Questioning the Relevance of Abercrombie

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Includes: AEO, ANF
by: Patrick Garot

Last Saturday was a sunny one in Carlsbad, CA., ground zero of diminished wealth effects with declines in home values and retirement savings, rising taxes and job insecurity. Here in California, our higher highs tend to lead to lower lows, but we also lead the nation in sea-changes, too.

Still, the mood was good out on the town. But inside the Abercrombie & Fitch (NYSE:ANF) stores at both the Plaza Camino and University Towne Center malls, the mood was decidedly glum.

No purchases. Few teens. You could smell the sea change.

“The highest quality, casual, All-American lifestyle clothing for aspirational men and women,” boasts Abercrombie’s website. Worried as I was – perhaps our teens no longer aspire? – I decided to ask my nieces, nephews and their friends about A&F, and their relationship with the brand.

One 15 year old girl whose moneyed parents hail from Rancho Santa Fe said, “It (Abercrombie) is not appropriate.” That about summed up the comments that I got from my empathetic nieces. The thought here ran that when your friends’ families are suffering, it’s no longer cool to flaunt a $70 sweater with a $190 pair of jeans.

Meanwhile, teen boys were enthused at Abercrombie’s lower relevancy to girls. “I’ve got better ideas for my money,” groused one. “I wore (A&F) only because I got gift cards,” said my nephew Chris (17). This holiday, Chris received no Abercrombie cards, but did get $250 worth of GameStop gift cards.

Parents around these parts confirmed the new ethic of their kids. Teen girls, if they even stay in the ANF family, are trading down to lower-priced Hollister. Teen boys were glad to be rid of A&F; they wore it because women told them to. Parents, with a new “recession” excuse to control the family spend, couldn’t be happier. One mom related that she stocked up at American Eagle’s pre-Christmas sales, and told her daughter (18) that she wouldn’t get any new clothes until her July birthday. Surprisingly, she said, her daughter was fine with that.

The implications for ANF stock are steady and consistent erosion of margins, profits and cash flows. ANF will experience decreasing brand loyalty – not just in its core group today, but in the future, as new teens (today’s tweens) absorb from older siblings that A&F merchandise is just not as cool.

This persistent erosion has yet to be valued into ANF stock. ANF today trades at $20-$21.

My background, incidentally, is this: my father was in retail, the President (albeit not CEO) of a mid-sized Abercrombie-like concept back in the mid 1970s (good ups) into the early 1980s (it ended in bankruptcy).

My father taught me two things in life. The first, “never get into retail”; this, as all retail concepts die, and the higher the retail flyer, the bigger its crash (Sharper Image, anyone?). The second, “you better ask your mother”.

Well, though my mother was no Wall Street analyst, she was herself a retail exec (women’s wear buyer) who would understand the following.

  • Ultra-high margins are not sustainable in a recession. Management’s assertion that it would hold the line on its 67% gross margin is being revealed as false on Abercrombie.com, where this year’s Spring Lines are priced 10% to 15% lower than last year’s.
  • “Aspirational” mid-luxury products – particularly clothing, where ready substitutes are available – take a big hit in a recession. Most often, these hits require a complete re-think of a retailer’s business model.
  • The momentum of a retailer who “grows up” in good times, like ANF, is cut off at the knees in bad times. The aspirational draw – big stores in pricey malls, in the priciest locations within those malls– acts as the worst form of leverage (the cost of existence) in bad times.
  • The ego of a visionary founder works against the company. Michael Jeffries is a great salesman and marketer. But he may need to learn humility… as Ralph Lauren will tell you he got in two different recessions (early 1980s, early 1990s), in order to ride out the third (early 2000s).
  • Cash is king in retail. And cash is eroding at ANF, and you would be a fool not to recognize it.

In the fall (Q3) of 2008, ANF’s back-to-school free cash flow (cash from operations less capital expenditures, per its 10-Q) was a negative -$20 million. In 2007, that Q3 number – you have to calculate the change between Q2 and Q3 – was a positive +$219 million. The YoY delta is a whopping -$240 million negative.

Mind you, this 2008 back-to-school disaster was before Christmas, and before the Feds told us we had been in a recession.

ANF’s analyst coverage is miserably trailing such signs. As I write this, Analyst Estimates on Yahoo (27 analyst universe) show an average estimate of $0.97 for the current quarter, with the low estimate at 80 cents per share. This is after management warned on January 9, 2009 that “net income per diluted share for the fourth quarter will be SIGNIFICANTLY BELOW (caps mine) the $1.00 to $1.05 per diluted share guidance previously issued”.

Obviously, most of these analysts can’t be bothered to update, have never worked in retail, or don’t talk to teens and their parents. “Significantly below” in retail (as in tech) means floods, fire and locusts. It means EPS down 40% or 50% against guidance, or more. Whatever the EPS– 97 cents, 80 cents, or my belief, 50 cents – that is against last year’s Q4 EPS of $2.36.

The analysts also are behind the curve on ANF’s vaunted “cash reserves”. Per the10-Q filed for Q3, ANF’s cash plus investments declined from $648 million in 2007, to $559 million. But $100 million of 2008’s cash was borrowed – the first time since January 1998 that ANF had tapped debt or a line of credit. Further, $262 million of those investments were in ARS (auction rate securities), which ANF recently classified as “Level 3” (management decides how to value them).

Add it all up – the $90 million decline from last year’s Q3 to this year’s, the $100 million borrowed to pump up cash on the left side of the balance sheet, and a mark-to-market loss on the ARS of, say, $40 million or so – and what you have is a Q3-to-Q3 decline in cash of negative -$230 million.

And again, this is before the disaster of this year’s Q4, where same store sales were -28% in November, and -24% in December (December’s SSS number was obtained, per DA Davidson analyst Crystal Kallik, only by ANF’s starting clearance sales with heavy discounts on Christmas Eve).

My parents lived the problem with “aspirational” retail. In a lasting recession, you can’t go forward, and you can’t go back. Your pricey rental agreements are locked in, and so long as you have an ounce of cash, your landlords demand it. The virtuous cycle that works in boom times – great spaces, great marketing, soaring margins – kills you in bad times.

If our recession is short, ANF is fairly valued today. If – and it looks like this is the case – the recession is long-lasting, and families continue to deleverage, ANF’s whole model has to be re-thought. All the signs point to such danger ahead. The California teens and their parents are telling us something, and this is that Abercrombie – its wares, and its stock – is not such a good value after all.

Disclosure: No positions on ANF or AEO