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Do you believe that Abercrombie & Fitch was correct in rescindingin shareholder rights plan (i.e. poison pill)? Why or why not? Who benefitted most from ANF’s takeover defenses: shareholders or management?The Future of Abercrombie & Fitch At year-end 2013, Abercrombie & Fitch found itself at a pressure filled cross roads. After several years of poor performance and unsuccessful strategy redesigns, the company was being compelled to quickly remake itself and reinvigorate its brands, or face a possible reorganization or sale to a competitor, corporate activist, or other private-equity group. This case is developed solely for the basis of classroom discussion and is not intended to serve as an endorsement, or to illustrate effective or ineffective management. Fall 15 08 Fall The Future of Abercrombie & Fitch 1 Introduction1 On January 27, 2014 Abercrombie & Fitch [ANF] officially ended the company’s rights agreement (aka poison pill), originally dated July 16, 1998. The rights agreement granted shareholders that owned less than 10% of the shares outstanding to purchase one new share for every share held, at a 50% discount to the market price, if and when any other shareholder increased his or her holdings to more than 10% of the shares outstanding without prior board approval. At the same time the board also decided to add three new directors, increasing the total number of board members to 12 from nine. Many investors hoped that the voiding of the rights agreement and the new additions to the board would be one of the final steps to complete a competitive repositioning in the retailing industry. Board composition in the industry was changing as competition was becoming more heated and more global. In the past ten years many companies had populated their boards with members that had an increasing amount of industry experience and expertise, and had demonstrated a high level of success in past industry endeavors. However, Engaged Capital LLC, a disgruntled activist shareholder, had already informed Abercrombie & Fitch that it believed that ANF should add 5 new seats to the board, and indicated that it had 5 nominees for the new board positions. Moreover, it previously communicated in December 2013 that it did not want the board to renew the employment contract of the 69-year old CEO Michael Jeffries (who owns 4.1% of shares), which was set to expire on February 1, 2014. ANF responded that it intended to offer Mr. Jeffries a new one-year contract.2 Even though Engaged only held 0.5% of ANF shares, it managed hundreds of millions of dollars and was prepared to start a proxy contest if the board did not respond to its demands in a meaningful way. As an alternative, Engaged suggested that ANF put itself up for sale to a private equity firm. 1 Abercrombie & Fitch Co. (A&F) is a retailer that operates stores and direct-to-consumer operations. The Company operates through three business segments: U.S. Stores, International Stores and Directto-Consumer. The U.S. Stores segment includes store operations in the United States and Puerto Rico. The International Stores segment includes store operations in Canada, Europe, Asia, Australia and the Middle East. The Direct-to-Consumer segment includes operations directly associated with on-line operations, both United States and international. A&F sells products, including casual sportswear apparel, including knit and woven shirts, graphic t-shirts, fleece, jeans and woven pants, shorts, sweaters and outerwear; personal care products, and accessories for men, women and kids under the Abercrombie & Fitch, abercrombie kids and Hollister brands. It also sells bras, underwear, personal care products, sleepwear and at-home products for girls through Hollister under the Gilly Hicks brand. 2 Mr. Jeffries new contract included $1.5 million in salary, $6.5 million in incentives, $4.5 million in bonuses, and use of the ANF corporate jet. The Future of Abercrombie & Fitch 2 Shareholder Activism and ANF’s Tumultuous Past Formerly labeled corporate raiders, activist investors have undergone an image makeover during the past decade (following the adoption of Dodd Frank legislation) and instigated sweeping overhauls at dozens of publicly traded companies. More than ever before, these shareholders are making their voices heard. Their intention is to create shareholder wealth by persuading or coercing management to boost returns through better operating strategies, increased share buybacks, higher dividends, divestitures, or even a breakup or outright sale of the company. “In general, activist hedge funds are estimated to have more than $100 billion of total collective assets under management, with approximately $10 billion to $12 billion invested in activist hedge funds in 2013,” said Lois Herzeca, a partner at Gibson, Dunn & Crutcher LLP and co-chair of the firm’s fashion, retail and consumer products group. According to FactSet, activists took action against 206 companies in 2013. Many of these actions involved companies in the clothing and teen clothing retail sector. For example, Blackstone group had recently invested $200 million in Crocs in exchange for two board seats. Barrington Capital Group LP arranged a going private transaction with the Jones Group, which was later split into four separate companies by Sycamore Partners LLC. Other Sycamore investments include stakes in women’s fashion retailer Talbots and teen retailer Hot Topic Inc. In another recent going private transaction, Mill Road Capital acquired R.G. Barry for $215 million. Finally, Aeropostale became the most recent target in the space. In November of 2013, Hirzel Capital purchased a 6% stake in the company after its stock price had declined by over 27 percent. Hirzel