however, we do believe that store closures can be somewhat offset by higher profile non-US growth.
-Eric Levine & Zach Brown