Abercrombie & Fitch: Power Shopper

With four distinct apparel brands and international expansion driving superior earnings growth, S&P gives the retailer's shares its highest recommendation

As the leader in casual luxury apparel for the 7- to 22-year-old demographic, Abercrombie & Fitch Co. (ANF) is well positioned to benefit from the trend we see of aspirational luxury brands outperforming their more moderate peers based on perceived brand differentiation and the value/price equation. Our favorable outlook for luxury brands is also supported by strong consumer spending trends, a favorable employment outlook, and continued moderate growth in consumer income. We look favorably on ANF's diverse retail-brand portfolio and believe incremental opportunities exist internationally. Based on our projected five-year compounded average annual earnings growth of 18%, we expect ANF shares to maintain and potentially exceed their peer-group multiple. Our recommendation for the stock is 5-STARS, or strong buy.

With four distinct apparel retail brands in various stages of growth and a fifth in the incubator (not yet articulated to the investment community), we think ANF's diversification provides room for a doubling of size while mitigating risk. Moreover, the brands target different age groups at different price points with little cannibalization.

We believe the company's international expansion should provide an additional growth vehicle while enhancing the aspirational positioning of the brands. Specifically, London and Japan flagship locations are planned for calendar 2007 and 2008, respectively, for the adult Abercrombie & Fitch brand.

One Platform, Four Brands

ANF's operating and financial metrics have historically been at the high end of its peer group even during extended periods of low sales productivity, attesting to management's acumen, in our opinion. We see the management team as brand managers par excellence, unwilling to forfeit long-term brand equity for a quarterly earnings target. To this end, the company has phased out seasonal sales events in keeping with luxury-brand practice.

One operational and financial platform supports the four brands, allowing for the leveraging of fixed costs on moderate same-store sales gains. ANF believes it can leverage store and distribution expense (36% of fiscal year 2005 [ended January] and fiscal year 2006 sales) on a flat to 3% comp-store sales gain. Year-to-date (February through September) same-store sales rose 5%, and accelerated in September to a 10% pace. At the same time, the company increased guidance for the second half of fiscal year 2007, despite the difficult monthly same-store sales comparisons, as ANF laps 31%, 23%, 29%, and 33% for the remaining four consecutive months of fiscal year 2007. We look for fiscal year 2008 comparisons to ease.

We see fiscal year 2007 sales growing 20% to $3.3 billion on an estimated 11% increase in square footage as the company opens another 107 new stores, and a 5% comp. We project operating margin expansion of 70 basis points, to 20.2% of sales, driven by a 30-basis-point gross margin improvement and an 80-basis-point improvement on the store and distribution expense line, partly offset by a 40-basis-point increase on the marketing, general, and administrative line item (the bulk of which has already occurred in the first half of fiscal year 2007).

Big Potential

For fiscal year 2008, we have modeled 10% growth in square footage along with a 5% comp to drive 14% sales growth to $3.8 billion. We have kept the gross margin at 66.8% of sales and the operating profit at 20.2%, with 10 basis points of improvement in marketing, general, and administrative expense offset by a 10-basis-point increase in the store and distribution expense ratio.

Longer term, we see ample growth opportunities with the continued rollout of existing concepts, expansion of RUEHL and internationally, as well as the development of a new undefined concept.

Looking at how the company operates, Abercrombie & Fitch is a leading specialty retailer of casual sportswear, accessories, and personal-care products under four differentiated brands. The Abercrombie & Fitch (A&F) brand is an all-American collegiate lifestyle brand, juxtaposing Ivy League and the great outdoors (its heritage) with playful sexiness for 18- to 22-year-olds.

The company currently operates about 356 A&F stores and believes the concept provides an opportunity for 400 U.S.-based stores and about 10 internationally. In fiscal year 2006, A&F represented 51% of corporate sales, posted an 18% comp-store gain, and achieved sales per average gross square foot of $432. It is the most mature concept in the company's stable.

Next Growth Vehicles

The abercrombie brand is all-American prep-school positioning for 7- to 14-year-olds. With 167 stores (generating 12% of consolidated fiscal year 2006 sales) and an estimated 275-store opportunity, this concept has been a stellar performer, in our view, with a 57% same-store sales gain in fiscal year 2006 and sales per average gross square foot of $446.

Hollister Co., a California surf lifestyle brand for 14- to 18-year-olds at price points about 30% south of its older sibling, was developed in 2000 as the next growth vehicle. It has quickly developed into a $1 billion brand, generating 36% of fiscal year 2006 sales. With 364 Hollister Co. stores in operation and a potential for a total of 800, we believe it remains a very viable growth vehicle. Fiscal year 2006 comps were 29% and sales per average gross square foot were the highest in the organization at $528.

The newest brand concept, RUEHL, which was introduced in 2004, draws on a Greenwich Village (N.Y.) leather artisan family for its brand inspiration and is targeted for the A&F graduate (22- to 35-year-olds), at price points approximately 30% higher than A&F. The company currently operates 10 RUEHL stores and sees potential for 250; plans are to end fiscal year 2007 with 15 stores in operation and to open another 20 to 25 in fiscal year 2008, with a projected breakeven at fiscal year 2008 yearend.

