An Investment Opinion
Abercrombie & Fitch: When Analysts Attack
So what happened?
Although I haven't listened to the conference call, I suspect that the analysts who were granted question-asking privileges did not precede their queries with the seemingly obligatory "Great quarter guys..." refrain that is so often heard. The same-store sales numbers came in at a positive 3% as compared to expectations of mid-to-high single digits. The company also guided this year's comps to "low to mid single digit comps" as compared to the mid-digit comps that were expected. Furthermore, management would not provide guidance on quarterly expectations for 2000.
Still is that enough to bring a company with plenty of cash, no debt, return on equity north of 40%, and a 30% growth rate down to a P/E ratio of about 8x this year's earnings?
Given the reaction of all these analysts, it might appear as though something must have radically changed with the company recently. But that's hard to prove if the focus is a little less myopic. Let's rewind the tape a bit, and check out an early June StockTalk conducted by our own David "e-commerce" Marino-Nachison with Lonnie Fogel, Investor Relations and Communications Director for Abercrombie. Regarding the long-term business plan, a relevant part the transcript reads:
"It's a very simple profitability model. The general idea is to open new stores at the approximate rate of 20% per year to achieve comparable-store sales in the range of 5% to 6% and with leverage on your fixed expense base you can achieve 30% EPS growth. Now, clearly the kids' business now is above and beyond the 20% profitability model so there's some upside to that, but in terms of a long-term profitability model that's our focus."
In other words, the long-term business model has not particularly changed at all. The projections are still that the company will be growing at an earnings per share rate of 30%, and comp-store sales are targeted for a range of perhaps 3-6%. At a recent writers meeting of staff members here, there seemed to be a lot of interest in Abercrombie at these prices. Perhaps though, we have a very different perspective on the company than a Wall Street analyst would have.
Consider these words from Marcia Aaron, an analyst at Deutsche Banc Alex Brown, who was interviewed in a CBS Marketwatch article published on Tuesday. Regarding the Tuesday earnings announcement she stated, "We are looking for earnings of 73 cents and same-store sales of 6 percent and we feel pretty confident that they will be able to upside our earnings estimate."
Now, I have two questions regarding such a pronouncement, and I wonder why they weren't asked by the interviewer in the Marketwatch piece. The first is "Whoever said it was permissible to use 'upside' as a verb?" and the other is "If you're pretty confident they'll 'upside' the earnings estimate, why exactly isn't your estimate higher in the first place?"
This brings us to the concept of the whisper number. The analyst in question very obviously had two numbers in her head, and it isn't all that often that you'll see an analyst so blatantly admit that her real expectations are not what her public pronouncements are. In fact, just after Abercrombie merely came in at $0.73 a share for the quarter -- meeting the analyst's actual earnings number, though definitely falling short of the same-store sales figure -- she downgraded the stock the next morning.
To get a feel for why it might be particularly easy for analysts to universally change their public feelings about the company, at this point in the tale it is necessary to look at another declaration in the StockTalk interview. Mr. Fogel declared, "Now, we have nearly 200 Abercrombie & Fitch stores at this point in time. Conservatively, our thinking is that 400 domestically is pretty much where we max out, although some people on Wall Street are arguing that there's more room. For us, we're feeling conservative. So we figure at some point you become close to at least theoretical saturation domestically. We haven't even really begun to seriously consider anything international." (Emphasis added.)
Here's a major problem for this company as far as a Wall Street might be concerned. Abercrombie can fund its own growth, and has announced its understanding of resisting the institutional imperative to grow simply for the sake of extra growth. Right now Abercrombie & Fitch has no debt and more than enough cash on hand to cover its business plan of growing 30% a year up to where its business plan maxes out. Wall Street's response to this apparently is, "So why don't you grow even more?"
Of course that's Wall Street's take on the situation -- it wants a symbiotic relationship with the companies it covers. Funding more aggressive expansion through debt or follow-on equity offerings, though not necessarily in the interest of shareholders, is in the interest of Wall Street. To throw salt in the wound, Abercrombie announced in its conference call that its board had authorized a new buyback plan of up to six million shares of common stock. Thus any chance that Abercrombie might pursue Wall Street financing in the near term seems completely out of the question.
Given this situation, where no symbiosis is available through investment banking opportunities, a parasitic relationship is more likely to evolve. An analyst's job is pretty much constrained to generating commissions, and in this regard the attack was massively successful yesterday. On Wednesday, in the wake of the mass downgrade, the volume of shares traded on the market was up to 12 times its usual level -- over 20 million shares as compared to the 30-day average of 1.6 million shares. As our own TMF Bobdog told me regarding his previous incarnation as a sell-side analyst, you're told explicitly that your job is to generate commissions. In that regard, Wall Street's sell-siders did their job very well on Wednesday.
I'm not stating that any particular analyst specifically changed his or her rating merely to generate commissions on Wednesday. After all, dropping same-store sales trends are a very real concern for a retailer. But I'm certainly not ruling out that one or another analyst changed his or her rating with the knowledge that enhanced commissions would be the logical result. Particularly in a Prisoner's Dilemma situation -- knowing that other analysts are likely to downgrade -- all the incentives move away from holding ground.
Where there's a healthy company and possible investment banking business in the future, the path of least resistance is going to be to maintain support of a company. Where no conceivable investment banking business is available, the path of least resistance is to generate commissions by changing ratings one way or the other.
In this regard, the new Motley Fool research reports are entering an area of competition for which there are shockingly low barriers to entry considering the enormous amounts of money invested into hiring and keeping sell-side analysts. Due to the fact that sell-side analysts are constrained and trained by a system that not only permits but explicitly encourages doublespeak at least, and misdirection at worst, virtually anyone can enter into the area of company analysis with the head start of an objectivity foreclosed from the Wall Street crowd.
Whether we as a company are ultimately the ones to produce the superior analysis isn't really the issue. I haven't yet had a chance to read our analyst reports, so I'm not going to use this space to hock wares for which I can't personally vouch. All I'm saying is that somebody is going to do it because it is so important to improve on the system currently in place.