Abercrombie & Fitch’s Margins Are Expected To Fall, But They Hold Potential For 10% Upside

Abercrombie & Fitch‘s (NYSE:ANF) overall EBITDA (earnings before interest tax depreciation & amortization) margins have trended in a wayward manner over the past five years. From 24.6% in 2010, margins declined to 22% in 2011, primarily driven by a sudden rise in cotton prices arising from a shortage in supply. From $0.84 per pound in July 2010, cotton prices rose to $2.30 per pound in March 2011. The major factor behind this price increase was the drought in Hubei province of China, a major cotton producing area. Government restrictions on exporting cotton out of India and a devastating flood in Pakistan further contributed to the supply shortage. Being the prime raw material for the apparel industry, surge in cotton prices increased production costs considerably for apparel retailers.

As cotton prices eased out, Abercrombie’s margins recovered to 24.1% in 2012, but declined again to 22.6% in 2013, when the company ushered heavy markdowns to compensate for low store traffic. This is turn resulted from a pullback in consumer spending on premium apparel and gradual customer shift to online channel. In 2014, margins surprisingly improved to 23.8% despite heavy markdowns, due to a fall in expenses related to closed under-performing stores. However, going forward, we expect the retailer’s overall EBITDA margins to decline slightly in the near term and stabilize over the next three-four years. We believe that Abercrombie will continue to offer heavy discounts on its products amid fierce competition from fast-fashion players and falling foot traffic across the industry.

Our price estimate for Abercrombie & Fitch stands at $33.69, which is about 50% above the current market price.

See our complete analysis for Abercrombie & Fitch

Why We Believe Margins Will Fall In The Near Term

Heavy Discounting: There was a time when Abercrombie’s logo on basic t-shirts and jeans was enough to attract customers, but this is no longer the case. Over the past two to three years, U.S. shoppers have shown great interest in fashion-forward products from Zara, Forever 21 and H&M, but little affinity towards logo branded basic products from Abercrombie. Coupled with the industry-wide fall in foot traffic and the retailer’s inefficient inventory management, this trend forced Abercrombie to usher heavy markdowns to attract customers and keep inventory running. While the company has improved considerably on its inventory management and is in the process of transitioning its merchandise portfolio, customer response to its basic logo apparel remains weak. Thus we believe that the company will continue to use  heavy markdowns in the near term, at least until it phases out its logo merchandise. This will negatively impact its gross margins.

Increased Expense Due To Omni-Channel Investments: Like other participants in the U.S. apparel market, Abercrombie is also trying hard to shift towards omni-channel retailing. In its most recent earnings call, the company stated that it is investing heavily in direct-to-consumer and omni-channel initiatives. The retailer’s ship from store service is live in 350 stores and its order in-store service has been added to 650 stores. Abercrombie said that it will continue the roll-out of these services in remaining stores this year. Moreover, it has almost completed the conversion of one of its distribution centers in New-Albany into a dedicated direct-to-consumer facility. We believe that the company will deploy more strategies on the omni-channel front, which coupled with the ongoing initiatives, will result in increased expenses in the near term.

Growing Proportion of Online Revenues: With growing Internet penetration and the proliferation of smartphones and tablets, U.S. buyers in numbers have been switching to online shopping. Understandably, apparel retailers are aggressively pushing to expand their direct-to-consumer portfolio to generate incremental online revenues. For Abercrombie, direct-to-consumer sales as percentage of net sales increased from 10% in 2009 to an estimated 23% in 2014. Direct-to-consumer business is a typically low margin business as compared to store business, because of the additional packing and shipping costs, and the workforce related to it. Hence, as proportion of online sales in Abercrombie’s overall revenues increases going forward (we currently estimate the figure to reach 31% six years down the line), its overall margins will experience a downward pressure.

On The Other Hand, Why Margins May Not Fall

Success of Portfolio Transition: In response to the continuous customer shift to fast-fashion brands, Abercrombie decided last year that it will aggressively phase out its logo merchandise and replace it with fashion-forward inventory. Last year in an earnings announcement, the management stated that they will reduce their logo business to “almost nothing” within 12 months. Although this is a much needed step, customers might not like this drastic change, as traditionally they have shopped at Abercrombie for its iconic logo products. However, if Abercrombie is able to achieve the desired results with this transition and succeeds in bringing customers back, it can usher a greater proportion of full price sales. This can have a positive impact on gross margins.

Store Consolidation: Abercrombie & Fitch is reducing its domestic store fleet to have an optimum presence in the country and reduce its expenses related to under-performing stores. The company closed 52 stores in 2014 and might look to close some more in the near future, which would reduce its expenses at a faster rate than revenue decline, thus suppressing its SG&A rate. This can likely have a positive impact on operating margins.

What If Margins Increase?

Assuming that the aforementioned two factors have a greater positive impact on Abercrombie’s operating profits, its overall EBITDA margins can improve going forward. We currently forecast that margins will decline in the near term and then stabilize at 23.1%.  If, however,  the company’s EBITDA margins increase to 24.9% by the end of our forecast period, there can be more than 10% upside to our price estimate. This scenario is very much plausible as an alternative and all Abercrombie needs to do is optimize its expenses, go proactive on launching its fashion merchandise and hope for promising customer response.

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