Abercrombie's Earnings Surprise Doesn't Tempt Us

| About: Abercrombie & (ANF)

Earlier this month, teen retailer Abercrombie & Fitch (NYSE:ANF) reported better-than-expected third-quarter earnings and issued a stronger outlook. Sales grew 9% year over year to $1.17 billion thanks to the company's international expansion, but it was still in line with expectations. Earnings grew 53% year over year to $0.87 per share, topping the consensus estimate by $0.28.

Our fair value estimate, which considers not only short-term performance but also the long-term cash flow generation of the firm, remains unchanged. Please click here to read how we calculate the intrinsic value of Abercrombie and the hundreds of other firms in our coverage universe. The only info we can really glean from Abercrombie's results to extrapolate to the broader clothing retail space is that cotton costs have declined, which should benefit the group.

Abercrombie's gross margins were relatively strong during the period, increasing 240 basis points to 62.5%. The company was highly promotional at both Abercrombie and Hollister during the quarter, so we were expecting some margin erosion. But declining input costs and a great mix of international sales boosted results. Still, the company struggled to attract customers, as same-store sales fell 3% on a company-wide basis, driven by a 4% fall at Abercrombie & Fitch, a 3% drop at Abercrombie Kids, and a decline of 1% at Hollister. However, direct-to-consumer sales in the U.S. and internationally grew 15% and 31%, respectively, reflecting a shift in product purchasing. The firm also effectively controlled store and distribution costs, which declined 40 basis points year over year to 42.5% of sales.

Although the company's results were a bit stronger than in the second quarter, we still don't think they were good. The firm continues to close stores throughout the U.S., and same-store sales continue to fall. We're still uncertain whether the company has a good product mix in its U.S. stores, or whether international sales and tourism have driven results.

Nevertheless, the near-term outlook for the retailer looks favorable. The firm updated its full-year earnings guidance to $2.85-$3.00 per share from its previous estimate of $2.50-$2.75 per share, and well above consensus of $2.49. Given recent margin trends and the fact that the company has plenty of money to buy back shares, fourth-quarter results should look relatively solid -- especially since guidance doesn't account for any reduction in the share count.

Still, we find little reason to get excited about the retailer at current levels, though it trades at the low end of our fair value range and carries a 2012 earnings multiple of about 13-14 times. For one, we're not huge fans of Abercrombie's long-term fashion strategy, and we continue to believe that the fickle nature of teen and adolescent styles makes it very difficult to determine the future. As a result, we won't be adding the name to the portfolio of our market-beating Best Ideas Newsletter at this time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.