Abercrombie & Fitch’s Aggressive Portfolio Transition Is A Necessary Risk

Abercrombie & Fitch (NYSE:ANF) is risking much by taking a giant leap in its retailing strategies in order to compensate for its lack of evolution. When consumer taste across the industry was shifting from basic logo merchandise to fashion-forward products, Abercrombie failed to age accordingly. Now, with drastic change in its store environment and product portfolio, it is hoping to become an apparel powerhouse yet again.

Many are skeptical about Abercrombie’s sudden change in merchandise portfolio from mostly basic to mostly fashion stating that it can drive away remaining customers, but we believe that it can work out for the best. A complete transition in product portfolio and brand image is proving a “sisyphean” task for other basic apparel retailers who continue to see their sales plummet. However, with sales already falling for Abercrombie, it feels that there is no point waiting long to position its entire merchandise portfolio inline with prevailing consumer taste.

Though there is an element of risk involved, potential rewards are high as a successful transition in products and brand image can reverse the declining trend in Abercrombie’s revenue per square feet, thus justifying our price estimate for the company. Better than expected reception of new products speeding recovery in revenue per square feet across the board holds a potential of over 5% upside for the company. On the contrary, if the risk taken does not pay off and revenue per square feet for the retailer’s brands continues to decline even at a moderate pace, it can lower the company’s value by almost 5%. However, Abercrombie’s sales were falling anyway, but the risk it has taken presents it with a chance to trigger a revival.

Our price estimate for Abercrombie & Fitch stands at $29.44, which is about 30% above the current market price.

See our complete analysis for Abercrombie & Fitch

Rewards At Hand

Abercrombie’s revenue per square feet fell significantly in 2013 and 2014 due to weak response to product offerings. While we project that this decline will continue in mid single digits in 2015 due to the ongoing portfolio transition, figures are expected to improve next year, thanks to the availability of a huge variety of fashion-forward merchandise. Last year, in an earnings call,  management announced that they will reduce their logo business to “almost nothing” within 12 months and replace it with fashion-forward inventory.

The company has been on-track with this strategy so far, removing most of the basic merchandise range from its stores. Though this had weighed heavily on Abercrombie’s sales, it does make way for fresh and more attractive inventory, which should help it entice more customers. In fact, there were some latent signs of recovery in the last quarter in the form of relatively weaker decline in comparable sales, thanks to comparatively better penetration of fashion merchandise in overall portfolio. Once Abercrombie completes the transition and has only fashion forward merchandise in its inventory, it can attract more buyers who are currently shopping at Zara and Forever 21.

Risk Involved

The risk involved in this strategy is that customers may not be able to digest such a drastic change in the brand they have always known for premium basic merchandise. Hence, Abercrombie can lose its loyal customers while trying to gain new ones. Something like this happened with Aeropostale (NYSE:ARO) back in 2013, when it integrated much fashion in one of its seasonal launches, which only confused buyers. Customers accustomed to shopping for basic jeans and t-shirts at Aeropostale shied away from unusual merchandise on display, and others did not want to buy fashion-forward products from a retailer known for cheap basic merchandise. These factors may not prove as intense for Abercrombie, but they could trouble it nonetheless. However, Abercrombie is willing to take this risk in order to recreate itself in the U.S. apparel market. It now depends on how effectively it can market the change in its retail strategies.

The Risk-Reward Balance

After gauging risks and rewards related to aggressive portfolio transition, we have projected only a moderate increase in Abercrombie & Fitch’s (ANF), Hollister’s and abercrombie kids’ revenue per square feet going forward. We believe that despite the complete change in products on offer, brand perception will not change overnight and hence, growth in revenue per square feet will be slow. Moreover, increasing competition and falling foot traffic can offset Abercrombie’s efforts, keeping a check on its growth.

However, the increase in revenue per square feet metrics for all brands will most likely remain steady, given that the retailer will be offering products that customers desire. We forecast that over the next five or six years, revenue per square feet for all the brands will only be slightly above their respective 2014 levels. If customer response to updated product mix turns out better than expected, pushing long term revenue per square feet forecast for ANF and Hollister to $450 and $390, respectively, up from the current projections of $420 and $366, there can be an upside of about 5% to our price estimate for Abercrombie. On the contrary, it these figures move down to $375 and $328, respectively, there can be over 5% downside to our price estimate.