Financial Analysis of Abercrombie & Fitch

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<h2>Financial Analysis of Abercrombie & Fitch</h2>

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Abercrombie & Fitch (A&F) (NYSE: ANF) is an American retailer, currently headed by chairman and CEO Michael S. Jeffries. A&F focuses on casual wear for consumers ages of 18 through 22.[2] With over 300 locations in the United States, the brand has embarked on international expansion throughout various world markets.[7] The company also operates three off-shoot brands: abercrombie (childrenswear), Hollister Co., and Gilly Hicks. The company also operated a post-grad brand, Ruehl No.925, that was shuttered in early 2010.

As a "near luxury" retailer, Abercrombie sells its clothing and accessories at a price premium. In addition, unlike almost every one of its competitors, ANF has not engaged in "sales" (i.e., price discounting), which helps retain its image and keep its profit margins high. However, as the American economy entered a recession in 2008 which has continued into 2009 ANF has found itself reassessing its pricing strategy and considering lowering average unit price in its stores, specifically Hollister and its kids' lines. Abercrombie and Fitch's financial woes have been exacerbated by CEO Michael Jeffries' retention pay. In 2008 it reported income tax expenses of $0.11 per share as a result of retention awards to Jeffries. Abercrombie & Fitch opened its first Asian flagship in Japan in December 2009, meaning it can take advantage of the Asian market, which has been a focus for the retail industry. Finally, as a fashion retailer ANF is susceptible to changing fashion trends. It missed out on two key trends during the first quarter of fiscal 2009--skirts and intricately patterned goods--which has contributed to a decrease in sales.

Business Overview

ANF sells premium-priced apparel and accessories and through its five independently-branded stores: Abercrombie & Fitch; abercrombie; Hollister Co.; and its newest concept Gilly Hicks. As of Apr 4, 2010 ANF operated 1098 total stores across its five brands in the U.S., Canada and the U.K. ANF manufactures and distributes its own private label clothing under each of its four in-house brands. Each of ANF's brands also sells products to customers directly via catalogs and e-commerce operations. ANF's direct-to-customer operations generated $249 million of sales in 2009, down 6% from 2008.[3] [4] In November, ANF reported net sales of $318.9 million for the month, which is a 32% increase from the same period a year ago. Total domestic net sales, including direct-to-consumer net sales, increased 25%. Total international net sales increased 73% to $64.2 million. Comparable store sales for the month increased 22% to $32.6 million.[5]

Business and Financial Metrics
ANF's premium-quality business model translates into high operating costs and it spent over $41.5 million for stores and distribution expense in 2009. As a percentage of net sales, this expense increased to 48.7% from 41.2% for last year. This is primarily due to higher store occupancy costs, including rent, depreciation, and other occupancy costs.[6]

Retention of ANF's CEO Michael Jeffries has also proved costly for ANF. ANF has recorded income tax expenses averaging $0.11 per share due purely to retention awards to Jeffries.[7] Although Jeffries agreed to cut his "stay bonus" in half in 2005 due to a shareholder lawsuit, his retention payments are another hit to ANF's revenues, especially when his no-discounts policy has resulted in the company's core demographic trading down to lower-priced stores.[8]

Abercrombie & Fitch's Store Types (2009)
Brand Primary Age Segment Net Sales (millions) Change in Net Sales from 2008 Same Store Sales Growth Sales per Average Store (thousands) Sales per Gross Square Foot (thousands) Change in Average Retail Unit Sold
Abercrombie & Fitch 18 to 22 Year Olds $1,272 17% 19% $3,193 $359 (2%)
abercrombie 7 to 14 Year Olds $343 18% 23% $1,453 $313 (8%)
Hollister 14 to 18 Year Olds $1,287 15% 27% $2,299 $338 (7%)
Gilly Hicks Young Women $25 N/A N/A N/A N/A N/A
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FY Q1 2010 Results (ended May 1, 2010)
ANF reported a net loss per basic and diluted share of $0.13 for the thirteen weeks ended May 1, 2010, compared to $0.68 over the same period last year. Net Income was negative $11.8 million, up 81% from the same quarter in 2009[10]

