FOOL ON THE HILL
An Investment Opinion
It's been two months since Abercrombie issued Q4 '99 earnings which were... ahem... ill-received, to put it nicely. It mattered not that the $0.73 per share profit met the published consensus estimate. The next day, analysts attacked with an onslaught of downgrades that sent the shares tumbling 40% to $15 1/4. Since then, the shares have tumbled even farther -- another 30%, in fact -- all the way down to a closing price of $10 11/16 yesterday.
The retail sector in general and Abercrombie in particular have been the victim of fiercely negative investor sentiment for the past six months. In hindsight now, we can see that the market clearly foresaw slowing retail sales growth.
Rising interest rates may indeed be hindering consumer spending on the margin. Abercrombie's same-store sales in the fourth quarter came in at only 3%. That was well below Wall Street's expectations for 8-10% comps and even below the company's more conservative guidance of 5-6%. More recently, Gap Inc. (NYSE: GPS) stunned investors with negative 11% same-store sales growth for the month of March. The Gap's poor results cast a dark cloud over the entire sector as investors began to worry that other retail apparel firms might report declining comp sales.
Unlike most other retail apparel companies, however, Abercrombie doesn't indulge Wall Street with monthly comp sales results. Investors will have to wait until May 9 to find out how the first quarter turned out. So, in the face of that uncertainty, investors have pummeled Abercrombie stock to historically low valuation levels. In typical Wall Street fashion, the logic goes: "If the company faces an adverse operating environment over the next 6-12 months, then the stock isn't worth owning."
It's at times like these, when fundamentally excellent companies face near-term obstacles, that long-term investors get a chance to pick up bargains. The semiconductor industry serves as a good example. In both 1996 and 1998, Applied Materials (Nasdaq: AMAT), the Rule Maker of the semiconductor equipment manufacturers, suffered declining sales and earnings because of near-term oversupply. But now the company has rebounded strongly and was yesterday's Foolish Daily Double. For the past six months, Wall Street has been pounding the table for semiconductor stocks, but the time to buy was at the peak of negativity in 1998. Look at Applied Material's chart for the past two years (the sluggish red line represents the Nasdaq's performance).
Similar to the ups and downs of the semiconductor cycle, sales in the retail apparel sector are tied partly to the economic cycle. Right now, retail sales are slowing. Perhaps Abercrombie will indeed report negative same-store sales for Q1. A contributing factor to slow growth in retail apparel during Q1 is the timing of Easter this year. See, the rollout of spring fashions is scheduled according to Easter. Last year, Easter came in March; this year, it's in April. The impact is that spring fashion sales this year will be pushed into Q2.
Investors with a time horizon of at least three years have the opportunity to take advantage of Wall Street's pessimism over these myopic concerns. All in all, the economy is still strong, inflation is benign, and the consumer has a thirst for fashionable clothing. None of the recent events take away from the popularity of Abercrombie's brand, nor its growth opportunities.
There are only 250 flagship Abercrombie & Fitch stores, which leaves room for 150 or so more domestic locations. Beyond that, the company is testing new concept stores with the eventual goal to operate five concepts, at 400 domestic stores a piece, for a grand total of 2,000 company-operated stores. According to February conference call coverage by Talksmooth, Abercrombie is achieving an 89% return on investment for each new store opened.
Abercrombie has the financial wherewithal to internally fund its expansion, too. The company has $193.5 million in cash on its balance sheet and no debt. That's $1.84 in net cash per share. Subtract that figure from today's closing price and you get a per share enterprise value of $9.91. That's only 5.6x estimated earnings for this year. Maybe those estimates are off the mark. Let's say they're twice too high. We're still only looking at a valuation of 11x forward earnings. Consider also that Abercrombie is a company that typically produces free cash flow in excess of earnings.
With a valuation this low, investors don't even need growth in order to earn a good rate of return. If, for perpetuity, Abercrombie produced only $1.78 each year, that would represent a 15% annual return -- forever! ($1.78 divided by $11.75 equals 0.151) If, however, Abercrombie can succeed in opening new stores and extending its franchise across new concepts, then the returns will be much, much higher. As of February, Abercrombie was still forecasting 30% EPS growth during the coming year. Further, they've authorized a buyback of 6 million shares, or 5% of the total float. A scenario such as this is what Warren Buffett calls "a margin of safety."