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Market Update

Abercrombie & Fitch Remains Resilient in Second Quarter

Abercrombie & Fitch continues to outpace its teen apparel peers, but outperformance already priced in.

 Abercrombie & Fitch (ANF) continued to outpace its teen apparel peers during the second quarter, including a 9% increase in consolidated comparable-store sales (compared to the previously announced 14% plunge at  Aeropostale  and our expectations of a mid-single-digit decline at  American Eagle (AEO)) and 150 basis points of operating margin expansion to 5.1% despite a challenging raw material cost backdrop. Second-quarter results keep the company on track to meet our full-year expectations--including top-line growth in the high-teens and operating margins around 10%--and we are leaving our $62 per share fair value estimate unchanged.

Despite a somewhat cautionary tone from management about the flow-through of cost pressures during the back half of the year and increased macroeconomic uncertainty (not to mention management's tongue-in-cheek brand association concerns with MTV's The Jersey Shore), we expect A&F to outperform its peers for the remainder of the year and into 2012, driven by cleaner inventory positions and a generally more affluent target audience. Still, we believe the market has given the company too much credit for this outperformance, and we find the shares modestly overvalued at current levels. While we believe A&F warrants a premium valuation relative to its peers, we view many of the pressures facing other teen apparel retailers as more cyclical than structural in nature, and expect the valuation gap to normalize as macroeconomic conditions improve over time.

The direct-to-consumer and international channels continued to be A&F's key growth drivers during the second quarter, up 28% and 74%, respectively (though admittedly building off smaller bases). Abercrombie's domestic operations were strong as well, with comparable sales gains at namesake A&F, abercrombie kids, and Hollister of 5%, 7% and 12%, respectively--suggesting market share gains. Although the company will start to lap more difficult comparisons as the year progresses, we continue to view high-single-digit comparable-store sales and high-teen revenue growth as realistic assumptions for 2011.

A&F's gross margin trends reversed from a 230-basis-point gain in the first quarter to a 150-basis-point decline in the second quarter to 63.6%. Still, much of this decline was anticipated as cotton cost protection measures rolled off during the quarter and operating margins remain well ahead of most of the teen apparel category. We continue to believe operating margins are on pace to be in the low-double-digit range for the year, especially if price increases planned for the third quarter are successful. Price increases have not been fully rolled out at this point, though early checks have not signaled much resistance among A&F consumers so far.

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