More Gains to Come for Resurgent Abercrombie

Despite the macro headwinds in Europe, the returns on ANF’s international stores are excellent (35%+ after incremental non 4-wall costs) and its Direct-to-Consumer business continues to deliver healthy revenue growth (20%+) and operating margins (40%+).

I think these two businesses will prove accretive to margins and capital returns, leading to an asset base that generates “steady-state” earnings/FCFE of ~$4.00 per share of under conservative assumptions before considering share repurchases (the current authorization is for 27% of shares outstanding). Normalized FCFE yield is 11%.

Value Drivers

1) International Stores

The Company’s international stores essentially come in 2 forms – mall-based Hollister stores and large, Abercrombie & Fitch branded flagships. The majority of its international units (>80%) are in Europe but there is a budding presence in emerging Asia. Regardless of type, ANF’s international units perform significantly better than its domestic units.

On average, Hollister stores overseas generate several times the volume of its US peers ($8-$10mn+ vs. $2mn-$3mn) at greater 4-wall EBIT margins (30%+ vs. < 20%). Its A&F flagship stores, located in major metropolitan areas, do even better, averaging ~$44mn in volume at 40%+ 4-wall margins. Even under onerous volume/margin assumptions, the returns on these stores are exceptional.

Will ANF’s European stores be able to command 2x-3x higher store volumes compared to US stores over time? Here are a few points to consider: First, management commented earlier this year that ANF’s top performing 250 US stores have 4-wall margins similar to its international stores (30%). If the US, a mature market with a population of 300mn+, can support 250 stores at a 30% 4-wall margin, then management’s goal of having ~200 stores (185 Hollisters + ~20 flagships) in Europe does not appear “over-stored” and it seems rather reasonable to me that the 30% targeted 4-wall margin can be maintained (Germany, France, UK and Italy together have a population of 270mn). Second, Urban Outfitters has been in Europe since 1998 and I estimate that its international stores – which have similar square footage to ANF’s international Hollisters - generate over $6mn in volume, which is the number I use in my base case scenario even though ANF’s European stores currently have 33% higher volumes. Finally, the last several years’ outcomes (which have seen European store volumes and margins well above the US even as demand has fallen precipitously) suggest sustainability, as does the fact that Hollister stores in the US have always had low volumes ($2.5mn-$3.0mn) vs. Europe.

2) Direct-to-Consumer

I don’t have too much insight into the online channel except that it is growing rapidly, consumes very little capital and currently generates operating margins in the mid-40s. Management continues to make investments in this business (especially the international DTC portion) and thinks longer-term margins shake out somewhere in the low to mid-40s.

3) Share buybacks

As the international store base expands, returns on capital will drift higher even under rather conservative assumptions and the earnings multiple should follow. Furthermore, borrowing at similar rates to J. Crew (4.5% after tax for money due 2019) and repurchasing shares that have a current normalized a/t free cash flow yield of ~11% to the equity is another value accretive option (though not one explicitly entertained by management). Issuing long-term debt to repurchase 22.9mn shares at the current price would add around $820mn to ANF’s current $75mn in debt vs. 2012E EBITDA of around $580mn, which doesn’t seem too aggressive (~1.6x total debt/EBITDA) even considering the Company’s cyclical characteristics (If we capitalize operating leases, the leverage multiple increases to ~3.8x. While this seems high, I still think it’s sustainable; consider that in 2009 (an awful year for ANF), the Company still generating $700mn in EBITDAR, which is still covers est. rent expense of $450mn and PF interest expense of $55mn. EBITDAR has improved significantly since then to around $1bn this year).

4) Shuttering more domestic stores

If 250 US stores have 30% 4-wall margins, then given the 20% 4-wall margin reported in 2011 implies that the other 696 US stores were operating at ~16.5% operating margins at the time. Shuttering close to 200 stores from 2011 to 2015, per managements plan, should provide a natural margin boost of around 1pt on US store revenue, all else equal. We should also see improved store productivity gains on the remaining stores due to reduced cannibalization.

Valuation

In my base case scenario, management fails to successfully deliver on most prongs of its strategy. Instead of opening 3-5 flagships and 30-40 Hollisters / year, management opens 2 and 20-30, respectively. Management achieves modest domestic store productivity improvements though much of the margin boost after 2012 comes from closing lower margin stores. DTC revenue growth decelerates materially to ~10%-15% (from 25%+ today) and margins contract some. I am also not giving ANF any credit for Gilly Hicks, ANF’s intimates brand, which has comp’ed 30%-40% over the last few years but does not currently contribute to earnings due to its sub-scale store base.

Under these assumptions, ANF’s return on capital (“Little Book” definition) accretes to ~17% vs. 12% today (and ~30% at the peak). The earnings multiple probably expands if this happens but I’ll stick with the current multiple for valuation purposes.

Applying ANF’s current earnings multiple (12.5x vs. ~16x for peers and a 10-year median of ~17x) and adding back excess cash/share gives us: $4.00 x 12.5 + ~$8 = ~$58 (no buybacks) to $5.48 x 12.5 = ~$70 (with buybacks). Maybe we get there soon after 2015. To put this in perspective, if management’s expectation of 15% operating margins is ever achieved, this would add an incremental 4% x $5.5bn = $220mn to EBIT, generating an additional $1.50 (no buyback) to $2.20 (w/ buybacks) to EPS, bringing total per share earnings to somewhere between ~$5.50 and $7.70 and returns on capital to over ~24%. I’ll just call this an optimistic case.
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