Motley Fool Hidden Gems Investing - Not Your Older Cousin’s Abercrombie

Episode Date: August 23, 2023

Abercrombie is back in vogue, but be careful chasing this cyclical business.  (00:21) Jason Moser and Dylan Lewis discuss: - The reality of Peloton’s seasonality, and how the company is doing with its recalls and digital ambitions.  - At all-time lows, is Peloton more interesting? - How Abercrombie’s back in vogue, and what the retailer is doing to connect with consumers in a tough retail environment.  Companies discussed: PTON, ANF Host: Dylan Lewis Guests: Jason Moser Engineers: Dan Boyd  Learn more about your ad choices. Visit megaphone.fm/adchoices

I saw my friend on the other side of the street. I was heading to school with the kids. I let go of mom's hand to wave. I had already forgotten their lunches. I ran over to hug her. She came out of nowhere. And then... It stopped.

Sometimes the moments that never happen matter most. Volvo's Automatic Emergency Braking helps ensure a safe ending for everyone. Learn more at volvocars.ca slash safety. Dylan Lewis, and I'm joined over the airwaves by Motley Fool analyst Jason Moser. Jason, thanks for joining me. Jason Moser, Motley Fool Analyst Hey, hey! Thanks for having me. We've got a rundown on Peloton's woes and the story behind Abercrombie's latest resurgence. Jason, we're going to start with the fitness company. Peloton shares down 20% after the company reported its fiscal fourth

quarter results. What drove the dive here? Jason Moser. Well, it's a few things. It certainly feels like things are poised to get worse for the company before they get better. Certainly, I think we all hope that they do eventually get better. It does feel the overarching theme with this company right now is that management just doesn't have a firm grasp on the business yet. It's a business that's dealing with a lot of challenges all at once. But you got to doff the cap. They are trying. Right now, I'd say the stock, it's a coin flip right now as to whether they're actually able to pull this off. Because even they admit there's no real North Star for modeling any type of reliable outcome

in regard to the business, because there's so many variables in play right now. I think there is just still a tremendous amount of uncertainty. We obviously know the past with this business, big challenges and recalls. Ultimately, a business that has had to make a tremendous pivot from what the initial value proposition was. They say turnarounds rarely turn around. This is a a turnaround, and we hope it does turn around. But I think right now, the market is probably maybe taking the glass half-empty view on this one. Let's take a little bit of a zoom in on some of those recall issues you mentioned. When we saw the earnings results from the company, revenue down 5%. There were a couple

different factors there. We saw some struggles in the hardware sales. We also saw, this is a subscription business. As there were issues with their products, I think they saw some people move away from their subscriptions while they're waiting for their hardware issues to get resolved, Jason. Do you feel like, as we look at this business going forward, they are out of the woods with this product recall? Or is this something that's going to continue to plague this business? We're definitely out of the woods, I don't think, yet. This type of thing stays front and center for a lot of folks. It's interesting to see the juxtaposition between recalls in this line of work and recalls

in the automobile industry. Recalls in the automobile industry are a dime a dozen. We see them all the time. Chances are, you've probably got two recalls outstanding on your vehicle right now, and you don't even know it. That's just the way that works. But with a business like this, it's obviously very headline-centric. We've read these stories in regard to the seatposts, for example. We know that they also had issues with their popular tread products. When you start talking about safety issues, unfortunately, when you bring the word death into certain situations like these, given the nature of why you're using these products to begin with and services, it really does make you do a double-take.

I think they are making the efforts to get past these recalls, but we're still in the early stages of actually them getting past it. You don't really know if they're actually going to be able to get past it yet or not. They're definitely getting positive responses, at least from consumers, in wanting to go ahead and take advantage of these repairs. What remains to be seen is, will consumers going forward really trust this brand enough to continue buying that hardware along with any new innovations that they bring to the market in regard to that hardware? You mentioned some of the challenges that they've run through before. Pick one. There's the inventory issues, there's the

recall we just talked about, there's some of the murkiness around the market size for some of their products. I have noticed in recent quarters that this business has tried to make a little bit more of a pivot to their digital ambitions, and moving away from the reliance on, we need the hardware in a consumer's home in order to have a relationship with them. Do you feel like there's traction there, or something that we can be optimistic about in terms of that being a growth lever? That, for me, right now, is one of the things I'm more optimistic about with this business. I like the hardware angle. Recalls notwithstanding, they, generally speaking, make good hardware. They've missed checking

a couple of boxes along the way. But you're right, this is an investment in any business that has really had to pivot away from what it was known initially as the bike, the connected fitness that comes with it. Now, we're seeing they're trying to steer away from the hardware side because of these issues they've had with their hardware. If you look at their website now, for example, and see their offering in regard to their digital presence, they've got the Peloton app free offering, which is $0 per month. You've got the Peloton app one, and then you've got the Peloton app plus. Peloton app one, $12.99 per month. Peloton app plus, $24 per month. Then you can see that these offerings give you all sorts of

