3 Reasons Abercrombie & Fitch’s Stock Looks Cheap

Specialty retailer Abercrombie & Fitch’s (NYSE:ANF) stock has seen a steady decline this year, falling by roughly 35% since January. The reasons for this decline are twofold. First, a large portion of this decline is attributable to the company’s excessive exposure to the European market, a region currently struggling from a sovereign debt crisis. As solid growth in international sales was the primary catalyst behind Abercrombie’s growth in recent years, weak European sales in the past few quarters have resulted in a decline in investor confidence on whether or not Abercrombie will be able to maintain its international growth.

Second, Abercrombie’s performance in the domestic market hasn’t been very assuring either. Crippled by a number of factors such as an unattractive pricing strategy for its products and the intense competition from peers such as American Eagle Outfitters (NYSE:AEO) and Gap Inc. (NYSE:GPS) in the teen apparel space, Abercrombie & Fitch recorded a decline of 5% in its Q2 fiscal ’12 US sales, further exacerbating investors’ concerns.

We, however, believe that the steep decline is an overreaction and that the company is undervalued at its current price. Here are three reasons why we believe that Abercrombie is worth at least 50% more than its stock price suggests. Check out our complete analysis of Abercrombie & Fitch

1) Revised international strategy

One of the primary focus of  Abercrombie’s Q2 earnings was its revised international growth strategy. Abercrombie is now adopting a more cautious approach to expansion in Europe. The company now plans to open only 20-25 new stores in 2013 against 30-35 store openings in 2012, leading to meaningful reductions in planned capital expenditures.

Hollister still remains the company’s brand of preference for European expansion due to the low-risk and high-return the company earns on its European Hollister stores. The decision is justified by the fact that over 90% of Abercrombie’s European Hollister stores have a four wall operating margin in excess of 30%. Additionally, for its new store openings, Abercrombie plans to focus on under-penetrated markets in order to negate the effect of cannibalization, which has been a major dampening factor for its European business.

In Asia, Abercrombie is taking a test-and-learn approach to new opportunities. After a successful opening of its Hong Kong flagship store earlier this year, Abercrombie plans to open a new A&F flagship in Shanghai to support its broader roll-out in China. Beyond Shanghai, the company has paused all of its other Asian flagship commitments, and we expect Abercrombie to review them after gauging the customer response to its Hong Kong and Shanghai stores.

2) Initiatives in domestic market

To improve its profitability in the domestic market, Abercrombie is adopting a 3 tiered approach. First, the company plans to consolidate its US business by closing unprofitable stores. The company plans to close nearly 185 stores in the US by the end of 2015, with the majority of closures happening in the A&F flagship and Abercrombie kids channel. The consolidation of the US business should be reflected in a long-term improvement in the company’s revenue per square foot.

Second, Abercrombie plans to reduce prices in order to make its merchandise more competitive. After the sudden spike in cotton prices in 2011, Abercrombie had increased its prices in order to pass the cost pressures to its customers. However, the move wasn’t well received by customers, resulting in a decline in its domestic comparable store sales.

Third,  Abercrombie is implementing a more conservative merchandising plan and shortening its product development calendar. We believe these steps should help the company better capture current fashion trends and decrease the lead time in bringing new products to its store shelves.

3) Prospects in e-commerce business

While the sales in both international and domestic stores have declined over the past few quarters, growth in direct business has stood out as a silver lining for Abercrombie & Fitch. We expect the trend to carry forward driven by a number of factors such as the customization of e-commerce websites for different countries and the addition of PayPal payment gateway as well as the growing brand recognition of Abercrombie & Fitch in Europe.

Additionally, the recent opening of a new distribution center in Netherlands should also result in attracting higher traffic from Europe, as the associated shipping costs are bound to decline. Previously, Abercrombie used to ship products to European customers from its US distribution center, resulting in higher costs.

An increase in the percentage contribution of the direct sales to the net revenues will also help Abercrombie in improving its margins as direct sales carry higher margins compared to that of retail sales.

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