CEO's Attention to Detail

RUEHL represented less than 1% of fiscal year 2006 sales, or $16.5 million, and achieved sales per average gross square foot of $315. We expect ANF to take its time perfecting the merchandise and positioning before an aggressive store rollout.

CEO and Chairman Mike Jeffries pays close attention to merchandise and in-store execution. We regard this trait as vital to steering the brands through the plethora of "me too" products in the marketplace and maintaining the aspirational positioning the brands enjoy. Good brand management, in our view, necessitates knowing your customers and staying focused on delighting their senses. Jeffries is a steward of the brands, and has the creative skill, we believe, to interpret prevailing fashion trends for ANF's customers. We get the sense that he signs off on virtually everything, a process that could get increasingly cumbersome with ANF's growing scale.

As for the industry outlook, ANF participates in the specialty-apparel retail market targeted at youth, spanning the tween-to-young-adult demographic. While the U.S. apparel market is considered mature, with demand mirroring population growth and a modicum related to fashion, the youth marketplace is generally considered attractive based on its spending clout. According to NPD consumer estimated data, collectively, this group accounts for approximately 35% of total apparel spending, with the "sweet spot" being teenagers, who represent about 20%.

Changing Retail Landscape

In 2005, U.S. total apparel sales reached $181.2 billion, a 3.6% year-over-year gain, using NPD consumer estimated data. Men's apparel represented 29% of the total and grew at a 5.1% rate; women's, at 56%, grew at a 3.2% pace; and children's, the final 15%, accreted 2.0%. In the first half of 2006, apparel sales growth accelerated 9.6% to $88.1 billion, with children's apparel outpacing the total with a gain of 13.9%, followed by women's (10.4%) and men's (5.7%). Unit growth trailed dollar growth, suggesting a diminution of deflationary pressure despite the consolidating retail environment due to the contraction of the better department-store channel.

The retail landscape is consolidating, with share accruing to the mass merchants and specialty chains while the traditional department store is losing ground. We believe that specialty chains compete on customer knowledge garnered from daily interactions, focus groups, and marketing intelligence, and this knowledge is often combined with high customer-service levels to result in an attractive price/value equation for the consumer.

ANF's target demographic is attracted to strong brands, as well as fashion and value, when determining apparel selections. While the specialty channel holds the largest share of the apparel market, S&P estimates that the subsegment serving the youth demographic represents about 3% of total apparel retail sales. With barriers to entry minimal (capital investment in merchandise, rent, and labor expense) and potential returns on investment high and quick (four-wall return on investment exceeds 40% in 12 months for many specialty retailers), there is a steady flow of new industry participants. In addition to competing with other apparel retailers, regardless of channel, for youth discretionary spending, ANF competes with merchandise and services, especially consumer electronics and entertainment services.

Target Price: $88

Our 12-month target price for ANF shares of $88 incorporates relative, historical, and peer valuations. The shares recently traded at about 15 times our fiscal year 2008 earnings-per-share (EPS) estimate of $5.26, around a 10% discount to the level of peers and in line with the S&P MidCap 400 as well as ANF's five-year average one-year forward p-e multiple.

We believe that as investors focus on what we view as ANF's brand-building strategies, superior operating metrics, and management acumen, the shares will be afforded a higher p-e multiple. We anticipate that over the course of the next 12 months, the stock will trade in line with peers (at 17 p-e) and its recent two-year average one-year forward p-e multiple (17) using our fiscal year 2008 projected EPS.

We believe ANF's corporate governance policies are generally sound. The company has adopted charters regarding the nomination of directors, corporate governance guidelines, as well as the audit and compensation committees. It regularly reviews board performance. The board is controlled by a super majority of independent outsiders (greater than two-thirds), and we are encouraged that the audit committee consists entirely of independent outside directors.

The primary negative factor in our view, is that the chairman of the board, Mike Jeffries, also serves as the CEO. While this is a fairly common practice in the specialty-apparel and apparel and accessories industries, and we think the bench strength at ANF's New Albany (Ohio) headquarters is deep, this single-person dependency is a risk. We note a board-approved CEO succession plan is in place.

Whims of Fashion

Risks to our recommendation and target price, in our view, include negative same-store sales trends, fashion, and inventory risk. ANF's retail locations exclusively sell its proprietary branded apparel, accessories, and personal-care products. Therefore, the company is dependent on the strength and attractiveness of its brands to its target audiences. Fashion apparel is fiercely competitive, and youth consumers can be fickle. While we think this risk is mitigated by ANF's four distinct brands and customer profiles, an adverse change in consumer perception toward any of the brands could make it difficult for ANF to achieve our sales and earnings projections.

Same-store sales comparisons are difficult for the remainder of fiscal year 2007, and this metric is (although oftentimes mistakenly, in our view) investors' north star. International retail expansion has met with varying degrees of success for most retailers. While ANF's Canadian stores are very viable, European and Asian expansion could be more difficult. It is worth noting that international demand has been steady and growing on A&F's Web site.

Finally, with the RUEHL concept, ANF enters the adult apparel market (although we know many thirtysomethings who frequent the A&F stores for tightly fitted polo shirts and jeans), a market segment that is capturing growing attention from other specialty-apparel retail operators. While there is no guarantee of success, ANF's brand-building and retail development acumen is considerable, in our view.

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