different features and options. But one thing is, across all three of these, no equipment is needed. You don't actually need the Peloton equipment to be able to subscribe to these services. I think that's a great call. They don't necessarily have to be an equipment company. To see them make this pivot and really start focusing on that subscriber side makes a big difference to me. As we know, we've seen subscription businesses all throughout our time here at The Fool covering all sorts of different companies. Subscription businesses can be very powerful. To be clear, while product revenue was down 25% for for the quarter. Subscription revenue was up 10% for the quarter. Clearly, one of the

few, unfortunately, right now, bright spots for this business. Yeah, and there's definitely a path there where they're able to appeal a little bit more to a more price-conscious customer, or someone that simply doesn't have the money on hand to buy one of their more expensive hardware products, but still wants a fitness experience. I think there's something interesting there. It's just a little tough because we've seen some missteps before from this management team. I wonder if they're capable of making that pivot happen. One of the things I wanted to zoom in on with this earnings release, Jason, was, management expects cash flow to be negative for the next few quarters.

But CEO Barry McCarthy said, I've never been more optimistic and excited about the future of this business. Stock is now at all-time lows. Do you feel like there's a reason to be interested and excited about this company, or are you waiting and seeing how this pivot and this resurgence may materialize. I want to be optimistic. I know there's some challenges on the horizon. This is a seasonal business. It was funny, they opened the shareholder letter with that very sentence. It was a reminder, please remember, this is a seasonal business. If you look in the 10-K, they even stated, it's not something they're just trying to pawn off results. They say in the 10-K, they've experienced higher

revenue in the second and third quarters of their fiscal year compared to the other quarters. Remember, this is the fourth fiscal quarter that they were reporting. In theory, we've got this holiday season coming up, and it is a seasonal business, so we should see some improvement there down the line. By the same token, again, going back to that point I made earlier, this is Barry McCarthy's third call with this company. He's still a relatively new CEO, So, you still want to give them a little bit of time to get an understanding of the business and a grip on the drivers. But there's a question in the call, even, in regard to this uptick in sales over the last eight weeks. Someone asking them, what was the cause of that? Management

literally said they didn't know. He didn't have an answer. He's like, I just don't know what to say. Maybe it was macro forces, maybe it was something else. The managers even fake it for me. Tell me something. Give me something to work with here. Positive response to the brand, because if you recall, that's something. I feel like there's still maybe some work to be done on that side, messaging and advocating for the brand. Maybe that could be seen as opportunity as well. This is clearly a business where the the market is not giving it much credit at all. We've seen that happen before. Sometimes that can represent opportunity. I'm not calling this one a value opportunity, but I'm not

calling it a value trap either. They're still making some interesting decisions here that lead me to believe that maybe there is a future where Peloton is a growing part of our lives. From down 20% to up 20%, Abercrombie & Fitch shares up big today after the clothing company reported beats on the top and bottom line with its second quarter results. Jason, huge jump post-earnings from a company that I think people have been sleeping on a little bit. What's behind the pop? I think we sleep on these companies a lot because we know fashion is so fickle. I think we've said on these shows for years and years, fashion is just a notoriously difficult investment because it is fickle and it's not

something that is terribly lasting. I think in this case, you've got the one-two punch about performance along with raising guidance. The market clearly loves that. But what's really interesting to note here, you go all the way back to 2019, the top line for this company hasn't really budged. Net income has been cut in half. Now you've got the stock trading at 25X full-year estimates. It's like the market is really excited about Abercrombie and Fitch again. But I do understand at least the optimism there. In a retail environment right now, where we've seen a lot with results from companies like Target, where there are a lot of consumer headwinds. We're talking about shrink in organized crime and theft,

inventory issues. Abercrombie is not really having to deal with that as much. It's seeing a little bit more positive momentum, I think, partly because maybe it's a little bit more of an understood customer base, as opposed to something like a Target that is a bit more of a broad customer base in what they have to offer. Listen, Abercrombie & Fitch, they've had their fair share of difficult years. It's nice to see them turning the tables here a little bit and enjoying some success. Yeah. You mentioned the financial picture. What's interesting is, we mentioned shares up 20% on the earnings news.

They're up 110% year to date, way ahead of the S&P's return, way ahead of what we're seeing from other retailers, like American Eagle, Gap, Urban Outfitters. This company is clearly doing something right. What I think is interesting, Jason, is, just anecdotally, their merchandising mix looks quite a bit different than maybe your older cousins Abercrombie & Fitch from the early aughts and 90s. I've seen it firsthand, because in my household, I had not really been thinking much about Abercrombie & Fitch.

