Abercrombie & Fitch Earnings Preview: Revenue Decline Likely To Slow

For some time now, Abercrombie & Fitch (NYSE:ANF) has been struggling to attract customers who have lost interest due to a number of factors, including its weak inventory management, and premium prices, as well as its slack response to changing fashion trends and fierce competition from fashion-forward brands. Over the past four quarters, the retailer’s sales have fallen by an average of 9% year over year.  Although its Q1 earnings were slightly better than analysts’ estimates, comparable sales declined by 4% on account of adverse weather and low brand loyalty. We expect the company’s sales decline to continue in the second quarter of fiscal 2014, albeit at a slower pace.

Abercrombie’s Q2 results are scheduled to be released on August 28. Analysts are predicting revenues will fall by 4% year over year, which is slower than the recent  rate. While the  industry-wide fall in foot traffic will impact the company’s comparable sales growth, a revamped Hollister brand can have a partially mitigating effect. Also, the integration of better fashion in the retailer’s namesake brand might have helped it scale back on promotional activities, which can have a positive impact on comparable sales growth.

Apart from revamping its fashion content, Abercrombie is planning to bring its prices down to a more competitive level. To ensure that this move doesn’t put pressure on its margins, the retailer is taking certain steps to lower its SG&A expenses and source goods at cheaper prices. These strategies helped the company reduce its revenue decline rate to just 2% in Q1, which indicated that its recovery was underway.

Our price estimate for Abercrombie & Fitch stands at $39.72, which is more than 10% below the market price.

See our complete analysis for Abercrombie & Fitch

Foot Traffic Decline To Weigh On Results

Due to the increased proliferation of smartphones and tablets, and the convenience of shopping on the Internet, U.S. buyers have been making more purchases online. Consequently, they are visiting  stores less frequently, which is a concern for a number of retailers including struggling Abercrombie. As per the data compiled by ShopperTrak, a firm that tracks store traffic in over 40,000 outlets across the U.S., store visits have fallen consistently by close to 5% year over year in all the months of the past two years, barring April 2014. This is impacting sales at Abercrombie, which earns close to 80% of its revenues from store sales. ((Gap, L Brands Drive July Retail Sales, The Wall Street Journal, Aug 7 2014))

Even if we consider the industry-wide fall in foot traffic as a proxy for traffic decline at Abercrombie, we get a minimum of 5% store traffic decline in the second quarter. However, Abercrombie has its own problems when it comes to attracting customers, and hence there is a possibility that its traffic decline in Q2 was worse than 5%.

However, Better Fashion Might Have Helped Abercrombie Attract Customers

Taking cue from successful low-cost fast-fashion brands such as Gap Inc (NYSE:GPS), Urban Outfitters(NASDAQ:URBN) and others,  Abercrombie is looking to revamp its product portfolio. The company is working on improving its designs, shortening lead times and increasing style differentiation to offer a better variety of fashion assortments and remain responsive to changing trends. Abercrombie’s partnership with First Insight Inc will enable it to test its products much earlier in the product development cycle and plan their launch accordingly. Management has retained First Insight Inc., a company that leverages online social engagement tools to study consumer preferences and provide predictive analytics. It also incorporates customer feedback before giving a recommendation to Abercrombie. In its Q4 quarterly update, the retailer stated that it was testing 100% of its assortments, which will help it better understand customer tastes, and reduce the risks related to its fashion launches.

Additionally, the company is employing a vertical organization structure for categories such as planning, merchandising and design for each individual brand. Along with brand differentiation, this should help Abercrombie effectively address the needs of its business. The retailer is utilizing new fabric platforming techniques to increase its speed to market and it started including vendor designed products in its merchandise mix Q1 fiscal 2014 onwards. Overall, we expect these efforts to translate into a more appealing product range that can help Abercrombie attract customers. However, Abercrombie’s brand image has taken severe damage over the past several quarters due not only to its missed fashion calls and but its CEO’s controversial comments on the body sizes of its customers.  Accordingly, a turnaround seems unlikely.   However, the company’s sales decline in Q1 was much slower than what it has been in preceding quarters, and we expect only a modest decline in this quarter as well.

Revamped Hollister Might Have Had A Small Impact

Being a value focused brand, Hollister is the most integral part of Abercrombie’s product portfolio, given that buyers are placing a greater value on the cost of products these days. However, the brand hasn’t been at its best for the last few quarters due to missed fashion calls and poor inventory mismanagement. As a result, buyers have moved to other low-cost fast-fashion brands such as Zara, Forever 21 and H&M. To win back customers, Abercrombie is making certain tweaks to its Hollister store structure. At the start of the year, the company started testing a new storefront for its Hollister stores, which it plans to roll out in another 75-100 stores by the year end. The retailer is also planning to change the environment inside Hollister stores, which is traditionally dark and heavily scented. In Q1, Abercrombie redesigned the brand website and recently launched a new marketing campaign that features an evolved image of the brand. We believe that these strategies might have garnered customer attention to some extent in Q2, that might have had a slight positive impact on store traffic.

Cost Savings Can Help Margins

Abercrombie is planning to reduce the cost of its clothing, to help offer products at lower prices without much pressure on its margins. The closure of its intimate brand Gilly Hicks is also expected to have a certain positive impact on its cost savings. The retailer closed 16 Gilly Hicks stores during Q4 fiscal 2013 and shut the remaining ones in the first quarter of 2014. In Q4 last earnings call, the company stated that it saved nearly $25 million during the fourth quarter as a part of its profit improvement initiative. For fiscal 2014, Abercrombie expects to save $175 million in areas such as store repairs and maintenance, store packaging, IT, supplies, and corporate overhead.

With better fashion content and lower product prices, the retailer should be able to drive greater store traffic and operate with fewer markdowns. Moreover, its enhanced savings can have a slight positive effect on its operating margins. That said, the impact of these factors might not be strong enough to pull Abercrombie out of its slump.

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