Abercrombie & Fitch's Q4 Doesn't Justify The Valuation
Summary
- Abercrombie & Fitch reported strong earnings on Wednesday.
- But guidance for this year is weak, as comps and margins should be up only slightly.
- That makes the exorbitant valuation even more pronounced, and I still think there's a lot of downside risk here.
I’ll admit that when it comes to Abercrombie & Fitch (NYSE:ANF), I’ve missed the boat. The stock was tremendously cheap back in the summer of 2017, but a rally that has seen its value roughly triple since that point has put me firmly in the bearish camp. But despite the enormous revaluation of the stock much higher, it just keeps climbing in what has been a stunning rally. After Q4 results were posted on Wednesday, the stock moved 12% higher once again, making new relative highs in what has become a pattern. The problem is that even though ANF’s results have certainly improved, the stock is so far out in front of the turnaround that I simply cannot find a scenario where today’s price is justified.
Comps impress
Total sales were up 15% in Q4, and that sounds very nice, but a lot of the gain was due to non-operational factors. Comps were up 9% during the quarter to beat estimates as Hollister continued its impressive run, leading the way at 11%. Importantly, the Abercrombie brand actually posted positive comps for the only time in 2017, coming in at 5%. That’s a huge achievement for ANF, and I suspect this is a big reason why investors took so well to the report. Unfortunately, the remainder of the 15% sales gain outside of comps was due to forex translation and an extra week during the quarter. These items added the balance of ANF’s sales growth in Q4, and while they still count, they aren’t repeatable, and thus, I’m more focused on comps than the total sales gain. Regardless, the company’s sales result from Q4 was tremendous, and there’s no way to spin it in some other light.
Expense leverage shines in Q4
ANF managed to boost its margins as well, as it overcame a weak gross margin number to see operating income more than double in dollar terms. Gross margins fell 90bps in Q4 due to higher unit costs and lower average unit retails. In other words, costs rose while revenue fell, causing gross margins to be squeezed on both ends. This is obviously less than ideal, but it also isn’t new and, indeed, is a big reason why I’ve doubted the ANF rally. On the plus side, G&A costs fell as a percentage of revenue, and so did store/distribution expenses - the product of a continuous cost reduction effort the company has undergone. That program has been very successful, and those results showed in Q4, to be sure. On the whole, between sales growth and margins, Q4 was a blockbuster, and ANF deserves a lot of credit.
Guidance doesn't support the rally
So we know 2017 ended on a high note, but what about going forward? Guidance for this year is a bit underwhelming, as there are a lot of metrics that were essentially guided around flat. Comps are expected to be up in the low single digits, and that would be about what total sales would see as well, given that forex and the absence of the extra week in the fiscal calendar are going to roughly offset each other in 2018. It would seem, then, that the euphoric reaction off of the hot comp number in Q4 was a bit overdone, if guidance is to be believed.
Gross margins were guided to be up “slightly,” while operating expenses were guided to be up 1%, meaning operating margins should be right around the flat level. We may see a bit of operating margin expansion if forex provides some additional leverage and/or if expense controls perform better than guidance, but the point here is that determining whether margins will rise very slightly or not at all is splitting hairs; overall guidance is okay, but not great.
That wouldn’t be an issue, except that the massive rally the stock has seen has taken its valuation into the mesosphere, and I just don’t get it. The stock is going for 43 times this year’s earnings, a truly staggering number given how guidance looks. Last year wasn’t anywhere near good enough to justify this sort of action, and even the medium-term growth rate for ANF in the low teens puts its PEG at 3.5-4. That is nosebleed territory without question, as PEGs in excess of 2 make me nervous. If ANF were some hot growth startup, I could maybe squint and see a scenario where that sort of valuation makes sense, but it isn’t. Keep in mind, the store count is flat to slightly down, comps are going to be slightly positive and margins will be slightly positive; what exactly are people paying 43 times earnings for? It doesn’t make any sense.
The yield is still very strong despite the rally, as it is still near 4%, but given the amount of downside risk in the stock here, a 4% yield is of little solace should this rally unwind at some point. ANF is clearly in a euphoric stage of what has been an epic rally, but the fundamentals simply do not support prices anything like what we’re seeing today. I still think there’s a lot of downside risk to the stock, and while I’m sure to be tarred and feathered by the bulls for being wrong, I can own my position. ANF will eventually see an unwinding of this rally once investors figure out it cannot support a $24 stock price.
This article was written by
I've been covering financial markets for ten years, using a combination of technical and fundamental analysis to identify potential winners (and losers) early, particularly when it comes to growth stocks.
Analyst’s Disclosure: I am/we are short ANF. 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.
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Comments (10)
It trades at a massive discount to other players on EV/sales showing the upside which can come as earnings recover on the back of strong operating leverage
Strong balance sheet with high single digits growth.
ANF would have done better if not for short term one time tax cost offset by future tax benefits , so earnings could have been better and will be moving forward. Management has retooled production chain cycle, Omni-channel and international sales across all brands, and began to improve clothing - more one-time costs likely to payoff bigly.
ANF repositioned for long-term growth on lower costs with higher velocity of sales and likely to beat easy guidance.
We could see $2 EPS in '18.
The strong balance sheet, cash position, fcf, and dividend make this a short trap to those looking to short anything retail. There are some great short opportunities in retail, but ANF is not one of them.
