Future at Abercrombie and American Eagle Not So Grim

Includes: AEO, ANF
by: Mark Hines

A closer look at clothing retailers American Eagle Outfitters (NYSE:AEO) and Abercrombie & Fitch (NYSE:ANF) suggests the future may be less grim than expected, especially for ANF.

On Wednesday, American Eagle Outfitters announced fourth quarter earnings of 66 cents per share in line with analyst estimates. During the conference call, management mentioned several encouraging items. For example, they continue to take disciplined steps to control inventory in this tough environment. Also, the company re-affirmed Q1 earnings guidance (which is in line with analyst estimates), valuation is attractive (forward P/E is near historical trough levels), the balance sheet is strong (zero debt), and AEO continues to rank well with teens.

On the negative side, AEO continues to struggle in women's apparel (which makes up 60% of their business), and there is question as to where future growth will come from considering the industry is very mature. Improving women's apparel is one growth opportunity, as is expansion of the aerie brand. International growth is another opportunity, but the American Eagle brands seem to have less international appeal compared to Abercrombie & Fitch.

Abercrombie & Fitch seems to have a strong enough brand to achieve significant success in international markets. For example, according to Bloomberg, ANF's first European venture (near London's Savile Row) charges twice as much as US stores, and has sales of about $4500 per square foot, matching its main shop on New York's Fifth Avenue. Based on early international success, Abercrombie has been laying the foundation for an accelerated international expansion (there is talk of store openings in Tokyo, Paris, Hong Kong, Dublin, and Shanghai), and some analysts are predicting that international could account for 25% of the company's sales within five years.

Abercrombie also has a variety of other positive things going for it. For example, ANF has $650 million in cash on its balance sheet (out of $2.5 billion in total assets), and it generates a free cash flow yield of around 5%. Also, ANF has a dividend yield of 1%, and it will likely use its excess cash to increase the yield AND repurchase shares. Currently, ANF trades at 13.1 times January 2009 estimates, which is a discount to its historical average of approximately 15. Similar to AEO, ANF has operating margins around 20%, which is considerably better than the industry average of only 5%. AEO is currently trading near its 52 week low, while ANF has held up slightly better over the last year. However, I suspect both companies are undervalued, and it will be interesting to watch them over the coming year and beyond.