ABERCROMBIE & FITCH CO quarterly report, Q3 FY2011

Abercrombie & Fitch Co. 10-Q Summary

Reporting period: Thirteen and thirty-nine weeks ended October 29, 2011, compared with October 30, 2010. The request metadata identifies “2010 Q3,” but the filing is the Fiscal 2011 third-quarter Form 10-Q, filed December 6, 2011.

Business context

Abercrombie & Fitch is a specialty retailer of casual apparel and related products under the Abercrombie & Fitch, abercrombie kids, Hollister and Gilly Hicks brands. It operates stores and direct-to-consumer channels in North America, Europe and Asia. The company reported one aggregated operating segment.

Financial performance

Metric	Q3 FY2011	Q3 FY2010	39 weeks FY2011	39 weeks FY2010
Net sales	$1.076 billion	$885.8 million	$2.829 billion	$2.319 billion
Gross profit	$646.5 million	$564.4 million	$1.773 billion	$1.481 billion
Gross margin	60.1%	63.7%	62.7%	63.9%
Operating income	$79.9 million	$78.4 million	$165.8 million	$87.2 million
Net income	$50.9 million	$50.0 million	$108.1 million	$57.7 million
Diluted EPS	$0.57	$0.56	$1.20	$0.64

Q3 sales increased 21%, supported by a 7% comparable-store-sales increase, a 41% increase in direct-to-consumer sales including shipping and handling, and international store growth.
Year-to-date sales increased 22%, comparable-store sales increased 8%, and direct-to-consumer sales including shipping and handling increased 34%.
Q3 operating margin was approximately 7.4%, versus 8.8% in the prior-year quarter. Year-to-date operating margin improved to approximately 5.9% from 3.8%.
Year-to-date net income benefited from stronger operating performance and included a $0.8 million after-tax benefit from discontinued operations related to RUEHL lease settlements. The prior-year period included a $0.02 per diluted share store-closure charge.
Effective tax rates were 35.8% in Q3 and 34.3% year-to-date, compared with 35.6% and 32.1%, respectively, in the prior-year periods.

Cash flow, liquidity and balance sheet

Net cash provided by operating activities was $64.5 million for the first 39 weeks, compared with $52.5 million in the prior-year period.
Capital expenditures were $227.6 million, compared with $117.0 million, primarily for international stores, store refreshes, information technology and infrastructure.
Net cash used in investing activities was $248.1 million; net cash used in financing activities was $156.9 million.
Cash and equivalents were $488.3 million at October 29, 2011, down from $826.4 million at January 29, 2011 and $593.3 million at October 30, 2010.
Inventory was $679.3 million, up 33% from $511.8 million at October 30, 2010. The inventory valuation reserve was $38.1 million.
The company had no borrowings under its amended credit agreement and approximately $350 million of availability, less immaterial letters of credit. Long-term debt was $26.3 million, primarily related to landlord financing obligations.
The amended unsecured credit facility matures July 27, 2016. The company was in compliance with its leverage, coverage and other covenants at October 29, 2011.
The company repurchased approximately 1.5 million shares for $98.7 million year-to-date, paid $45.8 million in dividends and had approximately 8.2 million shares remaining under its repurchase authorization.

Material changes versus the prior comparable period

Revenue growth accelerated through international expansion, Hollister growth, comparable-store sales and direct-to-consumer demand.
Gross margin declined 360 basis points in Q3 and 120 basis points year-to-date, primarily because of higher raw-material and average unit costs while average unit retail prices were approximately flat.
Stores and distribution expense leverage improved, with the expense rate declining to 42.9% from 43.5% in Q3 and to 45.5% from 47.6% year-to-date.
Marketing, general and administrative expense increased in dollars but declined as a percentage of sales to 10.0% from 11.6% in Q3 and to 11.5% from 12.7% year-to-date.
Capital spending and inventory increased substantially to support international growth and higher merchandise volumes.
The company entered into an amended and restated $350 million credit agreement in July 2011, extending maturity and reducing fees and interest rates. Prior-credit-agreement borrowings were repaid.
RUEHL exit obligations declined from $17.2 million at the beginning of the fiscal year to $0.2 million at October 29, 2011 after $15.7 million of cash payments.

Guidance, outlook, risks and unusual items

Management expected approximately $350 million of full-year 2011 capital expenditures, up to 40 international mall-based Hollister openings, four additional international Abercrombie & Fitch flagship locations, and approximately 55 to 60 U.S. store closures.
Management targeted approximately 90% of 2007 U.S. store productivity by 2012 and continued to state that a Fiscal 2012 diluted EPS target of $4.75 was realistic.
Management expected sourcing conditions to improve in 2012 because of lower raw-material costs, while noting that Q3 was adversely affected by sourcing-cost escalation, slowing European sales trends, and continued underperformance in Japan and Canada.
The company expected a full-year effective tax rate of approximately 35%, subject to domestic and international profit mix and currency effects.
The fourth-quarter real-estate review and long-lived-asset impairment analysis could result in charges.
Key risks include macroeconomic uncertainty, fashion and inventory execution, raw-material and freight costs, foreign-exchange exposure, international expansion, seasonal sales volatility, direct-to-consumer operations, store closures, competition, supply-chain and technology disruptions, litigation, taxes and potential impairment charges.
The company held $100.3 million of auction-rate securities with $13.6 million of cumulative temporary impairment. These securities have limited market liquidity and are valued using models with significant unobservable inputs.
Pending legal matters include a California wage-and-hour action with certified subclasses and derivative litigation involving present and former directors. The company could not quantify potential exposure for the identified contingencies.
Management stated that disclosure controls were effective at a reasonable level of assurance and that there were no material changes to internal control over financial reporting.

Investor verification items

Verify whether sales growth and comparable-store performance continued after the reporting date, particularly in Europe, Japan and Canada.
Assess whether raw-material costs, inventory levels and markdown reserves pressure future gross margins.
Reconcile planned capital expenditures, international openings and U.S. closures with actual cash generation and liquidity.
Review the valuation and liquidity risks associated with the $100.3 million of auction-rate securities.
Monitor compliance with the credit facility’s leverage and coverage covenants and any future borrowings.
Track potential fourth-quarter impairment charges, litigation outcomes and remaining RUEHL obligations.
Evaluate the sustainability of the Fiscal 2012 diluted EPS target of $4.75 in light of margin pressure and macroeconomic uncertainty.