SLS Management, LLC Issues Letter to Abercrombie & Fitch Co. Identifying Steps to Maximize Value for Shareholders

NEW YORK, July 18, 2017 /PRNewswire/ -- SLS Management, LLC today sent a letter to the Board of Directors of Abercrombie & Fitch Co. In the letter, SLS outlines actionable steps for the Board of Directors to undertake to maximize value for the shareholders.

The full text of the letter from SLS Management, LLC follows:

July 18, 2017

Board of Directors
Abercrombie & Fitch Co.
6301 Fitch Path
New Albany, OH 43054

To the Board of Directors of Abercrombie & Fitch Co.:

As you are aware, we have been a long-term investor in Abercrombie & Fitch Co. ("Abercrombie" or the "Company"). Despite Mr. Martinez's assurance in the Company's press release on July 10, 2017 that the company is taking "aggressive action", we do not believe the Board has been or is currently being aggressive enough. With an expected average cash position of nearly $500M, other assets worth as much as $300M, and a market capitalization down to around $600M, we believe that there is substantial opportunity for the Board and management team to reverse years of underperformance and create significant shareholder value.

We sent a letter to the Board on April 12, 2017 suggesting an "aggressive" plan of action to enhance shareholder value. We did not hear back. We subsequently spoke to the CEO and COO on June 13, 2017 and recommended that the Company contemplate outlining a clear Plan B for value creation as a standalone company should merger discussions terminate. We were told that no such parallel effort was being sought. This was confirmed on July 10, 2017 with a failed sales process and no "aggressive" announcement regarding actionable plans to create shareholder value. This resulted in Abercrombie's stock being down 21% and trading over 40% of its float in a single day. The stock has continued to trade lower. 

Management continues to promise a better second half and according to press reports the Board turned down offers which were around $13.50 per share, or around 45% higher than where the stock is today. To us, this suggests a deep internal confidence in Abercrombie. Given these factors, the ample cash cushion and substantial non-core assets, you should therefore be aggressively buying back stock and reducing the share count at these levels. Yet, there is no substantial, share-reducing buyback. 

Capital allocation, whether it involves investing in existing operations, making acquisitions or returning cash to shareholders in the form of dividends or buybacks, is a paramount responsibility of every CEO and Board.  William Thorndike in the acclaimed book The Outsiders describes the value creation decisions of Henry Singleton, the former CEO of Teledyne who pioneered alternating between dividends and large tenders depending on the lifecycle and valuation of the company.  According to Thorndike, "Singleton believed buying stock at attractive prices was self-catalyzing, analogous to coiling a spring that at some future point would surge forward to realize full value, generating exceptional returns in the process."

We welcome Abercrombie's commitment to shareholder returns; however, there is a time in every company's life for buybacks and a time for dividends. With the stock trading at current valuations and a margin of safety from the value of non-core assets, this is the time for buybacks. We highly recommend a change to Abercrombie's capital allocation strategy that will drive a significant increase in shareholder value. We are outlining two options. Option A is a large one-time buyback in conjunction with a reduction in your dividend. Option B is a monetization of assets comprising a substantial portion of Abercrombie's current valuation that Wall Street analysts and investors are giving you no credit for. 

Option A

• Initiate a Dutch tender to buy back $200M of Abercrombie stock. At current prices this represents over 30% of shares outstanding 
• Reduce the dividend to $0.18 per year or around a 2% dividend yield

With the dividend yield approaching 9%, it is clear that investors do not own Abercrombie for its stable yield. Indeed, market participants are likely indicating that they expect the dividend to be cut. While we believe that Abercrombie's dividend is sustainable given management's capital expenditure budget, which is well below depreciation expense, and normalization of working-capital outflows in fiscal 2017, this is a unique time to switch strategies and be a material buyer of your stock. A repurchase of almost 30% of Abercrombie's shares would be an important illustration of management's confidence in the turnaround and the attractiveness of the stock at current prices. The cash used would be returned in just over 4 years through the reduction of your dividend, which saves $46M per year.

We fully recognize that retail is suffering, especially at malls due to a number of factors including an over-stored position that exceeds demand and the competitive threat of e-commerce. This dutch tender would leave the Company with a pro forma cash balance of $220M. Given seasonal working capital swings and the substantial reduction in your cash outlays for the dividend, we would expect Abercrombie to be at the Board's target cash balances within one year. Our confidence is augmented by the fact that even in poor operating years such as fiscal 2016 and 2017, free cash flow would easily cover the new $9M dividend and start growing your cash balance. Indeed, management has guided to improving trends as we move through 2017. Given this, and the margin of safety from your non-core assets, we believe that Abercrombie has a unique opportunity to acquire a substantial amount of its shares at discounted levels without adding meaningful pressure to operations, leverage, or cash flow.

Option B

As an alternative to the tender and dividend reduction detailed above, the Company could maintain the dividend and its cash buffer, and monetize Abercrombie's non-core assets and use the proceeds to repurchase shares. The Company has a substantial set of assets on its balance sheet that we believe are worth $205M to $310M or 43-66% of the Company's enterprise value at current prices. These non-core assets include: (i) Home Campus & Distribution Centers and (ii) the overfunded Rabbi Trust. 

Abercrombie owns its 650K+ square foot home campus on 501 acres in New Albany, Ohio. Based on Colliers data on recent comparable office transactions in Columbus, we believe the headquarters and land are worth $100-150M if the company executed a sale-leaseback or mortgaged the property.  A $100-150M valuation for the headquarters and land with a 60% LTV mortgage at 5.0% would only add $3-5M of interest expense, but would enable the company to buy back 10-14% of shares outstanding. Abercrombie could also enter into a sale-leaseback on its two one million square foot state-of-the-art distribution centers built for $176M. We estimate this would lead to $80-120M of proceeds, and enable the company to buy back an additional 13-19% of shares outstanding, with additional rent of only $6.5-8.0M per year. Put simply, these two actions would monetize $175M of non-core assets worth 37% of Abercrombie's current enterprise value and add $12M, or less than 1% to your operating expense base of $2BN.

We recognize that the Board may take comfort in its safety-net of non-core assets. However, with the stock trading at levels not seen in 17 years and at a valuation of 2.5x consensus EBITDA, the value of these non-core assets now comprise a significant portion of the company's enterprise value.

Regardless of which of the above options the Board decides to pursue, we believe the Company should work to unwind the overfunded Rabbi Trust, which sits in Other Assets on the balance sheet and is a legacy of the Jefferies era. Based on our conversations with management, the trust is $25-40M overfunded and could be unwound, providing an additional source of liquidity for the company.

Let's hypothetically illustrate how significant the opportunities on balance sheet are. If you were to execute Option A, Option B and liquidate the Rabbi Trust, the Company could buy back roughly 65% of its shares and save $37M per year ($12M cost of Option A and B and $49M savings from dividend reduction).

We have proposed two actionable plans. Either of these two options should be enacted immediately. If you are right and the back half of the year is a turning point, a significant value enhancing opportunity will disappear.

We look forward to discussing these important matters.

Very truly yours,

Scott Swid

SOURCE SLS Management, LLC