indicated that Aeropostale was an attractive investment at the current price. As a counter to the Hirzel investment, (which together with a Sycamore subsidiary owned more than 14% of shares) Aeropostale adopted a poison pill. Like Aeropostale, Abercrombie & Fitch was facing stiff competition from the same up-and-coming brands. Leslee Herro, executive vice president for planning and allocation said, “We recognize that our businesses have been and will continue to be disrupted by both fast fashion, H&M, Forever 21, and pure-play e-com competitors.” Change was needed but was also delayed in coming. Activist shareholders had engaged Abercrombie & Fitch’s management team for several years because of its poor strategic choices, deteriorating performance, and executive pay. For example, during the 2010 directors election,two compensation committee members at Abercrombie & Fitch received more than 40 percent opposition amid a “vote no” campaign by the American Federation of State, County and Municipal Employees (AFSCME) Pension Plan. The labor pension fund raised concerns about succession planning and entrenchment, and argued that the committee has “approved guaranteed pay that fails to link pay to performance.” AFSCME also cited a $4 million lump-sum payment for ending CEO Michael S. Jeffries’ company aircraft The Future of Abercrombie & Fitch 3 usage as a significant concern. In response to A&F’s years of slumping performance, the retailer’s board ousted Jeffries from his position as chairman of the company in early 2014. Arthur Martinez, formerly the top executive of Sears, was named Jeffries’ replacement. Jeffries will remain CEO of the company. Jeffries recently came under fire both for his stewardship of the company and for a series of public relations gaffes. In 2012, he said that Abercrombie & Fitch only intended it’s clothing to be worn by “cool kids,” a statement that was interpreted as a condescending snub of many teen shoppers. The retailer has also weathered persistent criticism that it neglects to offer larger sizes for women, further reinforcing the perception of its elitist exclusion of many consumers. Recently, Engaged Capital LLC pushed Abercrombie & Fitch to force Jeffries to relinquish his spot on the board or to sell the firm outright. Tensions between the retailer and disgruntled investors reached such a fevered pitch that the company entertained the possibility of resorting to activating another “poison pill” in order to prevent a hostile takeover, but later announced it would not avail itself of such a drastic measure. While shareholder activism can result in substantial shareholder gains, it doesn’t always result in favorable outcomes. William Ackman of Pershing Square did J.C. Penney Co. no favors when he pressured the company to adopt his ill-fated plan to revive the retail chain. Ackman attempted to give J.C. Penney an extreme makeover by attempting to revitalize its brand, reimage its retail stores, and leverage its balance sheet to repurchase shares. The failed attempt caused Ackman to step down from the board last year, followed by reports that he lost more than $700 million on the bet. “Shareholder activism has a spotty track record,” said Morningstar analyst Paul Swinand. “In the case of J.C. Penney, Ackman ran the thing into the ground. While he monetized some of the assets, he put those unlocked proceeds toward covering losses.” Another criticism is that when aggressive shareholders take stakes in undervalued businesses ?and use their power to unseat boards, sell assets or even file for bankruptcy ?company share prices get an artificial boost. Some argue this serves activists’ short-term motives and can be detrimental to the more passive, longterm investors. “Some activists have been less than successful because a business turnaround in retail can take many years to accomplish, which doesn’t match their time frame. If you want to make a turnaround in the branded apparel sector, it’s easier to be a private company outside the glare of Wall Street analysts,” said Herzeca, identifying Kenneth Cole as a formerly listed company that has benefited from going private. The Future of Abercrombie & Fitch 4 The Turnaround Strategy3 By year-end 2013,ANF was engaging in dramatic cost cutting including closing U.S. stores (including all Gilly Hicks stores), and reemphasizing cyber retail and sales in Europe. ANF had already closed 170 retail storefronts in the U.S. over the past couple of years. ANF’s senior vice president for global real estate, David Leino, said, “The rationale for this is very obvious. The continued shift to customer spending online will make this necessary, especially in underperforming malls.” ANF had also begun price-cutting as a means to boost sales. The challenges facing ANF are broad and sizable. Analysts believe that ANF’s problems stem from an overall lack of store traffic and rapidly declining productivity. For example, its U.S. same-store sales declined 14 percent in the third quarter of 2013. Cowen Group, one of the more pessimistic financial analysis firms following ANF, believes that its international sales are also rapidly plummeting and has forecast 2014 earnings per share at 72% of the industry consensus forecast. Figure 14 – U.S. and DTC Comparable Sales: Quarter over Quarter 3 A&F’s New Turnaround Strategy: Change Everything; It’s Not Working, Sourcing Journal, March 18, 2014. 