Surviving in the highly competitive retail industry can be very tricky, especially in the midst of an economic recession and its recovery period. As a specialty retailer, Abercrombie & Fitch Company (ANF) sells a variety of apparel, ranging from casual sportswear to accessories. Despite the company’s past success in gaining market share through its brand name, management has been slacking in that department, focusing its attention more on marketing, distribution, and cutting costs. As a result, a lack of differential design and less discretionary spending amongst teenage consumers have led to a decline in same-store sales, as well as decreasing margins.
The main issue remains the lack of this retailer’s competitive advantages. Given the standard clothing designs and high-end prices, there is no particular aspect setting this firm apart from cheaper and qualified competitors like American Eagle Outfitters (AEO), Aeropostale Inc. (ARO), Zara or Forever 21. Thus, the company lack an economic moat rating, which makes me somewhat bearish about the future.
Now, looking at profitability is a very important step in understanding a company, since it’s essentially the reason for a company’s existence, and a key component in deciding whether to invest in or maintain your investment in a company. So, in this article I will look at Abercrombie’s earnings and earnings growth, profit margins, profitability ratios and cash flow. In addition, I will evaluate which institutional investors bought the stock in the recent quarters.
Earnings Per Share
If you go back through the history of the stock market, there is a recurring theme among those stocks which have had some of the strongest price appreciation, and it's related to their earnings growth. When comparing earnings growth against a company's stock price, you can find a strong relationship between the two. So, the first step in analyzing Abercrombie & Fitch is evaluating its earnings potential.
Last quarter, the retailer retrieved an EPS growth rate of -33% compared to the same quarter in the previous year. Some investors are bullish on the idea that the company will improve its quarterly EPS growth in the near future, but I do not like the fact that the firm generated less than 15% growth compared to the same quarter last year. It’s important to highlight that analysts just upgraded their estimates for the current year, increasing projected EPS growth rates to 22.50%.
Now let’s take a look at the company’s revenue growth. This is a key metric that needs to be analyzed before investing in a company, as it is one of the scarce figures that cannot be modified through accounting tricks and similar dodges. Abercrombie’s revenue declined by -12% last quarter, year over year, which is not impressive at all. I have found that the best growth opportunities come from companies that generated more than 15% quarterly revenue growth before the stock price entered a solid uptrend.
However, the fact that revenues grew more than earnings per share is very encouraging. If a company generates strong EPS growth levels and even stronger revenue growth levels, I tend to feel very bullish about it. Abercrombie generated quarterly EPS growth of -33%, while sales declined by -12%.
When betting on a company, an investor wants to see sales grow or improve over time -and not just in the last reported quarter. Looking at the company’s financials in comparison to previous years will give participants a much better idea of how well a company is doing. Abercrombie generated a three-year average annual sales growth rate of 15.49%, which is a very encouraging sign, as I think that strong sales growth levels clearly show that the company is doing well.
Gross Profit Margin
The gross profit margin measures a company's manufacturing and distribution efficiency during the production process. It also tells investors the percentage of revenue/sales left after subtracting the cost of the goods/services sold. Investors tend to pay more for businesses that have higher efficiency ratings, as these should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).
In the case of Abercrombie & Fitch, its gross margins have increased over the past years. While the five-year low for the gross margin was reported at 60.6%, the current margin of 66.7% is the five-year high point. Moreover, the TTM gross profit margin of 63.9% is above the five-year average of 63.56%, implying that management has been successful in making the manufacturing and distribution process more efficient over the past five years.
Operating Margin = Operating Income / Total Sales
The operating margin measures what proportion of a company's revenue is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. If a company's margin is increasing, it is earning more per dollar of sales. Needless to say: the higher the margin, the better.
Over the past five years, Abercrombie’s operating margin has been decreasing. In 2009, the company reported an operating margin of 12.4%, but the company’s current TTM operating margin stands at 5.0%, below the five-year average of 7.2%. This implies that there has been a reduction in the percentage of the total sales left over after paying for variable costs of production compared to the five-year average. I always stress that it is essential to find companies with improving profit margins and although a declining margin doesn’t necessarily prevent me from investing in the retailer, I hope to see this trend reverted sometime soon.
Net Profit Margin = Net Income / Total Sales
This ratio of profitability, calculated as net income divided by revenue, measures how much out of every dollar of sales a company actually keeps in earnings. The profit margin is a very useful metric when comparing companies in the same – or similar – industries. A higher profit margin indicates a more profitable company, with better control over its costs compared to its competitors. These companies will usually be more attractive to investors.
Abercrombie's net profit margin shrank, compared to the five-year average. While the TTM net profit margin is 3.40%, it’s slightly below the five-year average of 4.07%, implying that there has been a decline in the percentage of earnings that the company is able to keep compared to the company's five-year average. I think it’s important to look for stock with current net profit margins above the five year average margin. Basically, almost all my stock market winners were companies with above-average margins.
ROA - Return on Assets = Net Income / Total Assets
ROA is an indicator of how profitable a company is relative to its total assets and it also gives us an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage and is sometimes referred to as "return on investment".
Abercrombie’s 2012 ROA of 5.11% is slightly below the five-year average of 5.47%, which implies that management has been generating less earnings with the company's assets these past five years.
Free Cash Flow = Operating Cash Flow - Capital Expenditure
Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. This metric is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.
Abercrombie generated a ratio of cash flow from operations/total sales of 1.14. The higher this percentage is, the more cash available from sales.
I also evaluate recent institutional activity in the stock. In other words, I want to know which hedge funds bought the stock in the recent quarters. Investment gurus Joel Greenblatt (Trades, Portfolio) and George Soros (Trades, Portfolio) sold out all their Abercrombie shares this past quarter, at an average price of $35.01. This makes me think that investors are lacking faith in the retailers future profitability.
Currently, many analysts have a mediocre outlook for Abercrombie. While analysts at MSN money are predicting that the retailer will retrieve EPS of $2.78 for fiscal year 2014, Bloomberg estimates revenue to reach $4.03 billion for fiscal year 2014, marking only a very slight increase from the previous year. While growth will continue to be present in the next few years, numbers are overall flat compared to this company’s historical growth rate.
While the U.S. economy remains in recovery and the unemployment rate of 16 to 24 year olds continues to spike (currently at 16.2%, twice the rate of other ages groups), Abercrombie will have a difficult time sustaining its sales. The highly competitive retail industry has had to adapt to a more price sensitive consumer base, thus making low pricing an absolute must in order to maintain sales. I believe the firm will be at a disadvantage in this area, given the high-end pricing and quality of its clothes. Therefore, I would recommend investors to look around for other, more profitable industry players with upward potential.
Dislcosure: Victor Selva holds no position in any stocks mentioned.