Total Company net sales increased 14% to $687.8 million with comparable store sales increased 1%. Abercrombie & Fitch and abercrombie kids comparable store sales increased 3% and 6% respectively. Hollister comparable store sales decreased 2%. [10]
International net sales were very strong up 102% to $119 million. ANF plans to add 29 new international stores in 2010.[10]
FY Q2 2010 Results (ended July 31, 2010)
Net sales increased 17% year over year to $745.8 million. International net sales, including direct-to-consumer net sales, increased 85% to $133.2 million.
The gross profit rate for the second quarter was 65.1%, 150 basis points lower than last year's second quarter gross profit rate. The decrease in gross profit rate was primarily driven by a 15% decrease in average unit retail.
Comparable store sales increased 5%. [11]
FY Q3 2010 Results (ended October 31, 2010)
ANF reported net income of $50 million for the quarter, which is a 29% increase from the same quarter a year ago. Total company net sales increased 18% to $885.8 million while comparable store sales increased 7%.
In terms of business segments, comparable store sales for Abercrombie & Fitch, abercrombie kids, and Hollister Co. increased 8%, 2%, and 7% respectively. The gross profit rate for the quarter was 63.7%, which is 40 basis points lower than last year’s Q3.
ANF expects to open 11 more international mall-based Hollister stores, its first international Gilly Hicks store, and its first Abercrombie & Fitch store in Puerto Rico in fourth quarter.[12]
Overall, the last few months (starting in June) have yielded positive sales results for ANF, with double-digit growth in net sales every month.[13]
FY 2009 Results (ended January 30, 2010)
ANF reported net sales of $2.9 billion for 2009, which was a 15.9% decline from the $3.5 billion of 2008. Its gross profit was $1.9 billion. Operating profit was $254 million resulting in an operating margin of 8.6% (up from 7.8% in 2008). [10] In Q1, 2, 3, and 4 ANF reported a 23.5%, 23.3%, 14.6%, and 4.3% decrease in sales over the same period last year respectively. [14] [15] [16] Same store sales were down 23% from 2008, an even larger drop than in the previous year (in 2008 same store sales declined 13% from 2007). Same store sales fell 30% in the first half of 2009 and 17.5% in the second half. ANF cut back in capital expenditures in 2009 closing more stores than it opened and discontinuing its unprofitable RUEHL brand. Despite this, sales per gross square foot still decreased by 21% from the previous year. [10] Basic earnings per share dropped significantly as EPS was $0.90 at the end of 2009, down from $3.55 in 2008. Return on equity was 0% rounding out a poor 2009 for ANF shareholders. [10]

Trends and Forces

Poor Economic Climate Drives Away Customers
As a "near luxury" clothing company that sells clothes, ANF's business is sensitive to the economic climate. During the poor economic climate of 2008, ANF has seen many of its customers shift too shopping at lower cost stores.[17] Same stores sales fall across all of its stores as a result of this in 2008.[2] While CEO Jeffries and ANF continue to resist price discounting, they will see their sales and income worsen as a result. Not only does this hurt ANF's sales but it also damages its brand, as Time Magazine rated ANF as the worst recession brand of 2009. [18] In 2009 ANF saw revenues decline 17.2%, an even larger decline than in 2008. Operating margin fell a dramatic 67% and same store sales decreased 23% showing that ANF was not successful in weathering the continued economic recession. ANF will need to make changes in order to compete with companies such as Urban Outfitters (URBN) and J. Crew Group (JCG) which have produced strong results in 2009 and Q1 2010.

