The world of retail is a finicky one where consumers’ perception of merchandise assortments can make or break a retailer’s numbers in any given year. Consumer tastes are always changing, making it difficult for corporate buyers to anticipate which fashions will captivate shoppers’ interests when they make purchase orders for goods months before they hit store shelves. Some buyers are simply better than peers at identifying merchandise people will want. The same holds true for specialty retailers that design and manufacture their own merchandise.
Although investors aren’t normally privy to precise details about upcoming collections, most management teams are forthcoming with their general merchandise strategies, particularly those that work for retailers that have fallen out of favor with consumers. In this turbulent economy, many retailers have been adopting strategies focused on appealing value propositions. For most Americans, the days of splurging at the mall are long gone. Now, a “new normal” has emerged where the masses look for quality brand name merchandise at affordable prices.
A number of retailers continue to look to celebrity endorsements and lucrative private-label lines to increase diversification and prop up margins. Sometimes these bets (or the merchandise selection in general for that matter) don’t strike a chord with consumers, and retailers are forced to clear merchandise via increased discounts and promotions, at the expense of the bottom line. Also, one retailer may become more aggressive with pricing, forcing peers to follow suit. Thus, it is important to monitor how much clearance activity has taken place recently.
Often times, even desirable merchandise and a solid strategy aren’t enough to overcome a challenging environment. Astute retail investors consider the buying power of a retailer’s clientele, and how current and future macroeconomic factors, such as home prices, the unemployment rate, the savings rate, payrolls, indebtedness, and recent stock market performance play into where and when people choose to spend their hard earned disposable income. Also, if a retailer's store count is concentrated in a specific region, investors should consider the economy of said region when conducting analysis.
For this screen we have chosen to focus on a commonly referenced “value ratio”, low price to earnings, to identify retailers that are trading on the cheap. Companies with high price-to-earnings ratios often reflect unjustifiable investor enthusiasm and have routinely underperformed the broader market over long time periods, whereas the opposite is generally true for those with low-price-to-earnings ratios. We screened the Retail Soft Lines, Retail Hard Lines, and Retail Store Industries and came up with a list of 80 profitable companies. We only considered those with price-to-earnings ratios in the 10th percentile and below (see list at the bottom of this page). One company that stood out for its recovery potential is Abercrombie & Fitch Co. (ANF).
Abercrombie & Fitch Co.
Abercrombie & Fitch is a specialty retailer that operates brick and mortar stores (87% of 2011 net sales) and a direct-to-consumer operation (13%). The company sells casual sportswear apparel such as knit and woven shirts, graphic t-shirts, fleece, jeans and woven pants, shorts, sweaters, and outerwear; personal care products; and accessories for men, women and kids under the Abercrombie & Fitch, abercrombie kids, Hollister, and Gilly Hicks brands. As of January 28, 2012, the company operated 946 stores in the United States and 99 stores outside of the U.S with the following concept breakdown (percentage of total domestic/international sales) Abercrombie & Fitch (30%/14%), abercrombie kids (16%/5%), Hollister (52%/78%) Gilly Hicks (2%/3%).
The company describes its brands in its annual report on form 10-K as follows:
Abercrombie & Fitch. Rooted in East Coast traditions and Ivy League heritage, Abercrombie & Fitch is the essence of privilege and casual luxury. The Adirondacks supply a clean inspiration to this preppy, youthful All-American lifestyle. A combination of classic and sexy creates a charged atmosphere that is confident and just a bit provocative. Idolized and respected, Abercrombie & Fitch is timeless and always cool.
abercrombie kids. The essence of privilege and prestigious East Coast prep schools, abercrombie kids directly follows in the footsteps of Abercrombie & Fitch. With an energetic attitude, abercrombie kids are popular, wholesome and athletic. Casual, with classic, preppy style, abercrombie kids aspire to be like their older sibling, Abercrombie & Fitch. The perfect combination of maturity and mischief, abercrombie kids are the signature of All-American cool.
Hollister. Hollister is the fantasy of Southern California. It’s all about hot lifeguards and beautiful beaches. Young and fun, with a sense of humor, Hollister never takes itself too seriously. Hollister’s laidback lifestyle and All-American image is timeless and effortlessly cool. Hollister brings Southern California to the world.
Gilly Hicks. Gilly Hicks is the cheeky cousin of Abercrombie & Fitch. Inspired by the free spirit of Sydney, Australia, Gilly Hicks makes the hottest Push ‘Em Up bras and the cutest Down Undies for young, naturally beautiful, confident girls. Carefree and undeniably pretty, Gilly Hicks is the All-American brand with a Sydney sensibility.
At the beginning of the fiscal year, management had been calling for flat worldwide same-store sales growth across its brands. Since then, the macroeconomic backdrop in Europe has weakened. This, along with strength in the comparable period last year, caused international comps to be down significantly in the April quarter, just as overseas operations made up 30% of companywide sales for the first time. This offset a positive 4% comp in the U.S., which was driven largely by rampant promotional activity. Top-line growth is the primary performance metric management uses to determine guidance, which is why it took its July-quarter sales projection down to a negative mid-single digit estimate. This assumes international comps will be down around 20%, U.S. chain stores will be up slightly, and U.S. stores located in tourist destinations will decline in the mid-single digit range. The market views Europe as a primary source of earnings growth, which is why it did not respond favorably to the outlook and the shares are down over 30% since the May 16th earnings announcement.
Not only do European Hollister and Abercrombie stores face a potentially weaker consumer spending environment, but many investors believe the European store expansion initiative is overly aggressive. (By the end of 2012, the company will have opened 100 European stores in three and a half years). Cannibalization is a chief concern, and management admitted that this caused sales to take a 5% hit in the recent quarter. New flagship store openings have come under particular scrutiny as they only occur in brand new markets where no comparable mall data exists and it can be difficult to predict demand dynamics. Investors are also worried that certain store leases are too high, since they were agreed upon when volumes (and therefore rents) were elevated.
The company contends that “not in every single case but certainly in aggregate” new European stores are achieving volumes and margins that were targeted when real estate deals were negotiated. Future store expansion efforts will likely be disciplined thanks to more data on consumers’ disposable income and spending habits.
In the U.S., an initiative to close underperforming stores is underway. Since 2010, 135 stores were shut down and 180 have been earmarked to go between now and the end of 2015. We expect the reduced overhead to benefit operating margins in years to come.
Profitability is another area of concern after the gross margin was down 240 basis points in the April quarter on increased promotions. Encouragingly, multiple U.S. retailers have reported that the promotional environment has been less intense recently and inventories are generally lean. Cheaper cotton prices and favorable overall sourcing costs should provide a tailwind in the second half of 2012. Elsewhere, some European vendors have indicated that volumes appear to be stabilizing.
Counter to this anecdotal evidence of improving demand, U.S. retail sales slid for the second straight month in May, marking the first back to back decline in two years.
Clearly, visibility into consumer discretionary spending remains low. The market seems to be pricing in very weak near-term demand trends in Europe and minimal improvement in the United States. The company’s guidance has not set the bar particularly high and we think downside risk is limited. We anticipate demand trends will eventually improve and think patient investors that are tolerant of European exposure should take a closer look at this stock.
|Kohl's Corp. (KSS)
|PC Connection (PCCC)
|Joseph A. Bank (JOSB)
|Abercrombie & Fitch (ANF)
|Insight Enterprises (NSIT)
|Avis Budget Group (CAR)
|Game Stop Corp. (GME)
|Best Buy Co. (BBY)
At the time of this article's writing, the author did not have positions in any of the companies mentioned.