FOOL ON THE HILL
An Investment Opinion
The women's division continued to suffer -- CEO Mike Jefferies described it as "seriously off-track" during the quarter. Same-store sales for the men's line was approximately flat, while the kids experienced low-double-digit comps. It should be pointed out that the company faced an exceedingly tough comparison against what was a very strong 22% comp-store sales performance in the first quarter a year ago.
The key operational metrics broke down as follows: Revenue for the quarter came in at $206.6 million, representing 9.7% top-line growth. That's on top of a super-strong 40% performance a year ago. Material costs remained in check, as gross margins dropped a few ticks to 37.8% versus last year's 38.2%. As for bottom-line profits, net income of $16.2 million represents 8% growth over the year-ago period. Share repurchases enhanced that pace of growth on the EPS level to 14%. The company maintained net profit margins of 7.8%, down only slightly from 7.9% a year ago. (By the way, a number of the year-ago income statement items have been re-stated for the gift certificate accounting change enacted last quarter.) Nothing on the income statement was much to get excited about.
On the balance sheet, the picture is similarly so-so. Abercrombie has $117 million in cash and zero debt. That translates into $1.16 in net cash per share. Inventory increased 45%, which is disturbingly higher than sales growth. On a square foot basis, inventory increased 19%. Management expressed the need to carry more inventory in order to make sure not to miss any potential sales, as has happened in the past. True or not, rapidly increasing inventory is a cash drain. The Flow Ratio -- the best measure of overall working capital management -- rose sharply to 1.00. That's not a bad level all-in-all, but up 39% from the 0.72 Flowie at this time last year. This will be a key metric to watch going forward.
In the upcoming quarter, comp-store sales are expected to be negative once again. For the remainder of the year, management is cautious, expecting EPS growth of 10-20% in Q3 and Q4. That's below the previous estimates of 30% growth. Earnings estimates are going to come down based on this guidance.
Abercrombie investors have been beaten up pretty badly over the past six months. The stock has been pummeled in the face of rising interest rates, heightened fashion risk, last fall's run-in with the SEC over selective disclosure, and management's subsequent closed-mouth communication policy with Wall Street. Fortunately on that last point, the company announced today that it will begin releasing monthly comp-store sales -- as is the custom in the industry -- beginning with the month of May which will be announced on June 1.
The first quarter results confirmed my albeit-limited anecdotal experience, which has been that Hawaiian shirts, paratrooper shorts and pants, and surf-themed T-shirts are going over pretty well with the middle school crowd, but 20-somethings such as myself tend to prefer the more conservative look of privately owned J. Crew. This past Friday afternoon, I visited the Abercrombie & Fitch store in San Francisco's Union Square. Traffic was light, and I soon walked out with a $30 long-sleeve T-shirt. When it comes to T-shirts, Abercrombie is the best -- soft, thick, well-cut, and well worth the price.
But then again, that T-shirt was all I bought -- one measly accessory -- and my fiancee didn't see anything to her liking. The unisex fashions on the girls' side of the store just aren't catching on. After leaving Abercrombie, we walked across the street to a packed Gap store. Not a good sign.
On today's conference call, management said they will be introducing more feminine fashions in time for the back-to-school season. Management also promised less logo-covered shirts and lower entry price points for the autumn season.
Another fashion concern of late is the strong similarity between the offerings at the college-oriented Abercrombie & Fitch and the kids' abercrombie stores. College kids don't want to dress like their little brother. The company needs to more clearly segment these brands.
Then, of course, there's the constant worry of rising interest rates. The retail sector won't have the wind at its back until the threat of Fed tightening is gone. Actually, this is the one threat I'm least concerned about. Interest rates will rise and fall, but for long-term investors, interest rate pessimism is just an opportunity to buy shares on the cheap.
In sum, the bearish story is essentially centered around short-term concerns. For long-term investors who believe in the competency of Abercrombie management, the bullish argument is supported by a temptingly low valuation, a proven business model, and healthy growth prospects.
Trailing EPS of $1.42 and today's closing price of $10 13/16 translates into a P/E of 7.6. That multiple means Abercrombie can provide a solid return to investors without any earnings growth whatsoever. Flip that P/E ratio upside down to arrive at an earnings yield of 13%. The downside risk here is low.
Additionally, growth potential clearly exists. Abercrombie will open five new concept stores this year. Today's earnings release and conference call offered more clarity on the new concept. It's going to be a West Coast oriented lifestyle brand called Hollister Co. JoniM, a scout on our discussion boards, uncovered a story that one of these new stores will open in Kansas City in July. The company emphasized that Hollister will not look or feel anything like the existing Abercrombie & Fitch brand. The target market will be high schoolers, and the price point will be lower, along the lines of Gap prices. At this lower price point, the company believes Hollister has the potential for 600-800 stores at peak. That's an impressive number compared to the company's previous estimates of 200-400 stores for each individual concept.
Abercrombie is defining itself in the marketplace through distinctive fashions. Execution risk remains, but not without substantial opportunity for those with iron stomachs.