Abercrombie and Fitch is facing a New Identity Crisis: Why A&F is currently a SELL

Summary:

A&F is having identity crisis and a fundamental negative growth rate.

The firm could do restructuring, but this is not going to solve the problem. What the firm needs is a reinvestment into innovation, technology, and good ideas.

The firm needs a turnaround and is an overvalued firm in the market. At this point, the firm is a SELL.

A&F is having low revenues because tourists are not walking into the stores anymore and the clothes are relatively too expensive

A&F has seen its revenues decrease in the last 4 years, mainly as a consequence of Abercrombie brand poor performance. The firm is currently facing a brand crisis, where image and store experience had had to continually change but not yet with success. The firm attributes this revenue behavior to a cut on tourists and residents walking in the streets and going into stores to buy and stores are the place where most of the firm's changes are happening. In addition, the industry is following a promotion trend, and A&F has had to stick with it. Thus, firm's revenues are also reducing due to product discounts. But the real reason for the firm's bad results: customers are not identifying with today's A&F brand. Its expensive prices certainly do not help the firm at all.

EBIT trends

In the last five years, EBIT(operating income) has presented a very volatile behavior, although showing a negative overall performance. In this period, operating earnings showed a ~16% decrease, as a result of negative revenue growth, since costs have been following an important downward trend. This has also caused operating and net margins to plunge. In the last five years, operating margin decreased from 10.22% to 6.97%. However, net margin had the most impressive impact. Interest expenses increased 300% as a result of higher long-term debt and interest rates, therefore decreasing firm's net margin from 6.05% to almost 0.

A&F could do a restructuring but this is not going to solve the problem. The firm needs more reinvestment into innovation, technology, and good ideas.

Although firm's market capital structure is composed by 80% debt, it has shown strong capacity to increase its financing, either by bond or stock issuance. In order to turn around current firm's negative financials, A&F could raise more money and invest in the business. But A&F's current business problems are not due to lack of stores or investment in PPE. They are a consequence of a brand identity crisis, aggressive competence, and well, slow industry growth. Firm's reinvestment must be fully directed to innovation, technology, and good ideas to facilitate its product engagement with current and potential consumers.

Earnings are not the best, but they are enough to cover total debt (interest payments) in the short term.

Right now, although earnings are not the best, they are sufficient to cover total debt in the short term. It is important to mention that current debt load is composed mainly by ABL facility borrowings and operating lease commitments. The firm has currently no bonds outstanding. Borrowings have been intended to fund capital expenditures and working capital, taking advantage of firm's book interest rates. Although they have been increasing, interest rates have presented very low levels.

CAPEX(Capital Expenditures) is not creating value

The firm has been significantly decreasing its capital expenditures, since they are currently not generating added value to the firm. CAPEX has been mainly about PP&E, and it has decreased 60% in the last years as the firm continues to divest some of its PP&E and let store leases expire. Capital efficiency (sales to capital ratio) has shown strong levels in the past 5 years (all above 1,18x). However, this doesn’t tell us that the firm is being efficient with invested capital, since the ratio's healthy levels have been a result of an invested capital downward trend. Sales have been decreasing in the past years; therefore, capital invested has not been efficient. Regarding working capital, A&F has shown strong and positive ratios, which increase and decrease as the firm's needs change.

A&F has shown negative fundamental growth rates in the past five years. In all of them, except in 2013, the firm had a 69% reinvestment rate, which referred to new stores construction and technology investments. Sales decrease is leading the firm to diminish its growth as it continues to have negative reinvestment rates, which are a consequence of firm's asset divestitures, ended contractual leases, and high costs of depreciation, which currently surpass firm's CAPEX. The firm is getting rid of its PP&E in order to achieve more efficiency, which it is not getting. Although assets' value is decreasing, the fact that should push up Return on Asset metric, sales downward trend is generating more pressure, and therefore it is decreasing the measure (from 8.96% to almost 0 in the last five years). The little bit the firm is reinvesting is earning high returns, if we consider that ROIC is significantly higher than current firm's cost of capital (12.80% vs. 6.03%). In FY2016, the firm presented a negative ROIC, since after tax operating earnings ended up being negative (metric ended up being useless). Before that, the firm had positive but regular levels. EPS growth has also decreased in the last five years, a behavior that makes sense due to firm's earnings contraction. Nevertheless, it is impressive to see such low levels, since the firm has repurchased more than $950,000 in shares (which is supposed to push up EPS). Earnings trend is really affecting both the firm and its stockholders.

Dividends: showing a downward trend due the firm’s continuous negative financials.

Abercrombie has been paying a stable amount of dividends in the past years. In addition, as said before, it has repurchased more than $950,000 in shares. Nevertheless, total cash returned to stockholders has had a downward trend, which is logical due to firm's sustained negative financials. Each year, earnings are decreasing. Therefore, the firm is incapable of sustaining its total cash returned to stockholders. The firm's adjusted payout ratio (dividends + buybacks) has had a significant increase, although as a consequence of earnings behavior. In the past 5 years, A&F has paid way more than its net income and FCFE. It has paid non-affordable amounts of cash in almost all the past 5 years. When there is almost no reinvestment, the firm uses its savings and financing sources to compensate stockholders. The firm is trying to offer in dividends what it can't in business improvement. In other words, the firm is trying to cover in stockholder compensation its inefficient operating management.

Conclusions

1. Sales have been decreasing and there could be no solution except acquisitions: Sales have been decreasing, and they are expected to continue this behavior. Firm has been presenting a negative growth, and it is expected to have no changes, unless an acquisition comes along.  

2. Apparel industry will have a hard time maintaining current growth pace. It is currently demanding firms to offer something new, and it has been very difficult for them to respond efficiently. A&F has been offering new store changes, which include innovative services, but product characteristics are still intact.

5. A&F currently suffers an identity crisis. It is being highly surpassed by other brands such as Zara, H&M, and Forever 21, which count with important competitive advantages. It has been very difficult for the firm to recover lost clients, and it requires a huge business turnaround to return to its past gold stage. Here is where a business sale turns out to be a good choice for current management.

6. In conclusion, Abercrombie is overvalued by the market. The firm's value ranges from $7.20 to $10.84 per share with a target value of $9.83 per share.