Investors wary of getting burned again by
Abercrombie & Fitch
when it reports earnings next week could be missing the big picture on this best-in-breed retailer.
The short-term ups and downs of the teen fashion industry have not always been kind to the stock, as evidenced by its performance in recent months. But a long-run look at the company's history reveals a consistent performer, a durable brand and plenty of room to grow.
Despite its jagged chart, Abercrombie's stock, which was spun off by
in the late 1990s, has more than tripled over the last four years. Now, after stubbornly keeping its price points high for years while discounters ruled the day, high-end spending is retail's sweet spot, and Abercrombie is the upscale haven for preppy teens with wealthy parents and an allowance.
"It's going to be a tough holiday season in many areas of retailing, but I think Abercrombie is somewhat insulated given who their customer base is, given the strength of the brand and given its differentiated fashion assortments," says W.R. Hambrecht analyst Pamela Quintiliano.
The shares have come down since July, when Abercrombie's double-digit sales growth had powered them up over $70 on hopes of cashing in on the denim craze in teen fashions. That euphoria proved short-lived when the prepster clothing chain missed second-quarter earnings estimates and reported a buildup in inventory that made the denim craze look like a denim glut.
Its second-quarter per-share earnings, reported in early August, fell 6 cents short of Wall Street's consensus estimate. Worse, Abercrombie reported that inventories increased to $364 million from $227 million at the end of the first quarter, primarily reflecting a jump in denim merchandise.
The result was a selloff that lopped 30% out of the stock in two months; it was below $50 at the end of September. Now, another three months of double-digit growth in same-store sales, culminating in October's 31% jump in comps, has pushed the stock up to $59, or roughly 15 times next year's Thomson First Call earnings consensus. That's still a significant discount to the stock's summer highs, reflecting lingering concerns about an inventory fiasco that are probably overblown.
"The increased inventory commitment is a necessary evil for Abercrombie in order to maintain ongoing positive double-digit comps," Quintiliano says. She does not own shares of Abercrombie, and her firm has no investment banking relationship with the retailer.
"Traditionally, they've always been very lean on inventories, and people took issue with it because they felt the company was missing sales opportunities," she says. "Now that they're more aggressive with inventories, people are upset with them for being too aggressive."
Inventory buildup is not the only concern dogging specialty retail and Abercrombie in particular. Investors in the sector are on pins and needles lately given the rise in energy prices and interest rates. Fears of a consumer spending slowdown have been amplified by the economic fallout from a disastrous hurricane season, and given the astounding run-up in shares of teen apparel chains like Abercrombie,
American Eagle Outfitters
( AEOS) and
in recent years, some investors are convinced the group is due for a slump.
Meanwhile, Abercrombie's CEO, Michael Jeffries, has emerged as a controversial figure on Wall Street. In June, a Delaware court approved the settlement of a lawsuit challenging the size and disclosure of his compensation. Shareholders alleged that Abercrombie's board breached its fiduciary duty and wasted company resources by approving an excessive pay package for Jeffries, including a $12 million bonus, 1 million restricted shares awarded in 2003 and a grant of 2 million stock options in 2002.
In the settlement, Jeffries agreed to retain half of the net shares acquired from exercising his next million stock options, after factoring in the strike price and his tax liability from the transactions.
Then in July, Jeffries disclosed some large and timely sales of his Abercrombie shares that sparked a flurry of shareholder lawsuits against him alleging stock fraud.
A company representative didn't return calls seeking comment on the suits.
Next, the company's president and chief operating officer Robert Singer left the company after only a year of service amid a dispute with Jeffries over the direction of the business.
Jeffries said publicly that "there was a difference in approach to the timing and extent of our expansion into certain international markets."
Abercrombie expects to take a third-quarter charge for Singer's severance package. Tiburon Research analyst Rob Wilson predicts it will be about $13 million, roughly the amount of Jeffries compensation package he agreed to forgo as a result of the settlement.
"To me, all this just reinforces what I have been hearing for years about Jeffries -- that he's a hard guy to work with," Wilson says. "Still, you can't argue with his record in running a successful specialty retailer. Over the years, most of these companies -- like American Eagle,
-- have all lost their way for a year or two at one time or another. But Abercrombie has been consistently successful. That's tough to do in this industry."
Some of the controversy surrounding Abercrombie, like its sexually suggestive advertising campaigns, only reinforce the retailer's image as a cutting-edge brand for the in crowd.
Wilson, whose firm does not have an investment banking arm, said recent selling in the stock came as a result of Wall Street's unhealthy fixation on short-term data points -- a trend that Abercrombie rebelled against this year by refusing to issue quarterly earnings guidance. As a result, analysts' estimates have been off the mark.
"Some sell-side analysts didn't realize that last year's gross margin rate of 70% was an anomaly because the company had no inventory, and there was nothing to mark down," Wilson says. "They factored that number into their models and got burned that quarter. Now, I think, they're being overly conservative. I have Abercrombie crushing consensus estimates next week."
In the first half of 2005, Abercrombie's store expenses rose 39% over the same period last year. That mainly reflected increases in spending on personnel and shopping experience. While the resulting decline in margins may have taken Wall Street by surprise, the measure was necessary for a company trying to maintain premium pricing.
"In terms of gross margins, I'm in the store every week doing channel checks and Abercrombie, Ruehle and Hollister
the company's three chains have by far the lowest level of promotional activity among any teen or children's retailer in the mall," Quintiliano says. "That's a good sign in a retail atmosphere that is aggressively promotional these days."
In another sign boding well for the Abercrombie brand and its growth prospects, the company just debuted its newest flagship store on Fifth Avenue in Manhattan, to rave reviews, boasting such posh neighbors as
, Cartier, Henri Bendel, Bergdorf Goodman and Gucci. In addition to the off-mall exposure, Jeffries said he expects the store to be profitable after a year.
That followed the successful opening of its first accessories-only Ruehl store on Bleecker Street in Manhattan. The Ruehl concept is touted as Abercrombie's new growth engine, targeting postgraduate youths who are outgrowing their other brands.
The company has revealed plans for additional flagship stores in Las Vegas and Los Angeles, as well as its first international store London.
"Abercrombie has a great mixture of news store growth, growth in customer traffic and average ticket growth," Wilson says. "That's the kind of stock that's nice to own."
Analysts are expecting it to report third-quarter earnings of 80 cents a share next Tuesday, up from the 64 cents a share recorded in the same quarter last year. There's no guarantee of the retailer reporting any decrease in inventory levels, but whatever inventory risk exists for Abercrombie going into this holiday season has no bearing on the popularity of its brand. Credit Suisse First Boston analyst Paul Lejuez said in a research note that if it's forced to lower prices to clear out inventories, its competitive edge still offers a hedge against shrinking profit margins. Lejuez's firm has an investment banking relationship with Abercrombie & Fitch.
"Just think -- do you want to own American Eagle or
at a time when Abercrombie is promotional, given its momentum and customer loyalty?" Lejuez wrote.