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

by Marie Driscoll From Standard & Poor's Equity Research

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.