By Dee Gill
Unless you're a teenage girl or a mall rat, you might miss the differences between shopping experiences at Abercrombie & Fitch (ANF) and American Eagle Outfitters (AEO). They both run shops that aim to exude sex amid their jeans, flip flops and flimsy shirts with similar combinations of catchy music, mildly erotic images and a whole lot of cologne. However, investors, no doubt, have noticed some pretty harsh contrasts lately. American Eagle shares are up as much as Abercrombie shares are down, which at times this year has been as much as 50% in both cases.
For investors, it's a little unsettling that two such similar companies could take such divergent paths. Looking at events that pre-date the split offers some lessons - actually, reminders - of investment red flags.
YCharts Pro gives both these companies strong marks for fundamentals, and for many years, they were both favorites among retail investors. Earnings at each company were generally reliable even in rough years, and both companies had steady track records of capturing the fashion sensibilities of young adults. But around late 2010, Abercrombie pulled ahead as the golden child, revered for an unexpected ability for strong sales growth when its competitors were struggling to tread water.
Valuations on Abercrombie shares soared. By mid-2011, its PE ratio of 33 was about twice that of American Eagle.
But by the end of 2011, it became apparent that Abercrombie's big revenue growth had a rather large price: profit margins plunged. The product was selling at deep discounts.
This margin decline shouldn't have been a huge surprise to investors - a lot of the pundits noted that probability early on - but the revenue growth was too tempting. The bet was that earnings would eventually catch up with sales, just like they did when, say, Whole Foods Market (WFM) was growing fast.
Problem was, everyone underestimated just how much these sales were actually costing Abercrombie. An attempt to correct the slide by avoiding big sales just made revenues decline at existing stores. Abercrombie's share price started plunging after a couple of earnings reports came in well below estimates. The company announced plans to close about 10% of its stores.
Suddenly, American Eagle's more plodding performance looked a lot smarter. Its own same-store sales in the recent quarter were positive at double-digit levels, and its earnings beat forecasts. The shares have picked up a couple of buy recommendations in recent months, and those now outweigh the holds. The fact that its operating margins have held firm recently will help it in the days ahead when the rising price of cotton begins to make costs rise for all clothing retailers.
The take-home message here is hardly a new one. Revenue growth, as titillating as it is for investors, is a risk until it's backed by profits, especially when the shares are expensive. Sure, it's a risk worth taking at times, when the potential pitfalls are clear and expectations adjusted accordingly. There's always someone else selling skinny-leg denim down the road, and sometimes selling more of something doesn't mean selling it better.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.