Abercrombie & Fitch Co. (NYSE:ANF) Q3 2022 Earnings Call Transcript

Abercrombie & Fitch Co. (NYSE:ANF) Q3 2022 Earnings Call Transcript November 22, 2022

Abercrombie & Fitch Co. beats earnings expectations. Reported EPS is $0.01, expectations were $-0.15.

Operator: Good day, and welcome to the Abercrombie & Fitch Third Quarter of Fiscal Year 2022 Earnings Call. This conference is being recorded. At this time, I’d like to hand the call over to Kate Wagner. Please go ahead, ma’am.

Kate Wagner: Thank you. Good morning, and welcome to our third quarter 2022 earnings call. Joining me today on the call are Fran Horowitz, Chief Executive Officer; and Scott Lipesky, Chief Financial Officer. Earlier this morning, we issued our third quarter earnings release which is available on our website at corporate.abercrombie.com under the Investors section. Also available on our website is an investor presentation. Please keep in mind that any forward-looking statements made on the call are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from the expectations and assumptions we mentioned today.

A detailed discussion of these factors and uncertainties is contained in the company’s reports and filings with the Securities and Exchange Commission. In addition, we will be referring to certain non-GAAP financial measures during the call. Additional details and reconciliations of GAAP to adjusted non-GAAP financial measures are included in the release and investor presentation issued earlier this morning. With that, I will turn the call over to Fran.

Fran Horowitz: Good morning, and thank you for joining us today. Before we dive in, I’d like to thank our global team for their ongoing resiliency and focus on executing to our long-term goals as we navigate a dynamic global macroeconomic environment. Against the challenging backdrop, our Q2 results beat our expectations on the top and bottom line with Abercrombie’s sales up 10% and Hollister showing sequential sales improvement, and adjusted operating margin coming in 200 basis points higher than our expectation. We’re excited about our position going into the holiday season, the continued momentum at Abercrombie and inventory is healthy with the year-over-year change cut in half from our peak last quarter. I’m encouraged by the trajectory of our business and I’m confident the steps we’ve taken throughout the year will put us in a position to win in Q4 and beyond.

Onto our Q3 results, while global consumer continue to see significant inflation across their day-to-day lives, we were pleased to see our business improve on second quarter, delivering flat sales of 2021 on a constant currency basis. Throughout the quarter, we continued to execute against the key pillars outlined in our Investor Day. Focused brand growth, an enterprise-wide digital evolution and operating with financial discipline. These pillars give us confidence in our approach to the holiday season which we will enter with healthy inventory levels, momentum in our key merchandising initiatives, and a consumer that is engaging with us across channels. Starting with Focused Brand Growth, we saw sales trends improve across brands compared to Q2.

Abercrombie continue to significantly outperform Hollister as the bifurcation of sales and gross margin performance continued in the third quarter. For the third quarter, total company net sales declined 3% to 2021, and as I mentioned we were flat on a constant-currency basis. For Abercrombie brands, which includes Kids, we saw third quarter net sales grew 10% or 13% on a constant-currency basis, led by ongoing strength in Abercrombie adults. Importantly, third quarter sales for Abercrombie brands were up over 20% compared to the pre-pandemic level of 2019, even as we have reduced store square footage by around 40%. During the third quarter, we saw momentum continued Abercrombie adults as our customer transition to fall. Our assortments continue to evolve as we aspire to open our customer from a gym to the office to Happy Hour and beyond.

With our strong track request channels in AOR growth versus 2021, Adults to achieve its best Q3 sales since 2014, and its highest Q3 AORs in 2004. I am so proud to see this team continue to push boundaries on product and marketing and deliver some of the strongest sales results in our industry. On product, performance of our women’s assortment remains very strong, delivering the highest Q3 sales levels since 2007. The strength was driven by our best ever Q3 sales in jeans, dresses and pants, as we continue to build our Best Dressed Guest franchise and chasing the key trends across bottoms categories. And after seeing some green shoots demand in Q2, we saw growth in Q3 with strength across key top categories as well as outerwear. While the overall size of men’s lags that of women, we are optimistic about the growth opportunity ahead.

Across men’s and women’s, we are well positioned for holiday and are energized about emerging spring trends we will deliver in early 2023. On the marketing front, our team continues to deliver. We were thrilled to be recognized with Performance Marketing Strategy of the Year Award by LTK, which is the world’s largest Creator Commerce platform. The Abercrombie brand was also named to the Brands that Matter list by a SaaS company for effectively leading with purpose, inspiring conversation and communicating our value to all the work — through all of our work with the Trevor project, the Steve Fund and our communities. Kudos to our team for their passion around these projects and for all their hard work in ensuring successful partnerships. Moving on to abercrombie kids.

