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Abercrombie & Fitch's Post-Earnings Drop Isn't a Buying Opportunity

Leo Sun, The Motley Fool

Shares of Abercrombie & Fitch (NYSE: ANF) plunged 17% on Aug. 30, after the apparel retailer posted mixed second-quarter numbers. Revenue rose 8% year over year to $842.4 million, but that figure was inflated by a calendar shift and still missed estimates by $2.7 million.

On a non-GAAP basis, A&F reported a slim net profit of $4.17 million, or $0.06 per share, which cleared estimates by a dime and represented a significant improvement from its non-GAAP loss of $0.16 per share in the prior-year quarter.

A&F varsity wear.

Image source: Abercrombie & Fitch.

However, A&F remained unprofitable on a GAAP basis with a loss of $0.06 per share, compared to a loss of $0.23 a year earlier. A&F's headline numbers seem decent, but a closer look at the earnings report reveals some troubling issues.

A closer look at the comps

A&F owns two main brands: its namesake brand and Hollister. Under CEO Fran Horowitz, who took the top job in early 2017, the company has focused on building Hollister as its core business and turning the struggling Abercrombie & Fitch into a secondary brand.

Horowitz's main strategies are to bolster Hollister's appeal with younger shoppers with marketing blitzes, reduce A&F's brick-and-mortar presence, and refresh A&F's brand image with renovated stores and fresh marketing campaigns.

Horowitz also focused on expanding both brands' digital ecosystems and strengthening A&F's presence in key overseas markets like China. Here's how A&F's brands fared over the past year in terms of comparable store sales growth.

Brand

Q2 2017

Q3 2017

Q4 2017

Q1 2018

Q2 2018

Hollister

5%

8%

11%

6%

4%

A&F

(7%)

(2%)

5%

3%

2%

Total

(1%)

4%

9%

5%

3%

Comparable store sales growth. Data source: A&F quarterly reports. Chart by author.

In the past few quarters, both brands have generated positive comp sales growth, but their growth seems to be peaking. The company's total 3% comp sales increase last quarter missed the consensus forecast for 3.6% growth.

The company attributed Hollister's growth to robust sales of jeans, swimwear, and intimate apparel. In women's apparel, the brand saw strong demand for smocking, tube tops, and soft bottoms -- including jumpsuits, rompers, and skirts. Its Gilly Hicks line of lingerie also captured more female shoppers. Sales of men's apparel was boosted by healthy demand for T-shirts and shorts. Windbreakers also sold well across both genders.

A&F's Hollister.

Image source: Hollister.

Abercrombie saw strong demand for its skirts, soft bottoms, and denim for women, and T-shirts, swimwear, and shorts for men. It also reported healthy demand for kids apparel across both genders, buoyed by the strength of its "Everybody" line of unisex apparel.

For the full year, A&F expects both comp sales and total sales to rise 2% to 4%. Those figures compare poorly to its 5% sales growth and 3% comp growth last year.

A&F's growth also compares poorly to its rival American Eagle Outfitters (NYSE: AEO). During the second quarter, AEO posted 14% sales growth and 9% comp growth. It also anticipates high single-digit comp growth for the third quarter.

On the bright side...

However, A&F's gross margin expanded 110 basis points year over year to 60.2% during the quarter, indicating that it isn't driving sales growth with big markdowns anymore. It also expects its gross margin to rise "slightly" for the full year.

Additionally, direct-to-consumer sales rose 16% and accounted for 26% of its total sales during the quarter -- up from 24% a year earlier. A&F also reduced its total inventory by 3%, so it won't be swamped by unsold merchandise.

Abercrombie & Fitch generated $0.2 million in operating income last quarter, which represents a significant improvement from its operating loss of $21.1 million a year earlier. Excluding asset impairment charges, it reported non-GAAP operating income of $8.9 million, compared to a non-GAAP operating loss of $15 million last year. That gives it a slim non-GAAP operating margin of 1.1%.

Those improvements are encouraging, but Abercrombie's operating margin still seems weak relative to those of its rivals. American Eagle's operating margin expanded year over year from 4.6% to 7.9% last quarter, while Gap's operating margin slipped from 11.9% to 9.7%.

Here's the biggest problem

A&F's business is stabilizing, the company is improving its core brands, and it's keeping costs under control. However, the stock remains up about 70% over the past 12 months, and trades at 25 times this year's earnings and 22 times next year's earnings.

By comparison, American Eagle trades at 17 times this year's earnings and 16 times next year's earnings. Since American Eagle generates higher comp sales growth and a higher operating margin than Abercrombie, it makes more sense to buy the former than the latter. Therefore, investors shouldn't consider A&F's post-earnings plunge to be a buying opportunity. Instead, they should wait for its valuation to cool down to more reasonable levels.

More From The Motley Fool

Leo Sun has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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