Abercrombie & Fitch Could Fit Your Portfolio

Abercrombie & Fitch (NYSE: ANF) has offered to pay members of the cast of MTV's Jersey Shore not to wear its clothes on the air. That is a brilliant piece of marketing since it has garnered massive amounts of publicity for the clothing retailer while using the show's popularity at the same time defining itself as the opposite of the Jersey Shore ethos. Is A & F equally good at creating shareholder value?

After an 8% drop in its stock price Wednesday, the short-term answer is clearly no. To understand why, it's worth looking at the earnings it reported -- and they were great except for one problem. For its quarter ending July 30, A&F reported $32 million in net income, 64% more than the year before. Its adjusted earnings of 37 cents a share beat expectations by a whopping 30 cents a share.

A&F's revenues also soared. They were up 23% to $916.8 million. U.S. sales rose12%, while international sales leaped 74%.

The problem for A&F was that it could not increase its prices as fast as its costs rose. This resulted in a 150 basis point (100 basis points = 1%) decline in its gross margin to 63.6%, driven primarily by an increase in average unit costs.

Did the market over-react? Here are three reasons to consider investing in A&F:

• Cheap stock. A&F's price to earnings to growth of 0.69 (where a PEG of 1.0 is considered fairly priced) means it is cheap. It currently has a P/E of 29.5 and is expected to grow earnings 43% to $4.69 in fiscal 2013.
• Good quarterly earnings. A&F has been able to meet or surpass analysts’ expectations in all of its last five earnings reports.
• A&F is out-earning its cost of capital. A&F is earning more than its cost of capital – and it’s improving. How so? It produced no EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, A&F's EVA momentum was 2%, based on 2010 revenue of $2.9 million in 2010 to $66 million in 2011, using a 10% weighted average cost of capital.

One reason to hesitate is A&F's rising sales but declining profits -- with slightly more debt-laden balance sheet. A&F's $3.5 billion in revenues have increased at an average rate of 1.5% over the last five years while its net income of $150 million has tumbled at a 22.8% annual rate -- yielding a slim 4% net profit margin. But its debt has increased slightly to $68 million as its cash has grown at an 11.7% annual rate from $530 million (2006) to $826 billion (2011).

A&F looks like a good company and the recent plunge in its stock price has made it very inexpensive relative to its earnings growth. The big risk with this stock would be a further rise in costs -- but given the recent plunge in cotton prices from an all-time high of $2.27/pound in March 2011 to its most recent 93.5 cents/pound in July, the worst of that could be over.