In his June 20, 2012, presentation at Deutsche Bank Global Consumer Conference, Jonathan Ramsden, the CFO of Abercrombie & Fitch (NYSE:ANF), reiterated ANF's guidance for 2012 diluted EPS expectation of $3.50 to $3.75 per share. I am somewhat puzzled by ANF's confidence in making such a bold projection, and below is my reasoning.
At the same presentation, Mr. Ramsden projected that the same store sales for ANF's U.S. stores will decrease by around 5% and its international same store sales will decrease by around 20%. He also announced that ANF will close about 180 stores in the U.S. Since the number of U.S. stores is expected to decrease, and the sales of each store on average are expected to decrease, the total revenue in the U.S. stores is inevitably coming down. ANF's S&P core earning in year 2012 was $1.58 per share. If the total revenue from the U.S. is going down (I will touch upon international sales later), how could ANF increase its diluted EPS to $3.50 -$3.75 from around $1.58? The only way for ANF to increase its EPS so dramatically is for it to increase its net profit margin.
So, how did ANF propose to increase its net profit margin? As stated in the presentation, the $3.50 -$3.75 diluted EPS guidance was based upon (or should I say it "relied upon?") an assumption that there will be a substantial increase in ANF's gross margin. Specifically, the projected reduction of cotton cost is expected to be a "significant tailwind" for ANF for the rest of the year. In other words, for ANF to reach its projected EPS, cotton price has to decrease, or at least stay stable. Otherwise ANF's earnings will disappoint the market and the shares of ANF will almost certainly tank. Based upon the volatility we have seen of ANF's share price, you can bet that price decline will be significant if ANF misses the projected EPS of $3.50.
However, the CFO did not provide even a rough estimate as to how much cotton price would need to be for ANF to realize a diluted EPS of $3.50-3.75. What I would love to get from him is a step-by-step analysis with the cotton price being the starting point of such exercise: if cotton price is x1 dollars per pound, ANF's cost of inventory for each $1,000 revenue would be y1 dollars, which leads to a gross margin of z1 percent; but if cotton price is x2 dollars per pound, ANF's cost of inventory for each $1,000 revenue would be y2 dollars, which leads to a gross margin of z2 percent, so on and so forth. Essentially he just jumped into the $3.50-$3.75 diluted EPS projection without backing it up with any specific assumptions or concrete analysis.
Now going back to the store closures in the U.S. ANF is closing a lot of stores. The stores to be closed are allegedly less profitable but nonetheless profitable. This means revenue in the U.S. will go down unless such reduction in revenue caused by store closures is more than compensated by the increase in same store sales. However, ANF is projecting a mid-single-digit same store sales decrease.
It also puzzles me that they keep saying that the store closures are at ANF's own option, because the closures coincide with the expirations of the leases of such stores. Is ANF closing the 180 or so stores primarily because they are less profitable? Or is it primarily because their leases are about to expire? ANF would be extremely lucky if those stores whose leases will soon expire happen to be the least profitable among all of its stores in the U.S.
Other than a reduction of cotton price, it seems that ANF is also counting on substantial international growth. The CFO was very bullish about ANF's prospects in Asia and Europe, although at the same time ANF projected a 20% decrease of same store sales of its existing international stores. With Europe in a mess and Chinese economy slowing down, maybe it is better for ANF to have its long term plan tied to the recovery of the U.S. economy.
If ANF has to close so many stores in the U.S. and rely on international growth, I wonder if the brand has worn out in its home market. If you look at the trend of ANF's annual revenues during the last 5 years, it seems that ANF has become a cyclical stock, because there is no more organic growth. Maybe as investors of ANF, we have to ask ourselves whether we are counting on a turnaround of the brand, and whether the best days of ANF are behind us.
Or maybe even the best days of America's consumer discretionary stocks are behind us. I certainly do not expect the same level of return from such stocks now as that was common in the late 1990s and early 2000s. From the demand side for the clothes of ANF, few people are using their homes as their ATM machines now. Young people face a very challenging job market and will tighten their belts. Parents are more likely to shop in Wal-Mart, Costco or Target than in ANF for their children.
From the supply side, with China's dramatic rise comes with the rising labor cost there. As a result, ANF will face more pressure on its margin because the Chinese will continue to demand more money for producing the clothes for ANF. Such long-term steady increase in labor cost might more than offset any temporary reduction in cotton price. And talking about cotton price, I finally come back to the very first but certainly not the last question that I want to ask ANF's CFO: How much does cotton price need to be for ANF to reach a diluted EPS of $3.50-3.75?
Disclosure: I am long ANF.