Sales bounce, but what about margins?

Our decision to take some healthy profits off the table by selling half of Abercrombie in late march this year (FAT209) was in hindsight a very good move indeed. The fear of a double dip US recession and a return to GFC conditions that weighed down the market through the second quarter also took its toll on Abercrombie.

Being a retailer, Abercrombie is very sensitive to the ebb and flow of investor sentiment as it relates to the extent of the recovery. Taking a long term view and looking through the shorter term noise, however, Abercrombie remains a very attractive business.

Its management team is not completely error free, but it is certainly well-regarded and effective. A core component of the stock’s value is the strength of its various brands and management has done a good job of protecting their premium image through the downturn. A brand that is able to maintain a perception of premium quality will also deliver premium profitability. This is something Abercrombie has historically achieved through its strong profit margins and will do again as the recovery continues.

As Members may recall, Abercrombie's operating margin collapsed over the last two years, from around 20% to just 5% in the year to January 2010. This is a very poor metric for a premium brand retailer such as Abercrombie (albeit a symptom of exceptional circumstances) and its restitution is a central goal for management.

Abercrombie’s June sales data certainly highlights the recovery that has occurred from the dark and difficult retail environment of the previous year. The company reported sales revenue of $277.3 million for the five weeks to July 3 2010. This represents a healthy 23% gain on the same period last year.

We must of course always focus on same-store sales comparisons when it comes to retailers, given that it is an easy matter to increase sales revenue simply by adding stores. On this front Abercrombie’s sales growth was a more sedate 9%, but that still demonstrates recovery nonetheless.

In terms of the year to date, group sales are up 15% to $1.163 billion, while same-store sales are up 3%. The physical stores are the core of the company’s business, but Abercrombie does also distribute its product through other channels such as the internet.

Although this is not a major contributor to group earnings, earnings that flow through the “direct-to-consumer” channel typically have fewer costs attached to them and are therefore higher margin. It is therefore encouraging to see Abercrombie’s direct-to-consumer sales up 44% through the year to date, to $114.1 million.

Abercrombie is scheduled to report its second quarter results on August 17 2010. Given the transparency around its sales numbers there isn’t much uncertainty on that front. The primary area of interest will be the extent to which management has been able to regenerate the company’s profitability, as measured by its profit margins. If management has driven sales growth through excessive discounting, then the top line growth will have come at the expense of profitability. Given management’s general reluctance to discount and damage the brand, we do not expect this to be a serious issue and margins should therefore have made up some considerable ground. This is certainly necessary if management is to hit its goal of restoring Abercrombie's operating margin to 15% by 2012.

From a valuation perspective, Abercrombie trades on 19.8 times consensus earnings for the year to January 2011. This is not cheap, even considering Abercrombie’s international growth potential. The ratio should however be viewed in the context of the cycle low of its current earnings. Indeed, the stock’s forward price to earnings ratio falls to just 9.7 times consensus 2013 earnings.

The stock also provides a reliable dividend which equates to a yield of around 1.9%. Although this is not a particularly high yield, it does compare very well to the near zero level of official interest rates in the US.

Looking at the weekly chart of Abercrombie we can see that the rising channel that had been in place since the November 2008 low has now been broken and looks as though it may provide some resistance. The weekly MACD also has just crossed the zero signal line having already given a bearish reversal signal.

We can see on the daily chart of ANF that the $30 level looks to be providing solid support to the share price. We can see that the recent low of $29.94 made on the 1st of July saw buying interest at the confluence of uptrend and horizontal support at this $30 mark. The daily RSI is still trending up which is supportive of a continued move higher. The share price has just dropped back below its 200 day moving average which is concerning. We will likely see a test of the 50 day moving average as support.

In summary, Abercrombie will remain susceptible to bouts of volatility as investor sentiment runs through periods of excessive pessimism. We do however expect further gains over the longer term as management delivers on its strategy of restoring Abercrombie’s profitability and the broader economic recovery works its magic on group sales.