Retail Bust or Quick Double?

In my work running Motley Fool Hidden Gems -- the No. 1 place for small-cap investors -- I'm always digging up new ideas. Like any miner prospecting diamonds, I turn up the occasional gem of a different kind, or worse, a worthless stone. Beyond finding true hidden gems, distinguishing between these two is our greatest challenge.

While looking through the retail group, I returned again this month to specialty retailer Abercrombie & Fitch (NYSE: ANF  ) . With a market cap around $2.5 billion, it's larger and more widely known than the small-cap Hidden Gems I look for and expect to grow two to 10 times in value over the next few years. Yet, Abercrombie still has an interesting story and some great financials.

Abercrombie stumbles
It wasn't the happiest of holidays for the 100-year-old retailer. Amidst mounting protests from parents and educators, Abercrombie canceled its A&F Quarterly, which had become a tawdry and tired rag. Full-page ads shamed management in USA Today and The Wall Street Journal. Weeks later, 60 Minutes ran a segment questioning the company's hiring practices. From mid-October to early January, the stock fell 25%, while the S&P 500 rose 10%.

If it can pull it off, Abercrombie won't be the first to have risen from an embarrassing stumble. After all, the latest scuttle is only a short, recent chapter in Abercrombie's storied history. Surely, there's enough here to warrant an objective look at the business and the stock, with an eye to how it stacks up against its primary competition.

Abercrombie 101
Abercrombie & Fitch was founded back in 1892 as a sports equipment store. Big-game hunters, fishermen, and outdoor fanatics flocked to the stores, including a Madison-Avenue location that featured a live shooting range, an actual campfire in the store, and a practice fishing area.

Decades later, overexpansion led to serious financial trouble. In 1977, Abercrombie filed for bankruptcy, and was finally bought, 11 years after that, by Limited Brands (NYSE: LTD  ) . Recast as a clothier targeting young men and women, Limited Inc. took Abercrombie public in 1996, maintaining an 84% controlling position. In 1998, Limited spun off its shares to existing holders, completing Abercrombie & Fitch's evolution into a profitable, viable, independent franchise.

Today, the company runs three stores: abercrombie kids (ages 7-14), Hollister (ages 14-17), and Abercrombie & Fitch (ages 18-25). It's also promised a fourth retail concept to be announced later this year. The stores sell T-shirts, sweaters, corduroys, and jeans to young shoppers using their parent's credit cards. I emphasize that point because here's where A&F has made some poor judgments. By marketing sexually explicit material to teenagers, the company has succeeded in shutting the faucet on a primary supplier of cash: the parents.

Because Abercrombie goes head to head in this category with Gap (NYSE: GPS  ) , American Eagle Outfitters (NYSE: AEOS  ) , and Aeropostale (NYSE: ARO  ) , among others, there is little room for error. Unfortunately, mistakes have been made, and the company has suffered steady declines in same-store sales, despite an active campaign of new-store openings. If that trend continues, calamity will ultimately ensue.

A sound base
On a positive note, Abercrombie does have a firm financial foundation. The company's finance officers are clearly earning their pay. Abercrombie today offers investors a rock-solid balance sheet, excellent cash flows and -- strictly by the numbers - a very reasonably priced stock.

Abercrombie closed out its third quarter 2003 with trailing sales of $1.7 billion. It managed 11% profit margins, has $430 million in cash on the balance sheet, and carries no debt. Over the past year, while the stock has underperformed, the board of directors has authorized stock buybacks. Remarkably, even with its growth engine sputtering, the financial picture is bright.

So, why the same-store sales declines?

The primary reason for the recent troubles is management's decision not to discount its apparel. That's led to inventory build-ups during a period of predictable and now tedious marketing. While I think it makes sense to hold the line on prices as the economy strengthens, Abercrombie's marketing positions are clearly an obstacle to rising long-term demand. A fix is needed, and management says it's coming.

By the numbers
Abercrombie currently generates $170 million in annual free cash flow. In my work with Hidden Gems, I like to develop a range of fair value. Let's assume Abercrombie can increase free cash flow annually by ranges of 10%, 12%, and 15% over the next three years. With a sound balance sheet, only modest share dilution, and a high return on equity, I don't think it's unreasonable to project a market cap of between $3.5 billion and $5 billion three years out. Again, the company is valued just below $2.5 billion today.

In other words -- strictly by the numbers -- I can imagine this stock rising anywhere from 12%-25% per year over the next three years. Given the rich valuations afforded common stocks today, those type of returns would provide investors a dramatic outperformance of the market's average going forward.

I hope I've painted a clear picture of this business for you. Financial management is excellent. The balance sheet is strong. The company generates loads of free cash flow. The business features a very high, unleveraged return on equity. In my view, there's no question that Abercrombie is in a stronger financial position and more attractively valued than competitor American Eagle Outfitters, for example.

But should you invest?
No matter how precise or conservative we are with valuation, we must consider the company's prospects. The stock is not undervalued if management decides to keep forcing over-the-top sexuality into its presentation. Up to a point, that sells. Beyond that, Americans shift into two camps: They're either outraged or they're bored. Neither is great for a retailer over the long-term.

On the other hand, it's pretty clear that the company's fourth concept will be a retailer positioned to serve adults over the age of 25. This market holds promise, as it will graduate new customers for it every year. And who knows, maybe catering to an older crowd will bring a bit more sophistication to Abercrombie's overall branding approach. Best case, one thinks of an Ann Taylor (NYSE: ANN  ) or a younger, hipper Chico's FAS (NYSE: CHS  ) .

Taking a pass
To determine whether management can right the ship, we have to ask how it got in this predicament in the first place. Consider this: Through the bankruptcy, acquisition, spin off, and then distribution of its shares by Limited Inc., Abercrombie & Fitch is now almost entirely owned by outside institutional and individual shareholders.

With the exception of CEO Michael Jeffries, who recently received a handsome grant of restricted stock (some of which was based on performance in 2002), the leaders are not major owners, and it seems to show in their marketing strategies. Until we see otherwise, it's fair to ask whether they're focused on building a long-term reputation for service, quality, style, some level of decorum, and sure, sex appeal, too. In other words, are they fixated on where the franchise will be 15 or more years down the road.

Perhaps as importantly, if you factor in stock awards, Jeffries was awarded in excess of $30 million in total compensation last year. That's a big chunk of the entire load of owner's earnings over the same period. That's pretty rich when you consider that, over the last five years, Abercrombie shareholders have been treated to a dividend-less underperformance of the S&P 500.

Let's be clear: This is a national brand with excellent financials. The CEO pulls down $30 million last year in total compensation, and yet, his stock is losing out to the broader market average. I have to wonder how different the business and marketing approach would be if the top executives were major owners? A good deal different, I think.

This is one reason I'm a huge proponent of inside ownership -- stock, not options. Abercrombie doesn't have it. That's a risk I won't often take in Hidden Gems.

[An earlier version of this column reported CEO Michael Jeffries' annual salary and bonus as being in excess of $30 million. In fact, that figure represents his entire compensation package for the last reported fiscal year.]

Tom Gardner is co-founder of The Motley Fool and does not hold shares of any stocks mentioned in this article. Take a free trial of his Motley Fool Hidden Gemsnewsletter service. All you have to do isclick here.


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