January 10, 2009

American Eagle and Abercrombie: Inventory Foretells Margin Squeeze

Source: Flickr by k-ideas

This holiday shopping season has been dismal for retailers. Retail sales slipped dramatically year-over-year. Luxury sales were most hard hit clocking in at a 35% drop in sales year-over-year while women’s apparel saw a 23% decline. Most retailers resorted to large discounting of their products to move merchandise. One retailer however decided to go against the retail herd and refused to discount any of their merchandise sacrificing sales in the interim.


Abercrombie and Fitch (ANF) considers itself a premium brand in the teen apparel space. The company believes discounting will hurt the brand. According to Chairman and Chief Executive Michael Jeffries in an earnings call with analysts, "promotions are a short-term solution with dreadful long-term effects." Abercrombie’s main competitor in the space, American Eagle Outfitters (AEO), on the other hand has aggressively discounted its products in an effort to move inventory.

I believe Jeffries has a point. In a post the last summer, I suggested Target (TGT) should raise their prices in an effort to match the perception that Target more expensive than competitor Walmart (WMT). Human psychology has us place a higher value on items that are higher priced. Jeffries is aware of this psychology thus believes discounting will erode consumers’ perception they company's tees and jeans are of higher value than their competitors. Even though any casual observer can see Abercrombie’s and American Eagle’s clothing is of the exact same quality.

Generally, I would not have a problem with Abercrombie’s approach. But, if the company is going to successfully execute the no discount policy, they must do a better job with inventory management. Abercrombie seems to have flooded stores with merchandise consumers seem, for the moment at least, unwilling to buy. On the other hand, American Eagle has scaled back on inventory growth anticipating a tough holiday season. Sales and inventory growth for the most recent quarter from the same quarter a year ago are as follows:

Abercrombie’s, as opposed to American Eagle’s, aggressive approach in inventory management is bound to cut into the company's margins. For the most recent quarter Abercrombie has gross margins of 66% and has averaged the same over the last five years. American Eagle on the other hand has gross margins for the most recent quarter of 41%, down from its five year average of 46%.

Operating margins are another story. While Abercrombie sports some very high gross margins, their operating margins are very close to American Eagle’s. In fact Abercrombie’s cavalier attitude regarding inventory management, among other things, has chipped away at its operating margins. Abercrombie’s average operating margins for the past five years were 19% but were only 11% in its most recent quarter. Meanwhile American Eagle’s operating margins for the past five years average 18% but were 13% in the most recent quarter.

Although both companies will see their margins shrink due to anemic consumer market, I would bet you will see American Eagle’s operating margins continue the trend of outpacing the margins of Abercrombie’s in the very near future. Although both stocks are down substantially over the last year, I would expect American Eagle to rebound while I am not too optimistic about Abercrombie right now.

Disclosure: I and the clients of Brick Financial Management, LLC owned share of American Eagle Outfitters and Target at the time of this writing. But positions can change at any time.

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December 24, 2008

Coach’s Bags Are Expensive, But the Stock Is Cheap

Source: Flickr by

When the holiday shopping season is done for 2008 the results for retailers will show disappointing numbers. Consumers continue to pinch their pennies in this tough economic environment. The International Council of Shopping Centers expects November and December sales at stores open at least a year to fall as much as 1 percent, the largest drop since at least 1969, when the trade group began tracking such data [video].

However, there’s beauty in those numbers for stock investors. While the industry as a whole has performed poorly operationally, some have weathered the storm quite well. But panicked investors have thrown the baby out with the bathwater, pricing the stock of strong companies below reasonable levels.

Take for instance luxury bag and apparel designer, Coach, Inc (COH). Year-to-date, Coach is down 34% right along with the Apparel, Accessory and Luxury Goods sector which is down 37% as of December 19th. But the company has been around for nearly 70 years, a period which has seen at least 10 recessions. Certainly it has seen and weathered some bad times before. Since going public in 2000 they’ve done nothing but continue to strengthen the company.

According to Standard & Poor’s, “For the five years through FY 08, COH exhibited a revenue compound annual growth rate (CAGR) of 27%, a gross profit CAGR of 29%, an EBIT CAGR of 37%, and a net income CAGR of 40%. Total assets grew at a five-year CAGR of 30%, and inventory at a modest 19% CAGR, attesting to a tight operating structure that reduces inventory risk.” The company also sports gross margins of 74%, the highest in the industry. Only Luis Vuitton (LVMHF.PK) comes close with gross margins of 64%.

Coach also holds a commanding lead in the luxury handbag market in the U.S. and is making strides in Japan with a market share 13% behind only Luis Vuitton’s 30% share of the market. Coach sees promise overseas, especially in China. It expects the overall market to more than double in size over the next 5 years to more than $2.5 billion in annual sales, up from of $1.2 billion now.

Even in this difficult environment, Coach has increased sales 18 percent year-over-year has essentially no debt to speak of. Louis Vuitton on the other hand has $4.5 billion in long-term debt and a total-debt-to-equity (TDE) ratio 52%. The industry’s average TDE is 27% (Source: Reuters).

The bags may be expensive at Coach but the stock is cheap. In my humble opinion, a company that is able to perform like this even in bad times is deserving of more than the 9x trailing earnings it now fetches. 

Disclosure: I and the clients of Brick Financial Management, LLC owned share of Coach (COH) at the time of this writing. But positions may change at any time.

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Brick Financial Management, LLC is a Registered Investment Advisor specializing in providing investment management services to individuals, families, organizations and institutions. We implement highly focused stock, bond, and balanced portfolios using an investment approach commonly referred to as value investing. Disclosure


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