Expansion to new markets in Asia
New wealth has been developing in Asia, specifically China and India. The retail industry has sought to get in on the ground floor of the rapid development of the area by establishing a presence in Asia. ANF operated 38 international stores at the end of 2009 and plans open 29 new international stores in 2010. These include 25 mall-based Hollister stores, its first Gilly Hicks store in the UK, and flagship stores in Denmark and Japan. Accelerated international expansion is part of ANF's growth strategy with international sales increased 102% in Q1 2010. [10] In June 2010, international sales increased 88%. [19] Establishing a brand in Asia, especially when spending power in the area is increasing, can have repercussions in the future, especially if its main competitors enter the market before ANF decides to do so. Those repercussions would take the form of lower sales in comparison to its competitors. Setting up new overseas stores also requires a great amount of resources and could be affected by global economic conditions and exchange rates. However, since the Asian market has displayed a big appetite for luxury goods, ANF's image as a "luxury" retailer can work to its advantage by seeming more appealing to Asian consumers.

Seasonal Strength in the Second Half of the Year (Back-to-School and Holidays)
Because the overwhelming majority of the customers of ANF's brands range from 7 to 22 years old, many are students at some level of education. As a result, ANF traditionally experiences a significant boost in sales in August as students shop in preparation for school. The back-to-school shopping season also boosts sales for ANF's competitors such as American Eagle Outfitters (AEO), Aeropostale (ARO) and Pacific Sunwear of California (PSUN). In addition, the holiday season (November and December) is a big time for retail industries as customers begin to buy Christmas presents. In 2009, second half "fall" sales for the year ended January 10, 2010 were $1.66 million compared to $1.26 million in first half "spring" sales. Many of ANF's aforementioned competitors have incorporated sales into their business models at those specific times, meaning they want to take advantage of times when shopping is at its highest and make sure their customers are inclined to spend money at their stores. Until recently, however, ANF did not incorporate sales into its pricing strategy out of the belief that doing so would tarnish the "luxury" label the brand has cultivated.[20] When a recession hit the American economy in the end of 2008, however, ANF began to place seasonal goods on clearance to get rid of excess inventory. In addition it is currently seeking to introduce new, lower-priced items into its Hollister and kids lines. These decisions came on the heels of a 25% comparable store sales decrease during the 2008 holiday season.[21] ANF's decision to reassess its pricing strategy came too late to temper the decrease in sales during holiday 2008, however looking forward it can help ANF to retain its customers who are feeling the pinch of the recession.

Missing out on important trends leads to lower sales
Since ANF is primarily a fashion company, it's success relies heavily on its ability to anticipate changing fashion trends and adjust its product offering in order to accommodate those trends. In the first quarter of fiscal 2010 ANF missed two key trends, namely dresses and highly-decorated pieces. ANF, anticipating skirts would sell better than dresses, focused on skirts instead.[20] This misfire is one of the factors contributing to the first quarter's lower sales: $612 million for the 13 weeks leading to May 2, 2009 compared to $800 million for the 13 weeks leading to May 3, 2008.[20] Given the tough environment for retail companies in 2009, it is more important now than ever for brands such as ANF to correctly anticipate coming trends, as it will be even harder to convince consumers to spend money than it would have been in previous years when people had more disposable income.

Increases in Commodity Prices Will Raise Clothing Retailer Prices
In 2010, cotton consumption exceeded cotton production for the fifth year in the row, making cotton prices increase by 80.5% from last year.[22] [23] In 2009, natural disasters also severely damaged crops in many large cotton producer countries, such as China, India, and Pakistan. This led to decreases in cotton exports from these countries and increases in cotton imports as these countries sought to supplement their supply of cotton. [24][25] With limited cotton supplies and rising prices, retailers will either have to absorb these higher material costs, restructure the composition of their clothing to have less cotton, or pass these higher costs to its consumers. Higher clothing prices or lower quality clothing could discourage consumer spending, resulting in decreased net sales. However, adult or teen clothing retailers may not be too adversely affected as their clothing (which is usually 30-40% cotton based) has more flexibility in their composition and thus, costs.

