Why I’m still long even though everyone thinks I’m crazy.

On Thursday, 1/7/10, Abercrombie and Fitch (ANF) reported its same store sales numbers for the month of December.  It was unmitigated disaster.  I was nervous about this release (not really nervous, just concerned) because expectations had gotten too high. Most analysts had very optimistic expectations- the street was expecting a negative 10-12% number.  I was expecting something more like 15-18% down.  I had been in stores during December, and I could see that Hollister was going to be disastrous.  There was a day I was in the Soho flaghship and I was literally the only one in the store besides the spray-tanned models.

Then the bomb hit – overall sales were off 19%, with Hollister the worst, at -25%.  The company will even take an impairment charge on their next earnings report.

So after the “bad” number, the predictable happened.  Analysts downgraded the stock, and even Goldman Sachs, who had ANF on their “conviction buy list” gave up.  (Of course, they hedged themselves by saying the stock had attractive valuation, international growth story and improving results.”

The stock dropped 10% in one day.  Now what?

First, it’s a lot easier to analyze the situation the day after the stock plummets, because I can think much more clearly.

What really happened in December at ANF?  First, they held a gift card promotion in which you got a $25 card for every $100 you spent at the stores.  I like this promotion – it isn’t actually discounting, which protects the brand, even though it IS discounting.  And you have to go back into the store to use the card.  There are not a lot of items priced at exactly $25 in these stores, if you know what I mean.

But those gift cards get deducted from December sales.  So to properly analyze the situation, the first thing to do in my opinion, is to adjust the December comps for the gift card promotion, and assume some of those $22 million in unredeemed gift cards will be used in January.  Remember, I am not buying into the ANF story because of how sales were in the past. Nor am I buying it in expectations of great comps in the next few months.  I’m buying it for rate of change.  I want to see things get less worse.  By the time things are getting better, the stock will be breaking into new highs.

So first, let’s take out the gift cards, and adjust January as well:

Now there’s a chart that makes more sense to me.  Does this look like things are getting worse or better?  I think you could stop right here, but here are some words just in case:

The Bear Case: “Everyone’s broke, no one wants to keep paying for the expensive cool brands, and besides, they’re not that cool anymore anyway.  It’s cool enough to buy $10 hoodies from Aeropostale now.”

• The product is too expensive for the new normal
• Product is no longer a “must own” for teens/tweens – ARO and AEO product is about the same and much cheaper
• They missed the fashion cycle
• Hollister brand is a disaster – comps were off 25%

The Bull Case:  “Cheap stock, huge international opportunity, brand protected for good times that will follow.”

• Gross margins improve due to better sourcing
• ANF will close underperforming US locations
• International flagships sell product at 2-3x the US prices and are 5x as profitable
• ARO is TOO cheap, TOO ubiquitous and is making themselves into another Old Navy disaster.  Gap fell apart once it went to a constant discounting model.  Not “cool” at all.  Once your price point is $10, where do you go, $5?  $0? 
• Stock is trading at a very reasonable valuation
• Normalized comps aren’t as bad as people think (see chart above)
• Hollister was hurt by the unusually cold weather.  Hard to get excited about beach wear when it’s freezing – even the models were shivering in the stores
• Stock is universally hated, out of favor, and expectations have come way down

I rest my case, and would like to hear strong opinions from both informed and ill-informed observers.  I benefit from both – please send me your comments at dasan888comments@gmail.com or in the box below.