Abercrombie & Fitch Earnings: Could Europe And Weak Holiday Season Disrupt Recovery?

Feb.19.13 | About: Abercrombie & (ANF)

The third quarter of fiscal 2012 was a turnaround quarter for Abercrombie & Fitch (NYSE:ANF), as its earnings beat the market’s expectations, leading the stock to jump 30% following the announcement. Before Q3, the retailer had been struggling for almost a year due to weak U.S. consumer spending, excessive promotions due to inventory hangover and weak economic conditions in Europe.

However, Q3 results were boosted by better inventory control, fashion newness, the consolidation of ANF stores in the U.S. and its strategic expansion in some European markets. As the retailer’s Q4 fiscal 2012 earnings are expected on February 22, investors will be closely watching the continued impact of these strategies. Additionally, Abercrombie & Fitch possesses a strong direct-to-consumer channel, which is likely to aid its growth. Unfortunately, the U.S. witnessed its weakest holiday season in 2012 since 2008, and this might adversely impact Abercrombie & Fitch’s results.

Better Inventory Control And Fashion Newness Should Help Comparable Store Sales

Over the course of last year, Abercrombie & Fitch has faced some difficulty in managing its inventory. This resulted in excessive promotions, which led to a decline in the average price per unit. This not only impacted the comparable store sales, but also weighed on the retailer’s margins. Moreover, with this inventory hangover, the retailer was unable to roll out new fashions with the changing seasons, leading to a reduction in store traffic.

However in Q3 fiscal 2012, Abercrombie & Fitch increased its inventory at a much slower pace than the sales growth. Moreover, the retailer started sourcing the goods from within the U.S. and low-cost destinations of Central America, thus reducing the lead time. This allowed the retailer to improve its fashion offerings and remain responsive to changing fashion trends, which is of immense importance in the competitive U.S. apparel industry. We believe that these strategies and initiatives are likely to help Abercrombie’s fourth quarter results as well.

The U.S. Store Consolidation Will Assist Comparable Sales Growth

Abercrombie & Fitch has been consolidating its under-performing ANF stores in the U.S. to improve store productivity. This has helped the retailer in the past, as its revenue per square feet increased from $440 in 2008 to $500 in 2011, while the store count came down from 358 to 310. Although in the last quarter, the revenue growth in the U.S. was flat due to lesser number of stores, the comparable store sales increased by 2%, indicating that the retailer is moving in the right direction. Moreover, the U.S. chain stores, including the direct-to-consumer business have registered a positive comparable sales growth in the past 11 quarters. (Source: Abercrombie & Fitch SEC Filings) Therefore, we expect good results from Abercrombie & Fitch’s U.S. business in this quarter as well.

Strategic Expansion In Europe Can Slightly Offset Weak Economic Environment

International markets are quite lucrative for Abercrombie & Fitch (contributing around 25% to revenues), but Europe has been particularly weak. Driven by Europe’s weak economy and self-cannibalization, international comparable store sales decreased by 18% in Q3 fiscal 2012. (Source: Abercrombie & Fitch SEC Filings) It’s hard to believe that with a small number of stores in Europe (only 99 international stores as of fiscal 2011), the retailer is facing a self-cannibalization problem. This seems to be due to its over expansion in tourist locations and at local attractions, which resulted in a concentration of stores in particular locations.

Abercrombie & Fitch’s management has decided to slow down the expansion in Europe to build a platform for comparable store sales growth. To expand in the region, less penetrated markets will be targeted to negate the impact of cannibalization. However, the weak economic environment will continue to play a major role in the region’s revenue growth in the near term. A silver lining was that Abercrombie & Fitch’s stores in Scandinavia, Belgium and Spain performed well in the last quarter. (Source: Abercrombie & Fitch SEC Filings) We believe that Europe holds good potential for the retailer in the long term.

Direct-To-Consumer (Mainly E-Commerce) Growth Is Likely To Continue

The growth in the U.S. apparel industry is being driven by the direct-to-consumer channel. Retailers such as Urban Outfitters (NASDAQ:URBN) and American Eagle Outfitters (NYSE:AEO) have thrived from this trend. For Abercrombie & Fitch, this is the fastest growing and the most valuable segment. Direct-to-consumer revenue growth has averaged nearly 35% annually over the last two years. (Source: Abercrombie & Fitch SEC Filings) In the last quarter, this channel helped strong comparable store sales growth (7%) in the U.S., on top of 16% growth in the same quarter last year. This segment has also lifted the results from the international markets. In Q3 fiscal 2012, the international direct-to-consumer revenues increased by 31%, with Europe being the strongest despite weak economic conditions. We expect similar performance in this quarter as well.

However, the 2012 holiday season in the U.S. has been weak due to fiscal cliff concerns and superstorm Sandy. This is likely to have a negative impact on Abercrombie & Fitch’s results. Coach (NYSE:COH), a retailer offering products at premium prices, recently reported its quarterly results, which reflected weaker than expected holiday sales. (Source: Coach SEC filings) Investors shouldn’t lose focus due to this short-term issue, as fundamentals driving long-term growth seem to be improving for Abercrombie & Fitch.

Our price estimate for Abercrombie & Fitch Stands at $51, implying a premium of less than 5% to the market price.

See our complete analysis for Abercrombie & Fitch

Disclosure: No positions.