Abercrombie & Fitch Versus GAP

Both Abercrombie & Fitch (A&F) and Gap have unperformed the S&P 500 by almost 25% over the last 12 months.  Both of them have experienced the same issues, but their reactions have differed significantly.

First, their revenues are threatened by the recent “Fast Fashion” trend, a retail industry fad of constantly changing clothing styles that large name-brand stores cannot react to in time.  As a result, A&F’s revenue has dropped 17% since 2013 and Gap’s has dropped 2% so far in 2015 (largely protected by Old Navy’s strong growth).

Furthermore, no retailers can escape from e-commerce’s impact on the industry.  Brick and mortar stores are vital for e-commerce.  Most online retailers perform better if they also have physical locations.  People like going into the store to check out the product first, but they will still buy it online.  In just the last 5 years alone, both A&F and Gap lost 15-20% of their brick and mortal store sales to online sales.

Looking at Gap, the operating margin for online sales is 22% versus 11% for store sales. You would think that moving to higher-margin sales is a good thing.  But that is not the case for A&F.  As sales moving online is inevitable, A&F’s online sales has increased from 13% to 22%.  But it did not go to just the company’s websites. The majority of sales occur on third-party e-commerce such as Amazon & EBay.   As products are priced exactly the same on both retailers’ websites and Amazon, Amazon often has discounts or free shipping which attract consumers.  This means that Amazon, and the like, took a lion share of online sales from retailers’ own websites.  In fact, 20% of the 22% A&F online sales went to third-party online sales.  Even with a higher margin for their online sales, companies still have to pay Amazon a hefty 10 to 15% fee.

The bottom line is that A&F’s operating margins have dropped from 8.3% in 2013 to just 3% in 2015.  This is a double whammy for A&F particularly because both their top-line revenue and margin are squeezed simultaneously for something they cannot control.

Still, we like Gap. They were able to use their lower-price stores, Old Navy, as the foot solider to combat “Fast Fashion” effectively.  In fact, Old Navy has added $1 billion sales to Gap since 2011, and their margins have actually expanded in recent years.   A&F, on the other hand, cannot use Hollister, another high-priced, “cooler of the cool” surfer dudes brand, to test everyday new ideas for average people.

Our valuation indicates that Gap is currently 21% undervalued with a fair value $34, while A&F is fairly priced.

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