4 Bank of America Merrill Lynch Consumer & Retail Conference, March 2014. DTC is direct to consumer, or online, sales. The Future of Abercrombie & Fitch 5 John Kernan, CFA at the Cowen group, noted the limitations of shifting business online as the centerpiece of a turnaround strategy. “There’s only so much you can accomplish solely on the basis of omnichannel shifts. Ultimately, any successful sales model requires a product your targeted consumer wants.” He also observed that an emphasis on cost cutting, rather than providing desirable products, will likely result in brand erosion, especially overseas. This was a concern among many analysts as AFN continued to develop its presence abroad, especially in the Middle East and Asia. Wendy Liebman, CEO of Strategic Retail observed, “There is an opportunity there. The problem is that if you don’t have a successful brand at home, going global isn’t going to save you. People go online. They’re going to see the backstory.” Another important part of the revitalization strategy was to improve Abercrombie & Fitch’s online presence. To do this, ANF is partnering with First Insight Inc., a consulting firm specializing in product investment and pricing decisions. Insight’s job is to establish more accurate predictive models for ANF and to run weekly tests and monitor feedback in an attempt to attract and retain fickle teen consumers. However, analysts were also skeptical of this part of the strategy and felt that ANF had already squandered much of the premium positioning it once had with teens and noted that the deterioration was so extensive that ANF was forced to shift its marketing strategies to an older demographic, including an increased focus on college-aged consumers. Jonathan Ramsden, COO and CFO of Abercrombie & Fitch, observed that the new product lines that appeal to a more mature sensibility are part of wanting to separate the brands more, and to reinforce the premium perception of Abercrombie. He said “It’s an opportunity to connect Abercrombie & Fitch with its heritage and move it up in demographic.” Furthermore, in an effort to recapture some of the luster among teens the brand has lost, ANF is now exploring the possibility of selling thirdparty products in its stores. CEO Mike Jeffries said that tough times compel the company to investigate opportunities “outside of the confines of our existing vertical specialty retail model.” He continued, “”We have a long list of additional collaborations in the works, across footwear, apparel and accessories, which we are excited to launch in the coming months.” And although A&F is only in the nascent stages of considering such a move, many believe it intends to sell other brands aggressively as a “positioning device,” which means the move is an attempt to redeem its name by association. The Industry Outlook Abercrombie & Fitch In addition to the strategies given above, ANF management presented investors with the following goals: The Future of Abercrombie & Fitch 6 Achieve significant ROIC improvement through: 1. Operating margin expansion ?Recover productivity in U.S. stores, ?Maintain profitable international growth, ?Increase DTC penetration, ?Reduce expenses. 2. Disciplined capital allocation ?Maintain capital expenditures at ~$200 million per year, ?Prioritize DTC and IT investment short-term, ?Achieve minimum 30% ROI hurdle, ?Return cash to shareholders. Based on these objectives, ANF offered 2014 EPS guidance of $2.15 – $2.35. They also indicated that full year comparable sales would be 3% to 4% below 2013, that gross margins would be slightly down, and that capital expenditures would be approximately $210 – $220 million. The following data are the consensus projections from the 35 analysts covering ANF: Projection 2014 Revenue $3.8 – $4.2 B 2014 EPS $1.16 – $1.27 2015 Revenue $3.8 – $4.3B 2015 EPS $1.26 – $1.36 The analyst’s projections were somewhat less optimistic than those provided by ANF management. The Retail Industry5,6,7 Projections for retails sales were mixed. Because the price of oil had been declining slightly, some analysts felt that the increase in discretionary income would go to new clothing purchases. However, other analysts argued that the increase would be spent on durable goods, including replacing old automobiles. The general consensus for apparels sales growth for 2014 and 2015 is 1% to 3% annually, consistent with expected growth in U.S. GDP and consumer spending, but somewhat higher than expected growth in other parts of the world. Between 2005 and 2013, annual U.S. retail apparel revenue grew at less than 1% per year. Furthermore, a number of retail apparel establishments grew at an annual rate of 0% between 2007 and 2013. That rate is expected to increase to approximately 2% through 2021. 5 Value Line Research; Retail Sector, January 2014. 6 Standard & Poors Capital IQ, Industry Surveys: Specialty Retail August 2013. 7 IBISWorld Industry Report (NAICS) 44814. The Future of Abercrombie & Fitch 7 Questions 1. What are the favorable and unfavorable effects of corporate activism? In general, is the role of corporate activism healthy or unhealthy for shareholders and financial markets? Why? 2. Do you believe that Abercrombie & Fitch was correct in rescinding in shareholder rights plan (i.e. poison pill)? Why or why not? Who benefitted most from ANF’s takeover defenses: shareholders or management? 3. What is the value of Abercrombie & Fitch based on multiples of EBITDA and EBIT? On what basis did you form your peer group? 4. What is a reasonable range of value using the DCF methodology and assuming ANF remains an independent going concern? 5. In your opinion, is Abercrombie & Fitch a good takeover candidate? Why or why not? 6. Consider Abercrombie & Fitch as an LBO candidate. What are some characteristics that make ANF a good LBO candidate? What are some characteristics that make ANF a poor LBO candidate? Do you believe that ANF should consider an LBO or an MBO? 7. As a shareholder of Abercrombie & Fitch, would you continue to hold your shares or would you sell them? Why?AccountingBusinessFinancial AccountingFINANCE 668

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