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A red-tag sale at Abercrombie?
A big jump in inventories at Abercrombie & Fitch means even a small decline in demand could force the retailer to slash prices. That could also put the stock on sale.
By Robert Walberg
Remember the denim glut? A plethora of jeans was supposed to result in a dreadful quarter for the apparel retailers -- especially those focused on the teen and young-adult market. So much for conventional wisdom.
Bolstered in part by strong sales of its pricey jeans, Abercrombie & Fitch (ANF, news, msgs) reported a 57% jump in fiscal fourth-quarter net income on a 40% surge in sales. For the year, the company earned $3.66 per share on revenues of $2.78 billion, compared to $2.28 per share on $2.02 billion in fiscal 2004.
What was most impressive was the sales strength across its brands. Sales at the companys Hollister stores open at least a year rose 34%, and same-store sales at its Abercrombie stores rose 59%. Those stores are aimed at teens and young kids. Meanwhile, the flagship brand posted a same-store sales gain of 18%.
The companys long-standing policy against regular discounts, a stark contrast to one-time industry leader Gap (GPS, news, msgs), continued to pay big dividends, as operating income as a percentage of total sales jumped three percentage points to 27.8%. Abercrombies ability to sell more of its merchandise at full price is why the company sports some of the highest margins in the industry.
However, a troubling development over the last few quarters suggests that Abercrombie may be forced into marking down more of its merchandise in the future, thereby putting those industry-leading margins at risk. Over the last three quarters inventories have risen at a faster pace than sales, a trend that often foreshadows problems.
Clothes piling up in warehouses
The company ended the fourth quarter with merchandise inventories of $362.5 million, a year-over-year increase of 71.7%. That's nearly 32 percentage points above the rate of sales growth. While the 71% jump was better than the 87% rise seen in the fiscal third quarter and the 74% increase in the fiscal second quarter, its not enough of an improvement to assuage Wall Street fears on this front.
Given the excess inventory, even a modest decrease in demand could trigger an aggressive round of price cuts. Though Abercrombie has done an excellent job in recent quarters with its product mix, when you combine the rise in inventories to the fickle nature of the teen marketplace you have a recipe for trouble.
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In fact, trouble might already be brewing. To the disappointment of many analysts, most of which rated the stock a "buy" coming into the quarters numbers, Abercrombie guided first-half 2006 earnings to a range of $1.23 to $1.28 per share. The consensus on the Street was for earnings of $1.33 per share. As a result of the warning, the stock fell more than 2.5% in after-hours trading. Dont be surprised if a number of analysts cut their rating on the stock in the days ahead, adding to the negative tone.
Management cited a slowing in same-store sales growth as the reason for tempering earnings expectations. The company still expects to post positive same-store sales increases, just not at the blazing pace posted last year.
While a sales slowdown was expected -- no store can keep that pace up for long -- it merely feeds into concerns over margins and profits when viewed against the inventory backdrop. Until Abercrombie gets its inventories under control, look for the stock to struggle to keep pace with the industry and the market.
The stock could be poised for a 21% fall
Abercrombie, which has risen nearly 56% since last September, could easily see its stock price slide back to a support level near $54. A move back to this floor would represent a decline of 21% from Tuesdays close.
Relatively low valuations should keep the stock from falling much below the mid-50s. Abercrombie currently trades at 15.5 times the estimated earnings for the current fiscal year of $4.41. Even if you reduce that estimate by eight cents to reflect the first-half warning, the stock still trades at a relatively modest multiple given its growth rate.
Mark the stock down by over 20% and factor in cash and marketable securities of more than $3 per share and its difficult to make a case for the stock falling too far, even with the inventory concerns. Of course, the key to that theory is earnings holding close to current Street estimates.
At the time of publication, Robert Walberg did not own or control shares of any companies mentioned in this column.
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