In addition, raising commodity prices in other areas will also raise costs for retailers. The price of shipping a 40-foot dry container from China to the US has increased by 90% since 2009. Lumber and coal prices increased 36.3% and 23.7% from last year, respectively, while oil prices increased by 40% in early 2010 but has now decreased back to a steady single digit increase for the year.[22] While premium price and established brands, such as ANF, will be able to pass their higher costs to their consumers, value based companies will not fare as well and may suffer from lower profit margins.[22]

Competition

ANF competes with a bevy of apparel and accessory retailers competing for the 14-30 year old demographic. ANF has consistently been at the top of its sector in terms of profitability and sales. ANF's 64.3% gross margin in 2009 was by far the highest out of all of its competitors, largely because ANF's prices are considerably higher than those of its competitors and because the company does not discount its merchandise to the degree of its competitors. As a point of reference, the approximate average price for a pair of men's jeans at Abercrombie & Fitch is $80 compared with $45 at American Eagle, $25 at Aeropostale and $50 at Gap.

Abercrombie & Fitch's competitors include:

American Eagle Outfitters (AEO): American Eagle competes directly for the same customers (young men and women between the ages of 15 and 25} with Abercrombie & Fitch and Hollister stores. AEO is smaller than ANF in terms of total sales and profits, but AEO has exhibited stronger growth recently than ANF.[26]
Aeropostale (ARO): Aeropostale is a smaller company than ANF, operating only one brand of stores that targets 14 to 17 year olds. Aeropostale's business model also relies heavily on sales and promotions as opposed to ANF's high-quality, premium-price strategy. However, Aeropostale recently launched a new concept called Jimmy'Z, which is a chain of stores targeting 18-24 year olds with surf inspired apparel which will compete directly with Hollister stores if the concept grows. [27]
Pacific Sunwear of California (PSUN): Pacific Sunwear primarily serves several different customer segments through its three retail chains: PacSun, demo, and One Thousand Steps. PacSun stores are based mostly around trends in the alternative sports (surfing, snowboarding, skateboarding, etc.) lifestyle and offer third-party branded as well as private label apparel, footwear and accessories to teenagers and young adults. Finally, demo stores target 16 to 24 year olds with fashion and accessories influenced by hip-hop lifestyle and One Thousand Steps offer a wide range of casual footwear to the 18 to 24 year old customer segment. Because Pacific Sunwear's operations depend largely upon third-party brands, footwear and different lifestyle-focused customer segments it is less comparable to ANF than American Eagle Outfitters (AEO) or Aeropostale (ARO). [28]
Urban Outfitters (URBN): Urban Outfitters is a relatively young retailer that operates three different branded store chains, Urban Outfitters (18 to 30 year olds), Anthropologie (30 to 45 year old women), and Free People (16 to 35 year old women). Urban Outfitters is not as directly comparable to ANF due to its slight differentiation in targeted customer segments.
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Gap (GPS): Gap is a much larger company than ANF in terms of sales, stores and customer segments targeted. Through variations on Gap (Gap Kids, babyGap, Gap Maternity) the retailer serves a wide range of customers; also, Banana Republic and Old Navy stores serve different socio-economic segments. Because of the wider range of customers, Gap doesn't match up with ANF as closely as some other competitors, however there is considerable overlap. [30]
Company Revenue 2009 (mm) Gross Margin Operating Margin Revenue (Decline) from 2008 Same Store Sales Growth (Decline) Total Stores Sales per Store (thousands)
Abercrombie & Fitch $2,928 64.3% 4.0% (17.2%) (23.0%) 1,098 $2,412
American Eagle Outfitters (AEO) $2,990 38.7% 8.0% 0.5% (4.0%) 1,076 $2,404
Aeropostale $2,230 38.0% 17.2% 18.3% 10.0% 952 $2,206
Pacific Sunwear of California $1,027 25.2% (7.8%) (18.1)% (20.0)% 894 $1,100
Urban Outfitters (URBN) $1,937 40.6% 17.5% 5.6% 7.8% 327 $4,453
Gap (GPS) $14,197 40.3% 12.8% (2.2%) (3.0%) 3,095 $1,332