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Bull of the Day: Abercrombie & Fitch (ANF)

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All eyes are on the Fed today, and Wall Street is likely rooting for a more dovish tone from the central bank amid fresh economic uncertainties. These question marks have sent investors running from stocks, but if the market does get what it wants from the Fed, these same investors could return in search of bargains.

One such bargain is specialty retailer Abercrombie & Fitch (ANF - Free Report) ). The company operates more than 1,000 stores across three brands—Abercrombie & Fitch, Abercrombie Kids, and Hollister—that focus on upscale casual wear primarily for teens and young adults. ANF is currently sporting a Zacks Rank #1 (Strong Buy).

Abercrombie reimagined its brand several years ago, ditching the sexualized advertising and uptight employee dress code it had become known for. Its stores, and the apparel therein, got brighter, more modern, and back on trend.

It took a few years for these changes to materialize in terms of financial results, but the stock finally started to pick up steam last year. ANF emerged has one of 2017’s hottest momentum stocks and carried that rally well into 2018. Prior to its pullback, the stock had rallied more than 200% from its five-year low to the 52-week high reached this summer.

However, our recent stretch of market-wide volatility has battered these types of momentum plays as well as many retailers. But that same selling now makes ANF look cheap, especially as its earnings outlook continues to improve.

The keys to the thesis for ANF right now are P/E contraction and price-to-consensus divergence. The P/E contraction portion is relatively simple. Abercrombie is on track for significant EPS growth this fiscal year, and its outlook for next year is rising thanks to positive earnings estimate revisions. As that trend holds, a dip in the price makes the Forward P/E equation look even better:

ANF is now trading at just 19.6x forward 12-month earnings, which is near is lowest valuation in a year. This might not be attractive if the core business conditions were sluggish, but as the company’s latest earnings report showed, that’s hardly the case.

Abercrombie most recently reported earnings just a few weeks ago. For its fiscal third quarter, the retailer notched EPS of 33 cents, crushing the Zacks Consensus of 18 cents and improving 10% from the year-ago period. Net sales of $861 million were only flat on a year-over-year basis, but that result was well ahead of our consensus estimate of $854 million. Comps in the period were up 3%, marking the fifth consecutive quarter of comps for ANF.

More importantly, Abercrombie noted that its Q3 momentum carried into the start of Q4. Management expects a busy holiday shopping season and reaffirmed its previously stated outlook for the full fiscal year. Moreover, gross margin is likely to be flat or up slightly and operating expenses are expected to decline 1% to 2%, the company said.

This type of report paints a picture of a healthy specialty retailer in the midst of a strong consumer spending environment. This reinforces the value case that was made above; “cheap” stocks are great, but they’re better when the company’s core business is looking good.

Another way to think of this concept is in terms of price-to-consensus divergence. The divergence of the earnings trend and the share price trend is, of course, causing the P/E contraction—yet it can be easier to visualize when both factors are laid out on top of each other:

As we can see, the stock is down significantly from its highs, but it has also run into resistance at the $21 level in recent months, most recently at the beginning of December. The stock tried to mount a post-earnings rally but has since slumped lower throughout the month. Meanwhile, the strong earnings beat and outlook has caused its full-year and next-year EPS expectations to improve over that time.

Eventually, we expect the trend in earnings and share prices to coordinate. When we see this type of divergence, it is often a great buy signal, since investors can get the positive earnings trend for a discount.

To make the pot even sweeter, ANF is also a great dividend option if you’re interested in holding it for the long-run. The company has paid a consistent $0.20 per share quarterly dividend for several years now, and that currently yields about 4.3% on an annual basis.

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