Taking the Bull and Bear View of an Abercrombie-American Eagle Tie-up

Does any buyer get a good deal acquiring Abercrombie & Fitch (ANF 0.31%) with the significant headwinds the apparel brand will have to overcome?

In this segment from Industry Focus: Consumer Goods, Vincent Shen is joined by Fool.com contributor Asit Sharma as they break down the advantages and challenges of a potential tie-up between American Eagle (AEO 1.37%) and Abercrombie.

A full transcript follows the video.

This video was recorded on May 30, 2017.

Vincent Shen: I've been thinking about some of the synergies, always a buzzword behind a deal like this, in terms of what these companies can realize. Definitely, the obvious benefits that jump to mind for any deal of this nature, where you have that larger scale, which gives the combined company stronger negotiating power, be it with its suppliers and its vendors. You have the opportunity to merge production facilities and corporate functions like finance and marketing, etc. to reduce costs. Also, this idea kind of reminds me of Coach and Kate Spade's, operating in a similar space but ultimately diversifying the business with more than one established brand in the portfolio. Here, you would add Hollister and Abercrombie & Fitch to that portfolio for American Eagle. They also have their Todd Snyder and Tailgate stores, very small parts of their business but they're clearly trying to branch out and diversify the different storefronts that they have.

It also seems to me like Abercrombie has been a bit more of a significant international presence that can be leveraged for American Eagle further abroad, not only with that Zalora deal that I mentioned earlier, but for a sales revenue breakdown, Abercrombie & Fitch international business was about 36% of total revenue, whereas American Eagle, what I could find, it's about 15% of their company operated stores are international locations, so most likely a smaller footprint. And for Cerberus to be looking at it, from their end, you get two well-known brands that, arguably, this is their business that they can help return to favor with consumers with, potentially, the right rebranding, cost cuts for profitability, and as you mentioned in terms of those deep pockets, Cerberus has about $50 billion or so in assets under management, giving it the pocketbook it needs to really pursue this deal. 

But, all in all, in terms of final thoughts for this, considering the bleak outlook that we've mentioned for Abercrombie & Fitch in terms of some of its comparable sales and trends and the headwinds that it faces, I think that even at some of the current depressed trading levels, a lot of investors have to wonder whether the ultimate buyer is getting that good of a deal, whether it's Express or American Eagle or someone else. I think it's understandable that the market has been a little skeptical. American Eagle's stock has been pushed down with these deal rumors. I think a lot of people would also be skeptical to buy into a business that seems increasingly out of touch as you have some of those fast fashion houses stealing market share, and as malls continue to lose foot traffic. Do you take a more bullish view in terms of the overall benefits that these two companies have together? Or do you think you also have a similarly more skeptical view in terms of whether or not this will actually pan out well for both of the entities involved?

Asit Sharma: Vince, I have a slight sliver of optimism when I think about this deal. I'm skeptical about the industry. I'm skeptical about the market demand and these high fixed costs that both companies face, if we look at the deal being Abercrombie merging up with American Eagle backed by Cerberus. But, this private equity group is well-resourced, but contrary to what might appear on the surface, the company Cerberus is looking at a number of deals, and they have a great track record of extracting value for shareholders. They don't base the deal coming into it and helping out American Eagle on some projected numbers that the two companies can create together. They look at the deal according to their own internal rate of return, and they usually don't proceed with these types of deals until they think that, with this action plan, we'll work with management, we think we can hit our internal targets and get our value out in the deal. So, it's sort of a strong vote of confidence. That's why I have a slight bit of optimism. They're not going to pull their money into this merger and watch it sit. They will be a very active partner to make sure that value does get extracted, which will benefit current shareholders of both firms. I still think it's going to be an uphill climb, but I have a little bit of this optimistic feeling that value will be created.

Shen: Thank you, Asit, for bringing this up, in terms of the internal rate of return that all these private equity funds and firms will have before they look to invest in any deal like this. It's important to note that and, the idea that the vote of confidence that it provides. My last point before we move on to our next potential M&A deal is with American Eagle, for their business overall, something to highlight is that while their comps haven't suffered quite as much as Abercrombie & Fitch, and they're also seeing maybe 1% or single-digit declines in their comps during certain periods, but a big point of growth for them is their Aerie offshoot brand. It will be interesting to watch, if this deal goes through, how they can combine some of their more stable and high-growth brands and business with the struggles that we've seen from the portfolio brands at Abercrombie & Fitch.