Abercrombie & Fitch: No ‘Rebound’ After Accounting For Inflation And Share Buybacks

Summary:

• Abercrombie & Fitch’s stock price growth is primarily due to aggressive stock buybacks, not a fundamental recovery.
• After accounting for changes in shares outstanding and inflation, Abercrombie’s sales remain as stagnant as they have ever been.
• The company’s focus on malls exposes it to theft issues and ongoing declines in mall traffic, potentially hampering Q3 performance.
• The stock is ~20% trading at a valuation premium to its peers, which does not appear justified based on its weak fundamentals.
• Although ANF appears to be a strong short target, high speculative momentum and short squeeze pressures make it a risky trade.

The key to generating alpha in markets is determining whether or not a stock is undervalued or overvalued, and if so, whether or not the irrational trend will reverse or end favorably. For example, undervalued companies can often decline dramatically as investors capitulate further. Conversely, stocks trading in a speculative bubble, when sufficiently detached from their fair value, can often continue to rise in a highly irrational manner. Over recent years, I believe there has been a sharp increase in irrationally valued stocks due partly to increased speculative activity. Although not as extreme as in 2020-2021, many stock buyers are still buying or short-selling stocks due to their technical trend, with minimal regard to fundamental valuation.

One potential example of this issue may be seen today in Abercrombie & Fitch (NYSE:ANF), which has risen by a staggering 270% YoY and 177% YTD. The company has seen a decent rebound in its revenue and net income over this period. However, those figures remain much lower than a decade ago, while its stock price is much higher. Fundamentally, its rise was triggered by a massive increase in sales and income per share, but not necessarily a rebound in its performance. In other words, the company’s EPS and sales-per-share growth appear strong because it dramatically reduced its liquidity position in 2022 to pursue share buybacks. This approach can add value for investors, but it can also obfuscate actual performance and, in my opinion, most often leads to excessive and short-lasting stock price increases.

Some speculators appear to be aware of this issue. Short interest in ANF is very high at 17%, particularly considering it has performed well. High short speculation against ANF may be indirectly benefiting it, as those short-sellers are likely being forced out of their position at higher prices, creating a “short squeeze” boosting ANF’s value disproportionately. That said, Abercrombie & Fitch may be returning to its old popularity status; however, there remain significant macroeconomic pressures that could stop a fundamental recovery.

Don’t Be Fooled by Share Buybacks

On the surface, ANF’s revenue-per-share growth over the past two years appears stellar. In 2020, it had a sales-per-share of ~$48, up to $73 today on a TTM basis. Many investors have bought into the stock due to its perceived high growth rate. That said, its actual TTM sales have only risen by 11-12% over this period. Crucially, the clothing and footwear consumer price index has also increased by around 11% over the past three years, while the overall CPI has grown even more; thus, Abercrombie & Fitch’s inflation-adjusted sales are flat or lower today than it was in 2020. Aside from inflation, all of its per-share growth is due to aggressive stock buybacks that have dramatically reduced its liquidity position. See below:

The change in Abercrombie’s liquidity position due to buybacks is better seen in its working capital, ex. Inventories. See below:

Most retailers do not have positive working capital after inventories, so Abercrombie did have excessive liquidity in 2020. Its stock price was likely undervalued then, so its buyback program was, in my opinion, very justifiable. That said, the excess stock price growth we’ve seen in 2023, due to potential misunderstandings of inflation and buybacks on sales-per-share, does not seem justifiable.

Historically, ANF’s price is highly correlated to changes in its operating margin. After abysmal performance from 2015-2019, we see solid improvement in the company’s operating margin. Still, its operating margin is at ~6.3% TTM, which is worse than in 2013-2014, although the stock’s price is about as high as it was when its margin was close to 9%. Further, adjusting for clothing inflation, its revenue is entirely stagnant. See below:

Fundamentally, there are no firm signs that Abercrombie is in an operational rebound. The number of Abercrombie & Fitch stores worldwide in 2022 was around the lowest level since 1999, after losing over a third since its peak in the 2000s. As detailed in its last annual report, the company is still highly focused on malls. On the one hand, the general decay of malls may be lowering the company’s lease costs to a degree. On the other, this does expose the company to seemingly growing organized theft rings and the long-term decline in mall traffic.

