Updated from 8:24 a.m. EDT
The roller-coaster ride that is teen apparel tastes has long turned out sweet spots in the retail sector, but it's not for the faint of heart.
Shareholders of clothing chains like
American Eagle Outfitters
( AEOS) and
Abercrombie & Fitch
have enjoyed some of the richest returns on Wall Street in recent years, but they found themselves in a free-fall Tuesday as fans went into panic mode.
A sour outlook at
cast doubt on the underlying strength of consumer spending for the rest of the year, and an earnings miss and inventory build-up at Abercrombie seemed to confirm the worst fears of the apparel mavens: Is the denim craze a denim glut?
The so-called denim cycle -- a designer jeans-buying binge for teenyboppers trying to be cool -- made Abercrombie a Wall Street favorite this summer after the company wiped out earnings estimates last spring. It posted a 29% jump in same-store sales for May, and sellsiders jumped aboard with a slew of upgrades. In the month of June, the stock hurdled over 19% as traders declared a blue-jeans bonanza.
After Tuesday's closing bell, Abercrombie turned out the lights. Its second-quarter per-share earnings were 6 cents short of estimates. Worse, the company 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 company earned $57.4 million, or 63 cents a share, for the quarter, up from $42.9 million, or 44 cents a share, for the same quarter last year. Wall Street analysts were expecting earnings of 69 cents a share, according to consensus estimates reported by Thomson First Call.
The stock had sold off 3.6% during regular trading hours Tuesday, and it was recently off $3.81, or 6.2%, to $57.42 in Wednesday trading. After drifting steadily lower for most of August, the latest selloff has nearly erased all the stock's summer gains.
Meanwhile, the entire sector was getting hit. American Eagle shed 9.2%,
was down 3.1%,
dropped 2.9% and
lost 3.6%. Newcomers to the space,
also showed losses.
Of course, investors with the will to make money in this turbulent sector like what they smell: panic. With the back-to-school season right around the corner, high inventories of denim could be a goldmine if the fashionistas are to be trusted.
On a conference call with analysts Tuesday, Abercrombie CEO Mike Jeffries attributed some of the shortfall to markdowns of spring items, but he assured Wall Street that the company had inventories under control.
"Our fashion stock, our seasonal stock, is increasing at a very moderate rate," Jeffries said. "We are managing those markdowns. There will be no markdown impact in the third quarter or the fourth quarter or next year from our inventory intensification program."
Aside from the earnings shortfall, the company's numbers weren't bad. It raised its earnings guidance for 2005 to a range from $3.10 to $3.30 a share. That also fell short of the $3.38-a-share Wall Street consensus estimate. But the company was previously projecting a range from $2.80 to $3 a share. It expects annual sales of around $2.7 billion.
Clearly, Wall Street got a little ahead of itself amid all the excitement, but Abercrombie's strong sales figures show that it's still performing. During the quarter, the company posted net sales up 42% to $571.6 million on same-store sales that increased 30%. Its top line also benefited from 84 new Hollister stores, compared with last year's second quarter, and a 97% increase in total denim sales.
Its gross margin rate for the quarter was 68.2%, up from 65.3% in the first quarter, and 66.4% for all of last year. Also, it increased its quarterly dividend to 17.5 cents a share, and its board authorized the repurchase of an additional six million shares.
"We continue to believe that the risk of a denim glut is minimal for those retailers, such as
Abercrombie, who are selling premium-priced fashion denim," says Andy Graves, analyst with Pacific Growth Equities. "We continue to see high traffic and strong conversion during our store visits to all three concepts. We understand key categories, such as denim, polos and graphic T-shirts, continue to be the strongest performers in both men's and women's, despite the absence of markdowns or promotions."
Graves, who does not own shares of Abercrombie (his firm has no banking relationship with the company), trimmed his full-year earnings estimate on the retailer to $3.33 a share and maintained his overweight rating on the stock.
At around $57.50, Abercrombie is now trading at about 14 times its earnings estimates through 2006. Jeffrey Klinefelter, an analyst with Piper Jaffray, said in a research note that the 20 times estimates is a more appropriate valuation for the stock, and he set his price target at $78. His firm makes a market in Abercrombie shares, but it does not have an investment banking relationship with the company.
"We believe a 20x multiple is appropriate given our expectation for approximately 10% square footage growth, a mid to high single-digit comp, and modest incremental store and distribution expense leverage over the next several quarters," Klinefelter said.