Analysts expected third-quarter earnings per share of 59 cents. Abercrombie & Fitch (NYSE:ANF) had other ideas, delivering an 87 cent profit for the quarter. The 47% positive earnings surprise caused its stock to jump nearly 30% in early trading Nov. 14. While an impressive showing, investors are probably still leery about the future for this one-time retail star. Frankly, I'm not sure what to think. By the end of this article I hope we'll all have a better idea whether to bet long-term on Abercrombie.
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Before I get into the positive aspects of Abercrombie, I need to remind myself why it is Brian Sozzi, chief equities analyst at NBG Productions, feels it's still a troubled company. When Abercrombie announced its second quarter earnings on Aug. 2, they were dismal. Its stock dropped 14.5% on the news. At the time, Sozzi said this about the company: "I believe [there's] every reason to have avoided the stock." The analyst felt Abercrombie was being overly optimistic about its future prospects. Flash forward to its Q3 announcement and Sozzi's note to clients: "I don't believe Abercrombie is suddenly the share winner in teen apparel land, and what is being seen today is management of Street expectations and perhaps, top line related leverage from prior flagship store openings." I'd love for this guy to be my doctor because he's got an answer for everything, although I'm not sure his explanation for Abercrombie's results makes a whole lot of sense.
Let me break it down for you in terms we can all understand. Abercrombie's same-store sales growth is negative and expected to stay that way for the unforeseen future. Overall, its Q3 comps were down 3% with its namesake brand off 4% and Hollister, its growth brand, off just 1%. While negative, it was much lower than the 10% drop in Q2. Closing out the year it expects fourth quarter comps down 5% or so. It's definitely not good news when there's anything negative in an earnings report, but I learned a long time ago that positive same-store sales growth does not always equate to good earnings and negative same-store sales growth doesn't necessarily mean bad earnings. Buckle (NYSE:BKE), one of my all-time favorite retail stocks had flat same-store sales in fiscal 2006 and yet it managed to grow net income that year by 7.4% and expand its net margin by 10 basis points to 10.5%. In fiscal 2001, Buckle had -6.2% same-store sales growth, yet it still managed a net margin of 8.5%. Positive comps are nice to have but they aren't essential in the short term. If Abercrombie can squeeze more gross profits out of its business in the next couple of quarters, the impact of the negative comps won't be nearly as pronounced.
Since I left off the previous paragraph talking about gross margins, that's where I'll begin this one. Abercrombie's third quarter saw gross margins improve 240 basis points to 62.5%, while operating margins improved 220 basis points to 9.6%. Year-to-date they're not nearly as attractive, but with another increase in Q4, gross margins should come in flat relative to 2011 around 61%; operating margins should be higher than the 4.6% from 2011. As long as it keeps opening international stores, its profitability should be just fine.
Abercrombie's international revenues including online sales increased 37% in the third quarter to $351.1 million and now represent 30% of its overall revenues. In the first nine months of fiscal 2012 it's opened 32 stores internationally while closing 10 in the U.S. Three-quarters of its store openings are for the Hollister brand, which globally including the U.S., represents 55% of its total store count. Until the 10-Q comes out, it's hard to know how each segment did in Q3, but whatever the results, its international business is a big part of its overall profitability. In the second quarter its international stores generated 32% of its overall operating income from 27% of the revenues compared to the U.S. stores which produced 59% of the revenue but only 41% of the operating income. That's a big reason why it's closing stores in the U.S. instead of opening them. On that front, Brian Sozzi's correct. Until it gets its U.S. business working right, its profitability will always be much less than it could be. That doesn't mean you shouldn't buy the stock.
I'm like a broken record when it comes to online retail. If you're not building a strong e-commerce business you're hurting the long-term potential of your brand. Abercrombie's direct-to-consumer revenue grew 20% to $158.3 million. That's 13.5% of its overall revenue and an improvement of 120 basis points year-over-year. Sequentially it improved by 24% from the second quarter. While it's not quite at the level of Williams-Sonoma (NYSE:WSM), which sells 40% of its products online, Abercrombie's getting better. With operating margins of 44%, its direct-to-consumer segment helps keep its business moving forward.
The Bottom Line
Although Abercrombie's not out of the woods just yet, I see a business reporting a lot more good news than bad. Even with the big jump from its earnings announcement, its enterprise value is just 5 times EBITDA. There will be bumps in the road in the coming quarters, but historically this is a stock that trades much higher than $40. If you've got a 3-5 year horizon, I'd still make the bet.
At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.