As discussed last quarter, kids had a soft start to the back-to-school season, but we saw sequential improvement as we move through the quarter. We saw the best performance in our super soft sweatshirt and sweatpants. Turning to Hollister, which includes Gilly Hicks and Social Tourist. We saw selling trends improved slightly compared to Q2. Third quarter sales declined 12% or 9% on a constant currency basis. Consistent with Q2, we check closely to apparel store traffic in the U.S. but we saw lower conversion basket size compared to 2021 as we lap the lingering effects of stimulus last year and our customer deals with significant inflation this year. As we work through the remaining back-to-school period into September and October, we continue to see our customers shift spend towards top and out of bottoms as compared to 2021.

We are pleased to see stronger performance in higher fashion special occasion items like women’s dresses and men’s woven shirts. We’re looking at these categories as leading indicators of our ability to improve conversion and have chased into related categories in the past few months. We are seeing nice performance in our women’s tops business and will work to spread the success to other categories. in Hollister, while a key apparel space has seen softness in the back-to-school season, we continue to look inward at opportunities to improve the business. From an organizational perspective, towards the end of the second quarter, we made several key personnel moves at the senior levels of our Hollister merchandising team. We have also shifted ownership of Hollister marketing to Kerry Krug, who has been our Head of Abercrombie marketing for the past four years where she has built a great team and is instrumental in driving the amazing A&F turnaround.

Kerry has moved into a new role as Chief Marketing Officer and is now responsible for marketing strategy and creative across all brands. We look forward to seeing Kerry building the work our Hollister team has done over the past few years. From an operational perspective, we are continuing with the inventory actions discussed, which includes adjusting forward receipt plans in terms of total level and by category. With these adjustments, we are determined to improve Hollister’s performance in the quarters to come. At Gilly Hicks, as we continue to build awareness around the active lifestyle brand, we took a big step forward in opening additional freestanding stores. As of today, we have 14 freestanding Gilly stores with 11 in the U.S. and three in EMEA.

The team and I are excited to bring our updated positioning and product offering to our global customer as we continue to test and learn. Outside of Gilly, we continue to support our brand growth principle with new store openings across our brands. We opened 19 stores in the quarter and continued to track towards opening around 60 for the full year, which will make us a net store opener for the first time in more than a decade. It’s been great to see our brands deliver the updated experience in new centers as well as reenter key locations we exited over the past few years. For the year, we expect to open 18 Abercrombie adults, 24 Hollister’s, 15 Gilly Hicks and three kids stores. For Abercrombie adult, our customer has responded well to the new store concept near last quarter that features elevated fixtures and furnishings.

Styled space is dedicated to key merchandising categories and updated fitting rooms with customizable lighting. Financially, our new Abercrombie stores are delivering 60% higher sales per square foot compared to the average Abercrombie adult store. For Hollister, we are excited to start rolling out our Revolve store concept this quarter. The new format creates an optimistic and welcoming environment that is omni-focused and complements our digital shopping experience. The open concept interior is designed to be agile and adaptable, allowing for merchandising flexibility. Across all brands, we remain disciplined in our real estate approach with the new stores checking each acquired box: The right size, the right location and the right economics.

Shifting to inventory. The year-over-year inventory trend is playing out as planned with inventory growth moderating in Q3 after a peak in Q2. We ended the quarter with inventory up 36% to 2021 as we made good progress selling through summer and back-to-school inventory at Hollister. Consistent with last quarter, 92% of our inventory was current, defined fall and holiday product, new goods that haven’t been set for longer-life items. As we move through Q4, we expect year-over-year inventory growth to moderate further, and we are planning to be relatively flat to 2021 by year-end as we fully anniversary the late receipts we experienced last year. Turning to our second strategic principle, enterprise-wide digital revolution. During the quarter, we delivered share to pay, a new way for Hollister customers to pay on the mobile app.

Shared Pay was completely developed in-house, and I’m so proud of our internal team many of whom we’ve hired over the past 18 months as we add talent to accelerate our digital revolution. This first of its kind payment solution is based on the need we saw among our team customer to eliminate a barrier, a key barrier to conversion. The feature allows our Hollister customer to easily share their digital shopping bag with their parent. For example, to complete the purchase as many don’t have access to credit cards to transact digitally. The early response has been positive as share to pay transactions showing higher conversion and basket size than the average. We’ll continue to get feedback and evolve this technology with the goal of finding more use cases beyond Hollister.

This feature is one example of the work our teams are doing to support our digital evolution, which is necessary to grow our digital business off a 2021 base of roughly $1.7 billion. In addition to rolling out customer-facing technology, we also made progress on multiyear technology modernization efforts in areas like merchandising and data, which will enable us to be smarter and faster in the future. A huge thanks to our team, and I can’t wait to see what’s next. For our third strategic principle, operating with financial discipline, we are focused on managing controllable expenses in the third quarter. We currently manage headcount and adjusted marketing to better match demand patterns. As discussed last quarter, we reduced inventory buys for holiday and go forward to better align with sales trends and to ensure all brands are in a position to chase receipts in strong performing categories.