Just last week, my girlfriend had a package come from them. I was looking at what came in the mail. Five plain tees. She said they're her favorite plain tees. You look at their website, similar to what we were talking about with Peloton, actually looking at what they're offering here, it's a lot of stuff that looks a lot more like Madewell. Some of those retailers that are a little bit slimmer, a little bit more basic in terms of what they're offering, it's a big departure from what we've traditionally seen from this retailer. Yeah, well, sometimes less is more. I think maybe we've hit that stage in fashion. There was a time where logos were more in vogue,

and that was something that consumers appreciated more. Maybe now, understated is a little bit more the way to go. Talking about returns, if you look at the three-year chart for this thing, the stock is up 405% over the last three years. I'm just astounded by that. But hey, hats off to them. That's a tremendous performance. I think you're right. You go back to this idea, it's not this Abercrombie & Fitch that we knew from years ago. They consider themselves, and take this for better or for worse, they consider themselves a lifestyle brand now, Dylan. We know that comes with some caveats there. Sometimes you see companies leaning into that lifestyle brand at the peak of their success. I'm not calling this the top, but

I'm just saying. They threw the lifestyle thing out there, so let's keep that in mind. But I do appreciate the idea here, though, in that when you look at the business itself, they had the Abercrombie & Fitch brand along with the Hollister side of the business. Hollister, which is a bit more attractive to younger demographic, teenagers, so you've got that back-to-school demo there. Then you've got the Abercrombie & Fitch brand, which leans to a little bit more of an older demographic. But these two sides of the business play off of each other very well. You've got Abercrombie, which historically presents a higher operating margin business, but favors a more digital consumer. Then you've got Hollister, which

is a lower operating margin business because it favors a bit more of an in-store experience. I think that comes with that younger demographic that's actually looking to just get out there and go through the stores and whatnot. But about two-thirds of Hollister's business is still in-store. I think one thing this company is doing really well, and it goes to that omni-channel experience that we talk about with so many retailers that are witnessing successes, that they are meeting their customers where their customers want to be met. Whether it's that Hollister demographic or that Abercrombie & Fitch demographic, they're doing it all. I think that makes a big difference in certainly presenting itself in the numbers.

Yeah. I think we've seen some comments from management in the quarter talking about how they're really focusing on customers having clothing that they can wear in the workplace and also outside of the workplace, that kind of transitional outfit that works for nightlife and the 9-to-5. It seems to be connecting with the customer base. I think you hit on something there. I was thinking about this and putting together some notes for today. They really are benefiting from this notion that we've got a different view on the way we work right now. Some of it's all remote, some of it's back in the office, some of its hybrid, but it's not the way it was before. Fashion is extending itself into

more situations. Certainly, Abercrombie is benefiting from that. I think they're also benefiting from what we've seen here, at least, with a number of retailers. When you just get back down to the numbers of it all, the market's clearly excited about the fact that the company's inventory levels are down 30% from a year ago. The impressive part is with those inventory numbers down that much, 30%, we saw gross margin tick up 460 basis points. Based on strong store performance, lower freight costs, it was offset a little bit by some higher input costs on the cotton side. But ultimately, operating margin 9.6% up considerably from a year ago, where essentially they were just breakeven. All things considered, not

only are they meeting their customers where they want to be met, but you can see that materializing and manifesting into real, concrete numbers in the business. Listen, it's not a stock that I would be jumping on today at 25X full of your estimates, but I certainly understand the market's enthusiasm. Yeah, you beat me to it, Jason. I was going to ask. Oh, sorry! This is a business that I now think is trading at an earnings multiple that may surprise some people. We talked about the one-year look and the three-year look, but this is a business that is also highly cyclical. We have seen this story before, where it seems

like they catch lightning in a bottle, and then we wind up looking at the longer picture and saying, they actually haven't returned a ton of value to shareholders short-term, or even over one to three to five years, depending on the look and your cost basis. Is this a business or an industry in general that you're interested in, or do you feel like it's too hard to follow the trends here? I certainly cannot. I do not profess to be on top of the fashion trends, that's for sure. But just generally speaking, it's not a market that really, it's not one that I look to first, because it's a difficult one for me to really embrace that buy-to-hold mentality.

It's not one where I feel like I could buy and plan on owning for years on end and hopefully adding to as time goes on. I think it's a little bit more suitable to your value investment. for value investors looking to find impaired businesses that offer a proposition where there might be a short-term catalyst or a long-term trend in play. It reminds me many, many years ago here when I did that thing with Gap. I found Gap at the time was really suffering because of a number of self-inflicted issues along with some macro forces that were hurting the business. I jumped in there with that value thesis. I didn't get in quite at the bottom. I didn't sell quite at the top, but it was a rewarding investment and I enjoyed it. But man, I remember

afterwards feeling like, damn, that was a lot harder than I feel like it had to be. It requires a lot of work, it requires a lot of attention, it absolutely can be done. But I think it probably fits more in that value style of investing as opposed to that buy-to-hold investing. Just depending on what your flavor is there, take that into consideration. Jason, always happy to have your investing advice. I'll ask other people about the fashion advice. We're two men in T-shirts recording this podcast. Thanks so much for joining me for today's show! Thank you! As always, people on the program may own stocks mentioned and The Motley Fool

may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis. Thanks for listening. We'll be back tomorrow.