Is Abercrombie & Fitch’s withdrawal a buying opportunity?

Abercrombie & Fitch‘S (IT 3.76%) The stock fell 17% on Aug. 28 after the company followed a strong quarterly report with a cautious outlook for the rest of the year. In the second quarter of fiscal 2024, which ended Aug. 3, the clothing retailer’s net sales rose 21% year over year to $1.13 billion and beat analyst estimates by $40 million. Adjusted earnings per share rose 131% to $2.50 and beat the consensus forecast by $0.28.

A&F now expects its net sales to rise 12% to 13% for the full year, up from its previous forecast for growth of “around 10%” and in line with analysts’ expectations for a 12% increase. However, CEO Fran Horowitz warned that the company still operates in an “increasingly uncertain environment” — and those comments have clearly unsettled bulls.

But even after the latest pullback, A&F shares are up about 770% over the past two years. Should investors see the earnings drop as a buying opportunity?

How Abercrombie & Fitch Revitalized Its Failing Business

For many years, A&F was considered a dying mall clothing retailer. It grew rapidly during its heyday in the 1990s and early 2000s, but its sales fell as the “retail apocalypse” devastated malls and new fast-fashion competitors like Zara and Inditex. H&M divided the market. Its outdated marketing campaigns, dimly lit and heavily scented stores, and clothing with large logos also were poorly received by a new generation of teenage customers.

All that changed when Fran Horowitz, president of A&F’s fast-growing Hollister brand, took over as CEO in 2017. Under Horowitz, A&F closed weaker Abercrombie brick-and-mortar stores and refreshed the banner with inclusive marketing campaigns, modern store renovations and more apparel for older shoppers. It also expanded Abercrombie Kids and increased its investment in e-commerce and social media.

A&F then expanded Hollister’s business to compensate for Abercrombie’s slower growth and supported the development of its smaller Gilly Hicks underwear brand to better compete with American Eagle Outfitters Nest and Victoria’s Secret‘s Pink. It also righted the size of its international business and streamlined expenses.

As a result, A&F’s net sales amounted to fell every year from fiscal 2014 to fiscal 2017 — ultimately grew at a compound annual growth rate (CAGR) of 4% from fiscal 2017 to fiscal 2023. The company achieved this growth even as the pandemic shuttered its stores from fiscal 2020 to fiscal 2021 and inflationary headwinds limited its growth in fiscal 2023. Its adjusted earnings per share grew at an impressive CAGR of 46% over those six years.

Will Abercrombie & Fitch maintain its momentum?

For fiscal 2023 (which includes an extra week), A&F’s net sales rose 16%, gross margin increased 600 basis points to 62.9%, and adjusted earnings per share jumped from $0.25 to $6.28. Here’s how the company’s core businesses performed over the past year.

Data source: Abercrombie & Fitch. Y/Y = year-over-year.

Those headline numbers are impressive, but the company’s full-year forecast for 12% to 13% sales growth to about $4.3 billion means it will gradually lose momentum in the second half of the year. It will also lose an extra week of sales compared to fiscal 2023. Despite that short-term slowdown, however, A&F still aims to grow its annual revenue to $5 billion in the “long term.”

A&F’s revenue growth is slowing, but management expects operating margins to expand from 11.3% in fiscal 2023 to 14%-15% in fiscal 2024. It attributes this expansion to rising gross margins (suggesting the company still has strong pricing power) and improved operating leverage. Analysts expect adjusted earnings per share to rise 57% for the full year.

It looks undervalued relative to its growth potential

At $138, A&F shares are trading at just 14 times this year’s earnings. American Eagle Outfitters, which has been growing more slowly, is trading at 12 times forward earnings. A&F operates in a volatile industry and continues to face stiff competition, but steady sales growth and rising margins suggest it won’t become another victim of the retail apocalypse. The low valuation also suggests it’s undervalued relative to its growth potential, so its recent pullback after earnings looks like a great buy.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends American Eagle Outfitters. The Motley Fool has a disclosure policy.