Macroeconomic Consumer Pressures Return

Compared to September and August of 2022, indoor and outdoor mall traffic is down this year by around 5-9%. Every few months, I see headlines that “malls are finally back” after a month or quarter of improvement, but almost always, the long-term trend has been negative. Late 2020 to early 2022 was generally strong for Abercrombie, but that improvement was likely supported by a spike in retail sales driven by increased “pandemic savings.” Since last year, real retail sales have reversed as rising prices lower savings levels. More recently, there has been a massive decline in consumer credit, indicating a more significant decline in consumer discretionary spending. See below:

In my opinion, the slight rise in ANF’s operating margins is due to the lagged impact of higher demand in 2021, combined with a slowdown in cost inflation. Based on the most recent consumer data, I expect that excess spending levels should decline due to extreme growth in consumer credit and low savings levels. For the most part, similar economic trends are seen in Europe and Asia, which account for a quarter of its total sales. Of course, the company’s US business will also likely be disproportionately impacted by the student loan payment continuation, given its primary buyer demographic is in the younger generations. Time will judge this prediction, but I firmly believe that macroeconomic pressures will weaken the company’s inflation-adjusted sales and operating margins over the next two years.

The Bottom Line

While some aspects of the media are reporting “Abercrombie & Fitch is cool again,” there is little evidence to support that. Fundamentally, the company keeps up with inflation and avoided price cuts despite a slight relative decrease in its COGS, improving its operating margins. In my view, the rise in operating margins has more to do with higher consumer spending demand last year. Still, that macro tailwind is now essentially a headwind, particularly considering the uncertainty surrounding student loan payments on disposable consumer spending.

Aside from that, ANF’s outstanding “per share” sales and EPS growth is primarily the result of its share buyback program, which dramatically lowered its free liquidity position. To me, that was a relatively wise move due to its low valuation in 2021, but it does not justify its much higher valuation today. ANF’s three-year ahead forward “P/E” of 15.22X is greater than Urban Outfitters (URBN) at 10.4X, American Eagle (AEO) at 11.6X, and The Gap (GPS) at 14.6X. Among those, I believe ANF has the worst EPS prospects due to its general brand decline and mall dependence. Still, using the mean of its peer figures, I think a 12.2X three-year ahead “P/E” is reasonable, giving ANF a price target of $52, or 20% below its current price.

Over the next year, I expect the company’s operating margins will reverse due to negative consumer discretionary spending factors, higher theft, and a continued decline in mall traffic. Its Q4 performance will be very telling because I expect holiday sales to be weaker than many are likely hoping for. The company will report earnings later this month, with analysts expecting a slight rise in its EPS and sales. In my view, this earnings report may be a short opportunity because its stock price is so high that its downside is likely ample if we see a decline in profit margins and sales, as I expect based on economic trends since the end of Q2.

Although short interest on ANF is relatively high, borrowing costs remain near zero. That said, it is a very volatile stock, so its options are expensive, and the risk of a continued short-squeeze is very high. Thus, tight stop losses should be used if shorting ANF ahead of its Q3 report, as its squeeze may continue even if its fundamental prospects do not improve. There is also some potential that ANF’s brand value will improve, as many hope for, due to its “TikTok” marketing strategy. However, its brand is still mired by past policies of overt discrimination and allegations of sex trafficking under its ex-CEO. Significantly, that recent legal complaint may financially impact the company, although its current CEO refused to comment. As that lawsuit gets more media attention, I feel that any attempts to improve the struggling brand will most likely prove futile.

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