Despite the challenging macro backdrop, we remain cautiously optimistic as the holiday season ramps up in a big way this weekend. Quarter-to-date, sales are running consistent with Q3 levels. Across brands, I am pleased with our assortments, and we’ve seen good early reads in cold weather categories. Also much different than last year, we have the inventory on hand for our customers this year due to our efforts to deliver inventory earlier than normal to mitigate potential supply chain delays. While our teams are working to deliver a great holiday, we also remain laser-focused on the long term. As we move through Q4 and in 2023, we expect to continue to leverage our strong balance sheet to fund the multiyear strategic investments necessary to execute our Always Forward plan.

And with that, I’m going to turn it over to Scott to provide more details on the quarter and our updated outlook.

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Scott Lipesky: Thanks, Fran, and good morning. For the third quarter, we delivered net sales of $880 million, down 3% to last year on a reported basis and flat on a constant currency basis. We saw foreign currency pressure accelerate in the quarter, driving an approximately 300 basis point adverse impact to sales. Sales results were above our expectations as we saw trends improve sequentially at both Abercrombie and Hollister. Net sales at Abercrombie, which includes kids, rose 10% compared to 2021 on a reported basis and 13% on a constant currency basis. This compares to reported and constant currency growth of 5% and 7%, respectively, for Abercrombie in Q2. Hollister, which includes Gilly Hicks and Social Tourist, declined 12% or 9% on a constant currency basis.

This compares to reported and constant currency declines of 15% and 12%, respectively, for Hollister in Q2. By region, net sales increased 3% in the U.S. and declined 18% internationally or 8% on a constant currency basis. By region, EMEA was down 22% on a reported basis and 11% on a constant currency basis, and APAC was down 26% on a reported basis and 19% on a constant currency basis. In EMEA, our strongest performance was once again in the U.K. and Middle East, and we continue to see softness in other key countries in Western Europe. Obviously, there are many unknowns in Europe this winter. So our focus is on controlling our inventory and expenses and quickly reacting to the environment. In China, our trend remained negative but improved significantly from Q2.

Our gross profit rate was 59.2% compared to 63.7% last year. Key drivers of the year-over-year change were the adverse impact of exchange rates of 60 basis points and higher product costs of 370 basis points. On a constant currency basis, AUR was up slightly with Abercrombie higher than last year and Hollister lower than last year as we work through back-to-school inventory. On product costs, we are optimistic the recent pullback in freight and cotton prices will stick. We expect to see freight flip to a tailwind in Q4 as we anniversary elevated air rates and air usage due to Vietnam closures last year and start to see lower ocean rates materialize in cost of goods sold. For cotton, we will continue to see year-over-year cost pressure in the fourth quarter.

Looking ahead, assuming current prices hold, we expect to see a benefit from lower cotton starting in the back half of 2023. Moving on to inventory. We ended the quarter with inventory up 36% to last year, 92% of which was current. During the quarter, we made good progress clearing through Hollister back-to-school inventory that was bought at a level higher than trends. Looking to Q4 and beyond, Hollister inventory receipts have been reduced to match the summer and back-to-school trends and to reflect box and hold inventory that will set this coming spring, and we continue to chase in key categories for Abercrombie. More recently, we have seen greater stability in the supply chain with transit times coming in better than our expectations. In total, we are targeting an inventory level relatively flat to last year by year-end.

I’ll now cover the rest of our Q3 results on an adjusted non-GAAP basis. We excluded $4 million and $7 million of pretax asset impairment charges for this year and last year, respectively. Q3 operating expense, excluding other operating income, was $501 million compared to $498 million last year. The increase was driven by inflation in higher digital fulfillment expense, mostly offset by lower marketing, incentive-based compensation and foreign currency. Operating income was approximately $21 million compared to operating income of $79 million last year. Changes in foreign currency adversely impacted operating income by approximately $8 million. Net income per diluted share was $0.01 compared to net income per diluted share of $0.86 last year.

Changes in foreign currency adversely impacted EPS by approximately $0.10. Moving on to the balance sheet. We ended the quarter with cash of $257 million and liquidity of $617 million. We expect cash and liquidity to build nicely in Q4 as we sell through inventory during the holiday period. During the quarter, we repurchased 510,000 shares for approximately $8 million. At quarter end, we had 49 million shares outstanding, down around 20% from the start of 2021 with approximately $230 million remaining under our previously authorized share repurchase program. We also repurchased $8 million of senior secured notes at a slight discount to par value. We remain committed to putting excess cash to work, pending liquidity levels, market conditions and our ability to accelerate investments in the business.

