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Abercrombie Seen Inviting LBO as Bullish Options Surge

For private-equity shoppers, no teen-clothing retailer in America is offering a bigger bang for the buck than Abercrombie & Fitch Co. (ANF)

Abercrombie, which lost about half its value as markdowns depressed profit in the past two quarters, rallied twice as much as its competitors this month as takeover speculation emerged. The company still trades at 4.4 times the average analyst estimate for earnings before interest, taxes, depreciation and amortization through 2015, less than any of its closest comparable retailers, according to data compiled by Bloomberg.

With Chief Executive Officer Michael Jeffries predicting last month a rebound in international sales that could help Abercrombie double free cash flow to a half-billion dollars in three years, Morningstar Inc. and Cowen & Co. say it is an attractive target for a leveraged buyout. Options traders are also bullish on Abercrombie, with calls exceeding puts by the most in 19 months. The retailer could get at least $70 a share in a takeover, Cowen estimates, or a 34 percent premium.

“It’s got all the characteristics you like to see” for an LBO, R.J. Hottovy, director of consumer research at Chicago- based Morningstar, said in a telephone interview. “It’s relatively debt free, has a strong cash-generation profile, and ultimately a business that can be monetized. These teen apparel guys make a lot of sense for private equity buyers.”

Eric Cerny, a spokesman for New Albany, Ohio-based Abercrombie, said the company doesn’t comment on speculation.

Teddy and Hemingway

Today, Abercrombie rose 1.5 percent to $52.89 in New York.

Abercrombie & Fitch was founded in 1892 as a purveyor of guns, fishing rods and camping gear to adventure seekers and the rich, with customers that included Theodore Roosevelt and Ernest Hemingway, according to Hoover’s Inc.

Now, the retailer’s 294 namesake stores target 18- to 22- year-olds with jeans, polos and T-shirts recognizable by their moose logo. The company also owns the abercrombie children’s chain, the Southern California-style Hollister apparel outlets and the Gilly Hicks lingerie shops.

After approaching a more than three-year high at the end of October, Abercrombie tumbled 47 percent in the following three months as earnings (ANR) disappointed investors.

On Nov. 3, Abercrombie plunged after saying sales at its European flagship stores dropped and revenue in Japan and Canada continued to decline. Earnings in the third quarter also fell short of analysts’ projections as higher costs for commodities such as cotton and too many promotions eroded profit.

“We left dollars on the table and we really gave some margin away,” Jeffries said on a Nov. 16 conference call.

Holiday Markdown

Its fourth-quarter results on Feb. 2 trailed analysts’ estimates again as a “more aggressive promotional environment” during the holiday season led to an increase in discounts, which reduced the amount it earned on each dollar of sales.

Abercrombie has rebounded 14 percent this month, helped by speculation that private equity firms may be looking at the company as a candidate for a buyout. The advance was almost twice as large as the 7.8 percent gain in Bloomberg Industries’ 11-stock Specialty Apparel Teen, Tween & Young Adult Clothing Stores Index in the same period.

Abercrombie ended at $52.13 a share yesterday, giving it $4.5 billion in market value. With almost $600 million in cash and little debt, it has a so-called enterprise value of 4.4 times its average annual estimated Ebitda of $876 million in its fiscal years from 2013 to 2015, data compiled by Bloomberg show.

Its closest competitors, which include Pittsburgh-based American Eagle Outfitters Inc. (AEO) and Aeropostale Inc. of New York, command almost 30 percent more on average, the data show.

Global Franchise

Abercrombie may attract interest from private equity firms as it cuts costs and expands overseas, which will increase the retailer’s ability to generate cash to fund a leveraged buyout, according to John Kernan, an analyst at Cowen in New York.

The company plans to open flagship locations this year in Hong Kong, Amsterdam, Dublin, Hamburg, London and Munich, as well as 40 Hollister-brand stores outside the U.S. It also intends to close 180 underperforming stores by 2015.

International sales growth, along with its investments in the online business, will help boost profit in the fiscal year that began in February, Abercrombie’s Jeffries said last month.

“It’s one of those global franchises,” Dan Veru, who oversees $3.4 billion including Abercrombie shares as chief investment officer of Fort Lee, New Jersey-based Palisade Capital Management LLC, said in a telephone interview. “It’s not a niche, it’s a global franchise, in our opinion. While they maybe were a little bit too bullish with too much inventory going into the holiday season, it wasn’t catastrophic.”

LBO Model

After deducting capital expenses, analysts project that Abercrombie’s cash from operations will reach $224 million this fiscal year, data compiled by Bloomberg show. By 2015, its free cash flow will more than double to $475 million, the data show.

Neither American Eagle nor Aeropostale (ARO) will increase their free cash by more than 10 percent in the same span, analysts’ estimates compiled by Bloomberg show.

“Abercrombie would probably generate the most attractive economics for a private equity sponsor,” Kernan said in a telephone interview. “The balance sheet and cash flows can support a lot of debt.”

In a leveraged buyout, private equity firms can pay $70 a share and still generate a so-called internal rate of return of 22 percent, he wrote in a report dated March 15.

TPG Capital, run by David Bonderman, and Leonard Green & Partners LP, are among the private equity firms that would likely be interested in Abercrombie because of their history of LBOs in the retail industry, Morningstar’s Hottovy said.

J. Crew Redux

“Those are the kind of guys that typically play in the retail space,” he said.

TPG and Leonard Green joined to buy J. Crew Group Inc. for $2.6 billion in March 2011, data compiled by Bloomberg show.

Owen Blicksilver, a spokesman for Fort Worth, Texas-based TPG, declined to comment on whether it is considering an acquisition of Abercrombie. Michael Gennaro, chief operating officer of Los Angeles-based Leonard Green, didn’t immediately return a telephone message or e-mail requesting comment.

Abercrombie’s management and board may resist any buyout offers because as an independently run company, the shares rose last July to within 10 percent of a record before collapsing, according to Betty Chen, a San Francisco-based analyst at Wedbush Securities Inc.

The stock is currently worth about a third less than its peak of $77.14 a share in July and the board would probably hold out for a proposal of at least that much, she said.

Options Bulls

“I’d imagine that they would like to see some improvements in either the domestic business or positive reads from Asia before they would even consider selling the company at these levels,” Chen said in a telephone interview. “The board would be more likely to allow the existing team to execute the turnaround plan that they have.”

That hasn’t stopped traders in the options market from getting more bullish on the possibility that Abercrombie will become a takeover target, according to Steve Sosnick, equity risk manager at Timber Hill LLC, the market-making unit of Interactive Brokers Group Inc. in Greenwich, Connecticut.

The number of outstanding call contracts to buy Abercrombie stock exceeded puts to sell by 20 percent last week, the most since August 2010, data compiled by Bloomberg show. On Feb. 2, when shares of Abercrombie slumped to its low of the year, the number of puts surpassed calls by 43 percent.

The cost of calls to buy 30-day options relative to those to sell comparable puts, or the relationship known as skew, also increased to an 11-month high last week, the data show.

“The chatter seemed to dry up a bit after the successive guidance and earnings disappointments, and now as the market started to move higher and the stock started to inch up higher, we’re starting to hear it again,” Sosnick said.

To contact the reporters on this story: Katia Porzecanski in New York at kporzecansk1@bloomberg.net; Tara Lachapelle in New York at tlachapelle@bloomberg.net.

To contact the editor responsible for this story: Katherine Snyder at ksnyder@bloomberg.net.

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