Abercrombie & Fitch’s (NYSE:ANF) stock crashed by roughly 13% Wednesday to hit a two year low, after the disclosure of first quarter earnings results.  The primary reason behind the decline was concerns over Abercrombie’s European business, as the teen-apparel retailer’s comparable-store sales declined by 5% amid weak European sales.
While we do acknowledge that continuing weak macro-economic conditions in Europe put a shadow of doubt over Abercrombie in the near-term, we believe Wednesday’s massive decline was likely overdone. Here we try to highlight what were the major trends in the Q1 earnings release and what justifies our positive outlook on Abercrombie & Fitch going ahead. Abercrombie & Fitch competes with other specialty retailers such as Aeropostale (NYSE:ARO), American Eagle Outfitters (NYSE:AEO) and Gap Inc. (NYSE: GPS) in the teen apparel space.
We have a revised price estimate of $56.96 for Abercrombie & Fitch stock, which is roughly 55% ahead the current market price. Along with a change in Abercrombie’s current net cash/debt position, the adjustments in our price estimates primarily reflect a decline in Abercrombie’s near-term outlook on account of weak European sales.
Weakening European Business Takes a Toll on Abercrombie
The major highlight of Q1 earnings was the weakening business in Europe, which took a toll on Abercrombie’s Q1 comparable store sales. Owing to continuing weak macro-economic conditions in Europe, comp sales were significantly down across Abercrombie’s international and U.S. tourist stores. Brand wise, Abercrombie & Fitch registered a 4% decline in comps whereas Hollister, which was doing exceptionally well until quarter, slid by a significant 5%.
As solid growth in international sales was the primary catalyst behind Abercrombie’s growth in recent years, weak European sales this quarter has resulted in a decline in investor confidence on whether or not Abercrombie will be able to consistently maintain its international growth. The concerns were further exacerbated when Abercrombie projected same store sales to be down by a mid-single digit percentage on a full-year basis.
What Justifies Our 55% Upside for Abercrombie’s Stock
While we notice that Abercrombie’s weakening European business does provide challenges for the company in the near-term, still Wednesday’s massive decline was likely overdone. We believe, the international exposure is not enough of a reason to get entirely bearish on the company, especially when Abercrombie’s long term-growth strategy looks intact. Here we highlight the major factors that justify our sanguine view for Abercrombie’s stock.
1) Potential Upside in Margins: Abercrombie & Fitch Q1 2012 gross margin was 62.6% compared to 65% in Q1 last year. While the decline of 240 basis points is noteworthy, the figure has improved considerably compared to 750 basis points decline in Q4 2011. An interesting point to note here is that this improvement came entirely because of increase in Abercrombie’s Average Unit Retail (AUR) prices, which was due to a decline in promotional scales in the U.S. teen apparel market. 
Wednesday’s gradual improvement in margins on q-o-q basis was devoid of any contribution from declining cotton prices. Cotton prices have already slumped to a 21 month lowest prices recently, and we expect Abercrombie’s Average Unit Cost (AUC) prices to significantly decline on account of decreasing input costs.
2) Consolidation of U.S. stores: While the international business was the primary highlight of Wednesday’s earnings release, Abercrombie’s overall U.S. retail segment comps were up 4% on top of strong growth last year. In addition to a solid merchandise mix for the Spring season, we believe the increase in U.S. comps was also due to the company’s strategy of consolidating its U.S. stores in Abercrombie & Fitch and abercrombie kids channels.
The trend was highly visible in 2011, as Abercrombie & Fitch closed 36 under performing A&F stores, bringing the U.S. store count to 280 from the 2010 level of 316. The company plans to carry forward the consolidation of U.S. business in 2012-13 also, which should drive Abercrombie’s same-store sales going ahead.
3) Growth in China: Though weakening European business took the limelight this quarter, China is emerging as a major growth priority for Abercrombie & Fitch this year. Abercrombie already has 3 Hollister stores in China and plans to double its Hollister store count in the country this year. Additionally, the opening of Hong Kong A&F flagship store in August this year, should play a key role in raising awareness of Abercrombie’s brands in Mainland China. As China is gradually becoming the focal point of global retail industry, we expect the increase in Abercrombie’s Chinese business to drive its international growth in the long-term.Notes:
- Abercrombie & Fitch declares Q1 earnings results, Source: Abercrombie’s IR [↩]
- Abercrombie & Fitch’s management discusses Q1 2012 results, Source: Seeking Alpha [↩]