Tricky Turnaround for This Teen Retailer

 Abercrombie & Fitch (ANF) posted a first-quarter comparable sales decline of only 4%, much better than peers American Eagle (AEO) and Aeropostale , whose comp sales fell 10% and 13%, respectively. Additionally, the profitability-improvement initiative continued to play out, with the stand-alone Gilly Hicks store closures (24) substantially completed and the plan contributing to a $37 million decline in adjusted operating expenses. As management has proved its ability to execute on its strategic plan in the quarter and has already begun to see some positive results, we will probably make no material change to our $40 fair value estimate. We recommend investors wait for a wider margin of safety, because we believe performance can be volatile in the midst of significant restructuring efforts and the company has no sustainable competitive advantage in an overcrowded space facing a challenging and fundamentally shifting target market--the basis for our no-moat rating.

The profitability-improvement initiative is on track to deliver $175 million in annual savings. However, we think some of this upside will be offset by at least $30 million in additional marketing investments that we view as necessary to reposition the brand and re-energize its customer base. The store base is now being managed strategically. For 2014, we expect four additional stores in outperforming China, two Hollisters in Japan, and additional openings in the Middle East. Management continues to expect to close 60-70 stores in the United States through natural lease expirations and notes that 500 of the 840 U.S. leases are up for renewal between now and the end of 2016, yielding significant flexibility in rightsizing the store base. Thus, we think there is additional long-term upside to the announced savings.

Clothing's Cachet Cools
With no cost advantages or customer switching costs, Abercrombie & Fitch has traditionally relied on its brand intangible asset to preserve and expand market share. However, we think its brand power has eroded and the company now lacks a moat. To sustain a strong brand, it is imperative to be maniacally focused on product design and quality, but we think A&F management is more focused on marketing, distribution, and cutting costs. On top of that, the teen apparel space is highly competitive, exposed to the negative economic trends hitting youth, and sensitive to wide swings in fashion trends among its highly fickle audience. We expect sales to be highly volatile but trend down and deleverage to persist.

A&F has historically skewed to the higher-price aspirational market, but the current economic environment has shrunk this demographic, and current trends favor price over brand. In addition, we think A&F's product design and quality are no longer differentiated enough to command higher prices. Selling wool sweaters and cotton sweatshirts in the $58-$88 range that can be found elsewhere for less is not going to cut it with today's sophisticated shopper. In our opinion, the merchandise lacks a differentiated prep school heritage design, and there are few luxury details to justify price points and differentiate from competitors, such as touches of fur, leather, cashmere, or embellishments. We think plans to stock vendor designs and increase speed to market could result in a further decline of quality and uniqueness.

We expect same-store sales to decline 4% annually over the next five years, given the lack of product differentiation and premium pricing. International expansion should somewhat offset this, and we think sales will decline about 1% annually. We expect some of these top-line losses to be offset by better cost management, the addressing of noncore brands, and a clearer focus on international expansion and rightsizing the U.S. store base. We believe operating income will grow 12% and earnings per share will increase 17% on share repurchases.

Lack of Product Differentiation Means Lack of Moat
We are maintaining our no-moat rating given the lack of differentiation of product, the competitive nature of the teen retail space, and A&F's loss of brand cachet.

Abercrombie & Fitch markets a line of sportswear apparel including knit and woven shirts, graphic T-shirts, fleece, jeans, shorts, sweaters, and outerwear for teens and kids. Except for logo products, which have fallen out of fashion in recent years, the products are mostly undifferentiated in style and fabrication from its peers. Given the lack of protection from competitive duplication leading to an array of similar products, we think that value-minded teens and parents will pick the cheapest product and that brand will have little bearing on the decision. Full-price hoodies and sweatshirts at Abercrombie & Fitch's website are $48-$110 versus American Eagle's $29.95-$49.95 and Aeropostale's $26.50-$59.50. All three sites were offering a promotional discount between 30% and 70% off, showing that pricing, more than brand or design, is a significant deciding factor for teens.

The retail industry has very low barriers to entry and is becoming an increasingly global marketplace. Both trends have drastically increased competition over the past decade. Social media sites, blogs, and e-commerce have opened awareness and opportunity beyond geographical boundaries, making it more difficult to control a brand's image and message and to be heard over a slew of voices. New fast-fashion retailers, including Forever 21, H&M, and Zara, grew as they responded to this need by providing edgy runway fashions at a low price quickly after their debut. With the world getting smaller and the U.S. still the dominant retail market, foreign brands including Uniqlo are turning to the U.S. for growth.

In this sea of competition, we believe two attributes can give a retailer a competitive edge: price and brand. Abercrombie & Fitch is certainly not a discount store and has no cost advantages that would allow it to become one. Instead, we see its strength in its brand, which has been steadily eroding to the point where it seems to have no benefit over competitors. Abercrombie & Fitch has posted negative same-store sales growth for 35 out of the past 55 quarters, with an average decline of 2% annually during the 13-year historical period. We see this as a sign that consumers consistently believe that the brand does not justify the store's premium pricing. Admittedly, some of the decline can be attributed to the recession; however, we note that competitors such as H&M posted roughly flat same-store sales over the past five years versus A&F's average 5% annual decline. We take this as a sign that the brand value has eroded and that Abercrombie & Fitch has no moat to protect itself from competition. Our model calls for average adjusted return on invested capital of 10% over the next five years, in line with our cost of capital assumption.

Fashion's Fast and Fickle
The teen apparel retailer space is highly competitive, exposed to one of the most damaged economic bases, and subject to quickly changing fashion trends and a fickle consumer base. As such, we give Abercrombie & Fitch a high uncertainty rating.

A&F's core teen target market has suffered the brunt of the effects of the weak economy. According to the Bureau of Labor Statistics and Center for American Progress, the unemployment rate of Americans ages 16-24 is about 16.2%, more than twice the unemployment rate for people of all ages. The teen and young adult populations are increasingly failing to make payments on student loans, delaying retirement savings, and moving back in with their parents. Even those who have found employment are often working at lower-wage, low-skill jobs. We think cash-strapped teens are being forced to choose between categories and that other sectors including food, entertainment, and electronics are now competing with apparel retailers for a portion of the teen wallet.

The company's success hinges on accurately predicting teen fashion trends. This is a very difficult task, and the company has seen much volatility in same-store sales. High levels of competition from other teen retailers like Aeropostale and American Eagle, department stores, and fast-fashion retailers like Forever 21 mean that there are more than enough alternatives for teens to shop if A&F gets it wrong. In our opinion, international expansion increases this risk. Trends that are popular in America may not translate to foreign markets.