Turning to investments, we expect fiscal 2022 CapEx of approximately $170 million, up slightly to our previous outlook as we accelerate certain technology investments. In total, we expect half of our capital spend to be for digital and technology and half for stores and maintenance. We continue to expect to be a net store opener this year with approximately 60 new stores globally with the majority in the U.S. We opened 31 stores through Q3 and the remaining 29 are set to open in Q4. We have approximately 220 leases up for renewal by year-end, and we continue to expect to close approximately 30 stores pending the negotiations with our landlord partners. As we look to the remainder of the year, we assume inflation-related pressure on consumer demand continues and that our brand and regional performance will be relatively consistent with Q3, with Abercrombie outperforming Hollister and U.S. outperforming international.

Our updated outlook replaces all previous full year guidance. For the full year, we are planning as follows: net sales will be down 2% to 3% to 2021 level of approximately $3.7 billion, an increase to our previous outlook of down mid-single digits. Embedded in this outlook is an estimated adverse impact of approximately 250 basis points from foreign currency, slightly worse than our prior expectation. Operating margin in the range of 2% to 3%, with the lower end up slightly from our previous range of 1% to 3%, reflecting better-than-expected results in Q3. We continue to expect a total inflationary impact around $250 million across product costs and operating costs compared to 2021. For the fourth quarter, we are planning as follows: net sales will be down 2% to 4% to 2021 level of approximately $1.19 billion, consistent with the Q3 trends.

Embedded in this outlook is an estimated adverse impact of approximately 300 basis points from foreign currency. For operating margin, we expect a level between 5% and 7%, and an effective tax rate in the mid- to high 40s as the rate remains sensitive to earnings levels by geography. As we manage through the holiday season, we are also keeping an eye on the long term. This year and next are pivotal years as we accelerate our digital revolution and evolve our omnichannel experience across brands. We are mindful of the macroeconomic environment and are managing expenses and inventory tightly with a goal to maximize cash flow to fund key investments. Looking to 2023, while we are closely monitoring consumer demand, we remain cautiously optimistic that we’ll see significant relief on product costs and some stabilization of inflation across other key expense categories.

We will learn a lot more in the months to come, and we’ll discuss assumptions for 2023 on our Q4 earnings call. With that, operator, we are ready for questions.

Q&A Session

Operator: Our first question comes from Dana Telsey from Telsey Advisory Group. Please go ahead. Your line is open.

Dana Telsey: Good morning. Nice to see the progress. Can you expand on the enhancements that you’ve been making to Hollister and how you expect the brand to unfold in progress go forward given the people changes that have occurred there? And then any comments on — we’ve been hearing about October and into November, how your trends have been exiting the quarter and into the other — into this current quarter? And then lastly, Scott, you mentioned about product cost opportunities. How do you see it with supply chain in the first half of ’23 compared to the second half? Thank you.

Fran Horowitz: Hi Dana, good morning. So as you mentioned, we were pleased to see the sequential improvement from Q2 to Q3. In fact, we were pleased to see it in both of our brands. If you do take a step back, the Hollister customer, as we’ve talked about recently, has definitely been more impacted by inflation than our Abercrombie consumer seems to be at the moment. But we are controlling what we can control. The leadership changes came towards the end of Q2, the inventory changes. We got on those as soon as we started to see some opportunities hit us as back-to-school kicked off at the end of the last quarter. It’s exciting to see our tops business is very strong. We chased into those. Our story there when we talk to the consumer is that perhaps they can’t buy a couple of pairs of jeans this year, but they want their outputs to look new, so they’re putting new tops with those.

We are determined to continue to see these improvements in the quarters to come, and the team is working very hard on adjusting inventories and really leaning into categories that are working. Let’s see question two, October into November. Go ahead.

Scott Lipesky: I’ll grab that one. So similar trends than what we’ve been seeing across the industry. It sounds like it was pervasive across the industry. A little bit of softness there, late October, and maybe into the first week of November. Super warm there in the Midwest and Northeast. And obviously, that’s not optimal for selling cold weather products. I have seen those trends improve since like others, which is exciting. We are seeing good early selling through our cold weather categories and outerwear fleece, sweaters, places where we need to win in Q4. So happy with the results there, the results in those categories. On product cost opportunities as we look through — look to next year. The great thing to see these costs coming back in, significant reductions in freight through the ocean and air as well as seeing the cotton prices stabilize here and down pretty significantly year-over-year.

Obviously, it’s going to take a little bit longer to see that cotton flow through. So first half of next year, cotton will be pressure, and then we’ll start to see the benefits in the second half of next year. Optimistic that we’ll see the freight benefit throughout the entire year, assuming those ocean costs stay where they are. So good news coming, hopefully, on the product cost front.

Dana Telsey: Thank you.