Abercrombie & Fitch Continues to Struggle; Might Be A While Before It Can Bounce Back

Abercrombie & Fitch‘s (NYSE:ANF) sales declined for the seventh straight quarter as the teen retailer struggled to attract customers in what is a relatively weak retail market. The retailer stumbled as its comparable store sales declined by 14%, its revenues decreased by 12%, and its gross margins shrunk by 130 basis points. We do not expect Abercrombie to perform better in the near-term as the company continues to execute poorly in relatively weak retail markets.

To get better in the future, the company has to effectively address the inventory problems that have troubled it in the past. Otherwise, it will continue losing customers to competitors offering the merchandise they seek. In an effort to resuscitate its brand image and broaden its reach, Abercrombie will start offering plus sized clothes, reversing its earlier stated focus on only cool and lithe teenagers. Still, the controversy over its prior policies persists and it might not see any positive effects in the near-term. In addition, the company has decided to close its Gilly Hicks stores to primarily focus on its core business. However, this chain is small and its closure will not liberate too many resources for Abercrombie. At this point of time, only the retailer’s direct-to-consumer business appears to be the key growth driver.

Our price estimate for Abercrombie & Fitch stands at $40, implying a premium of about 15% to the market price.

See our complete analysis for Abercrombie & Fitch

Inventory Management Needs To be Better

Abercrombie has had a difficult time in managing its inventory, which has impacted its sales growth. It went through most of fiscal 2012 trying to clear surplus inventory that dragged its comparable store sales down. High inventories prevented the retailer from launching new collections on time, which drove away its customers. Moreover, Abercrombie had to usher heavy markdowns to attain a clean inventory position, which weighed heavily on its comparable store sales growth and gross margins. In early fiscal 2013, the retailer’s inventory levels dipped too low, leaving it with less to sell. This resulted in significant weakness in the first quarter in comparable store sales. During this third quarter, total inventory at cost increased by a staggering 22%, while overall sales declined by 12%. This clearly suggests that once again the company failed to stock merchandise that would sell. That said,management indicates its fall merchandise inventory should fall to appropriate levels in the seasonally strong fourth quarter. Moreover, they plan to bring the levels of Spring merchandise inventory up, having ended last fiscal year understocked. ^[1]

It is clear that Abercrombie needs to have a firm grasp over its inventory control if it wants to get better in future. Urban Outfitters (NASDAQ:URBN) and Limited Brands (NYSE:LTD) are good examples of disciplined inventory control. By providing their customers with relevant fashion in accordance to the changing seasons, these retailer’s have acquired a loyal customer base. The main reason behind Abercrombie’s inventory problems is its buying strategy. The retailer’s buying process is focused on anticipating the success of upcoming fashion trends followed by appropriate bulk purchases. Although it predicts the success of these fashion trends through rigorous testing and R&D, there is always an associated risk when fashion is changing rapidly.

Abercrombie is working on shortening its lead times by sourcing products from within the U.S. and low cost destinations of Central America. The retailer is also increasing its vendor collaborations to utilize its supply chain expertise during product development cycle, which will help in timely delivery of merchandise. We believe that the company can improve its inventory management over time as it operates a diverse supply chain with more than 150 vendors across 20 countries, with no single vendor accounting for more than 10% of its inventory. However, the near term does not look too promising for Abercrombie.

Adding Plus Sized Clothes To Its Portfolio Might Not Have An Immediate Impact

To mend its brand image and expand its customer base, Abercrombie has decided that it will start offering plus size clothes for U.S. women. ^[2] Few months back, the website Business Insider pointed out that the company does not offer XL, XXL and above-10 sizes for women. Although this was a part of Abercrombie’s strategy to keep a firm focus on thin women in order to clinch a distinct market position, it ended up hurting its brand image. This news shed a new light on Abercrombie’s CEO Mike Jeffries’ long standing strategy to exclusively target slimmer, better looking and popular “cool kids”. ^[3]

This sounded offensive to a number of consumers and the retailer faced significant criticism in media. In response, Mr. Jeffries retracted his comments and apologized for his choice of words. Now as the company is struggling for growth, it decided to focus on plus sized women as well. Though the move seems right, we do not expect Abercrombie to benefit from it in the near-term. It might be a while before offended customers make their way back to the retailer’s stores and websites.

Abercrombie Is Closing Gilly Hicks Stores To Focus On Core Business

Through its Gilly Hicks brand, Abercrombie offers a wide range of undergarments and sleepwear. The retailer launched this chain in 2008, and currently operates 20 such stores in the U.S. and 8 stores in international markets. ^[4] Since this is a small business and was not performing well, Abercrombie decided to close the brand’s free standing stores. Gilly Hicks operates in a highly competitive market against players such as Victoria’s Secret, Aerie, and Frederick’s of Hollywood. Moreover, it is rather expensive and its store design is confusing. With this closure, Abercrombie plans to divert its focus and resources to its core business.

However, the company will continue to offer this brand through its Hollister stores. It even witnessed some initial success for this strategy. ^[1] We believe that Abercrombie should develop Gilly Hicks through alternate channels as intimates are doing well in the U.S. It is a niche market segment, which is more resilient to unfavorable economic headwinds. In the present scenario, intimates market is growing despite a lull in the overall apparel market, which is evident from Victoria’s Secret’s results.

Direct-To-Consumer Business Looks Promising

Despite Abercrombie’s weak results during the third quarter, its direct-to-consumer revenues increased by 10%. This business registered strong in all the regions with Asia being the strongest performer. The company stated that the investments made in this channel in the past are finally paying off. ^[1] However, this channel accounts for just 16% of Abercrombie’s net sales and hence, was not strong enough to have a noticeable impact on its results.

Nevertheless, it has been growing at a rapid pace over the past few years and we expect this growth to continue in the future. During the last three year, Abercrombie’s direct revenues have grown at an average annual rate of over 35%, which has resulted in an increase in online revenues’ proportion in the retailer’s net sales. From 10% in 2009, the proportion increased to 16% in 2012. As the outlook for global online apparel retail is very optimistic, we expect this figure to reach 26% by the end of our forecast period.  To propel this growth, Abercrombie is reducing the number of SKUs in its stores and adding more to its websites. ^[1]

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1. Abercrombie & Fitch’s Q3 fiscal 2013 earnings transcript, Nov 21 2013 [↩] [↩] [↩] [↩]
2. Abercrombie promises more styles, sizes for women, Reuters, Nov 6 2013 [↩]
3. Abercrombie & Fitch Refuses To Make Clothing For Large Women, Business Insider, May 3 2013 [↩]
4. Abercrombie to close its Gilly Hicks stores, The Columbus Dispatch, Nov 6 2013 [↩]