Ain't technology wonderful? Thanks to the Internet and mobile computing, I'm typing this report far away from the confines of Fool HQ in comfortably cool, sunny... Milwaukee. (Yes, believe it or not, the weather is fantastic up here.)
Armed with a Dell notebook computer, Nokia cell phone, and Palm VII, I can do my "work" from the comfort of an overstuffed couch with my feet propped up. This is the life, Fools. Is it any wonder the market is so handsomely rewarding the companies that are making this new way of life possible? Even after the Nasdaq's mind-boggling 85% run last year, it's already up another 20% year-to-date. QQQ's (AMEX: QQQ) anyone?
Even so, this morning I still had to do mundane tasks like... get dressed, eat, shave. Most aspects of the so-called Old Economy aren't going away anytime soon. Take, for example, the getting dressed part of my day. My grunge-around-the-house ensemble includes Gap (NYSE: GPS) mesh athletic pants and an Abercrombie & Fitch (NYSE: ANF) tee shirt. Here are two solid companies with numerous Rule Maker characteristics: strong brands, repeat-purchase business models, healthy profit margins, a penchant for cash, and sales growth a plenty -- all located in a mall conveniently near you. Best of all, these stocks are hated -- and I mean loathed -- by the market these days.
Here's a cross section of apparel retailers, comparing Friday's closing prices to their 52-week highs:
Company 3/3 Price 52-Week High % Off High American Eagle $27 $58 1/2 -53.8% Abercrombie $13 7/8 $50 3/4 -72.7% Ann Taylor $20 3/4 $53 1/16 -60.9% Gap $45 1/2 $53 3/4 -15.3% The Limited $33 13/16 $50 5/8 -33.2%
Why is it a good thing that the market cares not for the retailers? Because it gives us the chance to invest in great companies at a better-than-usual price. Most of the time, investing in Rule Makers demands that we pay up because we invest in companies that are obviously the best of the best. But every once in a while, even great companies get kicked down to Wall Street's clearance rack. That's the current situation with Gap and especially with Abercrombie. Yes, there are risks, but the payoff can be quite large when you buy 'em when everybody else hates 'em.
First though, let's look at the risks and figure out why the market has pounded these issues so mercilessly. It all boils down to just one thing -- rising interest rates -- but this one thing puts the hurt on retail apparel stocks in three distinct ways: First, because of our soaring economy, Alan Greenspan has promised to increase short-term rates until consumer demand cools (read: less mall traffic). For retailers, the obvious implication is slower sales growth.
Second, our wonderful economy has yielded the lowest unemployment in 30 years. That's a marvelous thing for you and me, but if you're a retailer in need of employees for your new stores, then a tight labor market means higher wage expenses and more frequent employee turnover. Both of those things threaten to squeeze profit margins. Third, higher interest rates make mall dwellers think twice about whipping out the plastic for their umpteenth pair of designer jeans. That's another impediment to sales growth. All told, the current interest rate environment is a major negative for apparel retailers that rely upon discretionary consumer income.
Okay, so we now know why these stocks are down. Namely, the problem is an external one. That's key. If these companies had crappy merchandise, shoddy management, or other such internal problems, then I wouldn't touch 'em with a ten-foot pole. But that's not the case at all. Gap is an almost ubiquitous default fashion solution. Abercrombie is the most appealing fashion brand in America. These are fantastic businesses. As long as your investment horizon is at least three years -- and it better be, Fool! -- then the top-quality retailers are pretty compelling. Comparing Gap and Abercrombie, take a look at the financial results from the just-completed fourth quarter:
Gap Inc. Abercrombie Sales Growth 27.4% 20.8% Gross Margins 41.5% 51.9% Net Margins 10.7% 20.9% Cash-to-Debt Ratio 0.47 No Debt Flow Ratio 1.10 0.74
As you can see, Abercrombie kicks Gap's butt on every one of these metrics except for sales growth. And, not surprisingly, it was this slower-than-expected sales growth that caused Abercrombie shares to implode after reporting earnings in mid-February, falling from an already-beaten-down $21 to $14 more recently. Abercrombie's fourth-quarter same-store sales growth came in at only 3%, compared to 26% last year. (For all of fiscal 2000, same-store sales were 10% versus 35% for the year prior.) There was no mercy for the obviously tough comparison that Abercrombie faced. At $14 per share, Abercrombie's market value is a mere $1.5 billion, compared to $40 billion for Gap. By any measure, Abercrombie is cheap, selling for less than 10x trailing earnings versus 35x for Gap.
Why the disparity in valuations? As the Fool's own Robert Fredeen notes in his Gap Research Coverage -- a great read, by the way -- the specialty retail industry is characterized by volatility due to the fickle nature of fashion and the aforementioned reliance on interest rates. A small retailer like Abercrombie, which has only 250 stores, is prone to having its business snatched away by a trendy competitor. Thus, investors heavily discount future earnings, a process that reveals itself in the low earnings multiple.
In contrast, Gap has proven its ability to grow sales steadily for years, despite changes and fashion and the economy at large. Part of Gap's secret to success is its diversification strategy through multiple concepts -- Gap Stores, BabyGap, Gap Kids, GapBody, Banana Republic, and Old Navy. With more than 2,900 stores, Gap is almost the Wal-Mart (NYSE: WMT) of apparel. That's what makes Gap a true Rule Maker deserving a premium valuation.
But Abercrombie shows the promise of a Cash Prince. During 1999, the company surpassed our traditional Rule Maker minimum hurdle of $1 billion in annual sales. Overall, its financial quality surpasses our Rule Maker standards with kudos. The last time we put Abercrombie to the test on our Rule Maker Ranker, it cleaned up with a Top Tier score of 52. If the company can make improvements on the women's side of its Abercrombie & Fitch stores and successfully introduce some new store concepts, then there could be substantial upside at the current price.
Let me reiterate, the Rule Maker philosophy is always to focus first and foremost on business quality, not price. But if we can find great quality at a great price, so much the better! And in a world where most Rule Makers fall under the broad umbrella of technology, it's still quite prudent to be diversified among some excellent non-tech companies.
One final announcement... per Zeke's conclusion on Friday, we've decided to invest this month's $500 savings in American Express (NYSE: AXP). As usual, in the next five business days, we'll make the trade.