Why the Price Tag for Abercrombie & Fitch Is Larger Than It Appears

If you only consider market capitalization, American Eagle (AEO -0.24%) appears to have the resources to acquire Abercrombie & Fitch (ANF -2.04%) on its own. However, the company is reportedly enlisting the help of private equity group Cerberus Capital and its over $40 billion of assets under management to bring a deal forward.

In this segment from Industry Focus: Consumer Goods, the team covers deal value and the benefit to American Eagle of working with an acquisition partner.

A full transcript follows the video.

This video was recorded on May 30, 2017.

Vincent Shen: I want to establish a little bit of a timeline for what we know so far regarding the buyout process, and the negotiations that are going on between Abercrombie & Fitch and the potential buyers. On May 9th, the company confirmed that it has employed an investment bank to help navigate buyout talks with multiple interested parties. The following day, some initial reports indicated that at least two of the interested buyers for Abercrombie & Fitch were American Eagle and Express. In the meantime, Abercrombie shares initially jumped over 12% on the news, before gradually losing those gains until an update made headlines last week. Last week, May 24th, there was news from American Eagle, which not only was still interested in a deal, but it may be presenting a joint offer with Cerberus Capital, which is a private equity fund known for its interest in these distressed businesses. I think it would be fair to say Abercrombie is part of that category. 

So, the named suitors we have so far potentially negotiating this deal include Express, American Eagle, and Cerberus, and there are likely other entities as well. Express -- just a breakdown of who some of these potential suitors are -- is actually a smaller business than Abercrombie. It has a market cap of just over $600 million, Abercrombie is about $850 million. The revenue in Express' most recent fiscal year was $2.2 billion. Abercrombie's was closer to about $3.3 billion. So, if the companies were to agree to a deal, it would be more so a merger of equals, with a combination of probably cash and stock-based consideration. But, if I were a gambling man, I would have to put my chips on American Eagle and Cerberus rather than this deal, just because I think they have the more substantial resources, and also the aesthetic and branding fit that's more complementary between the two brands. Asit, if you're an American Eagle shareholder and you see this news, how are you thinking about this acquisition and evaluating it?

Asit Sharma: I think you're pleased. If you're an American Eagle shareholder, then you, too, have seen the ravages of the retail industry in recent years, especially if you've held the stock for quite a while. But, looking at American Eagle's balance sheet, the company has around $225 million worth of cash. It's liquid. What does liquidity mean? Liquidity means that you have enough current assets on hand to cover your short-term obligations. It's also solvent, meaning that American Eagle doesn't have a lot of debt. However, because that profit margin has declined in recent years, I think last year's net profit margin was just over 5%, the company isn't really throwing off enough cash flow to cover its own operations, grow its business, and then take over an Abercrombie & Fitch. So, you must be pleased that this very deep-pocketed private equity firm, Cerberus Capital, is stepping in. Without that, it's going to be a tough deal for American Eagle. 

Looking at the market capitalization, Vince, you mentioned that Abercrombie's market cap is down to about $850 million. That looks sort of doable if you only look at the market cap. But American Eagle needs this private investor because there's more to the price tag of Abercrombie than meets the eye. Abercrombie has about $2.2 billion worth of long-term commitments. These are those operating store leases that I spoke about, and also materials purchased obligations for their inventory. That's a pretty big balance that you have to add on to the market cap, because whoever buys this company is on the hook for those obligations. When you look at total value, enterprise value, it's over about $3 billion, somewhere between $3 billion to $4 billion, once you consider some type of premium for the shares. Hooking up with a very well-resourced private equity group will help American Eagle not just acquire the company, but have the resources to realize the synergies that you mentioned, the fact that the product lines are similar, much more complementary than an Express and an Abercrombie. So, I think you have to be feeling pretty good if you are an American Eagle shareholder. But still, this larger question looms -- once you can buy into these two companies, the same problem still exists. They have to find a way to reinvent themselves as a merged-up entity.