After Taking Some Tough Medicine, Is Abercrombie & Fitch a Good Bet?

It is clearly tough times for teen retailer Abercrombie & Fitch, with declining sales and a shareholder base that is up in arms. Amid the gloom, is it time to buy?

Apr 29, 2014 at 9:05AM

It was a tough 2013 for teen retailer Abercrombie & Fitch (NYSE:ANF), evidenced by a second-straight year of declining same-store sales across its brands and major geographies.  Like many of its teen-retailing compatriots, the company was hurt by highly promotional selling tactics, an industrywide phenomenon that seemed to hurt everyone's merchandise margin except Urban Outfitters (NASDAQ:URBN), an outlier that benefits from its significant wholesale business .  Abercrombie & Fitch was also dogged by shareholders who are impatient with the downward trajectory of its stock price, epitomized by shareholder Engaged Capital's ongoing drive to shake things up in the boardroom. 

In response, management has embarked on a restructuring plan, hoping to create approximately $175 million in savings through supply chain efficiencies and the closure of underperforming stores.  So, is it time to bet on a new day for Abercrombie & Fitch?

What's the value?
Along with peers Aeropostale (NYSE:ARO) and American Eagle Outfitters, Abercrombie & Fitch was part of a triumvirate of companies that found success in the teen-retailing space with relatively pricey product lines, heavy on apparel and denim with logos. Unfortunately, the company's core demographic has recently seemed to have found better value from so-called fast-fashion retailers, like Forever 21 and H&M, a trend that has led to lower average price points, margin compression, and some soul searching.

In FY2013, Abercrombie & Fitch's results were poor across the board, highlighted by a top-line decline that was the byproduct of lower comparable-store sales, and a selective pruning of its global store base, including the closure of its Gilly Hicks intimates unit.  More notably, the company's adjusted operating profitability was cut sharply, down 45.2%, due to a need to engage in aggressive marketing schemes in order to match competitors' reduced pricing. As might be expected, the net result for Abercrombie & Fitch was a sharp decline in cash flow, barely sufficient to meet its required capital expenditure needs.

Misery loves company
Of course, the grass isn't any greener on the other side of the fence, given the struggles that both Aeropostale and American Eagle Outfitters have had in remaining profitable in the current selling environment.  While American Eagle Outfitters managed to stay in the black in FY2013, Aeropostale was not so lucky, reporting a large operating loss due to steep markdowns that caused its merchandise margin to dip into the dangerous mid-teens range. With its cash reserves dwindling, Aeropostale was recently forced to seek a capital infusion to avoid running into a potential liquidity trap, hopefully buying the company time to overhaul its operations.

What's an investor to do?
Abercrombie & Fitch seems to be making the right move with its restructuring plan, but it's probably too early to bet on a quick turnaround for the Ohio-based retailer. While the company certainly has a solid financial profile, including a net cash position of more than $450 million, it needs to figure out a way to reduce its unit costs in order to stabilize its operating margin, a task that management readily acknowledged in its fourth-quarter report.

As such, investors would likely find better returns with a more diversified operator in the teen space, like Urban Outfitters(NASDAQ:URBN). In contrast to Abercrombie & Fitch, Urban Outfitters eked out a comparable-store sales gain in FY2013, thanks in part to a balanced business mix that includes a major position in the wholesale trade through its Free People brand. The strong top-line performance at Free People, as well as at its Anthropologie unit, helped to offset weakness at its core Urban Outfitters store base, allowing the company to maintain its overall merchandise margin and post a double digit increase in operating income during the period.  More importantly, the higher profitability is leading to better cash flow, thereby providing the opportunity for Urban Outfitters to expand at a time when its primary teen retailing competitors all seem to be retrenching.

The bottom line
Abercrombie & Fitch is an intriguing story, given the lengths that its shareholders seem to be willing to go to in order to effect change. However, with the company expecting negative sales growth and further margin compression in 2014, there's little to like at Abercrombie & Fitch, and most investors should steer clear of it.

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Robert Hanley owns shares of Aeropostale and Urban Outfitters. The Motley Fool recommends Urban Outfitters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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