Unexpectedly, Abercrombie & Fitch Rallies

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Longtime Abercrombie & Fitch (NYSE: ANF  ) shareholders woke up to some great news today -- their shares are down 17% year to date. Champagne time! But seriously, they were probably pretty excited, since the stock was down 32% when they went to bed the night before. Thanks to some much better than expected earnings in the third quarter, and a revised annual income forecast, Abercrombie shares jumped more than 30% today. So what changed, and what does it mean for the long term? Also, does anyone know how to put a cork back in a bottle of preemptively popped champagne?

Where'd all that money come from?
Abercrombie's good news was driven by a 9% increase in revenue. Due to cost decreases, that increase in sales translated into a massive 40% increase in income, with the company booking $0.87 per share last quarter. Analysts had been expecting only $0.59 per share, which helped bump up the stock price throughout the day. As an added treat, Abercrombie revised its yearly earnings forecast up to the $2.85-$3.00 per-share range. Good news travels fast, and the stock's surge helped Guess? (NYSE: GES  ) and Areopostale (NYSE: ARO  ) , with both companies up more than 2% on the day.

As I said above, the biggest income generator for Abercrombie wasn't its increase in sales, but the relative decrease in cost of goods sold. The company managed to push its gross margin up from 60% last year to 62.5% this year. On top of that, it cut its store and distribution expenses by a few points, to generate that increase at the bottom line. Overall, operating income margin rose from 7.4% last year to 9.6% this year. So is it time to jump into this skyrocketing retailer?

The not-so-great news
I'd hold off for at least a few more paragraphs. The driver of real sales strength in retail is same-store sales increases. Yes, Abercrombie cut costs and saw cotton prices fall. Yes, the bottom line jumped. But overall same-store sales fell by 3%. While the company managed a 2% increase in the U.S., international same-store sales were dragged down 18%. That was due largely to the more than 20% decline in the U.K., where Abercrombie is clearly struggling. That decline brings the year-to-date same-store sales position to a 6% fall, and no amount of cost-cutting is going to change that.

Abercrombie has an answer to the drop in sales at the London flagship: cannibalization. Management claims, not unfairly, that as it expands its European footprint, it's going to start cutting into its own sales. Opening a Hollister in the same market as an Abercrombie & Fitch will hurt sales. Opening a store in Paris means that Parisian visitors to London are less likely to drop a huge chunk of change at the U.K. store. Apparently, that reasoning has rung true with investors.

If it is true, then Abercrombie could very well be in a position similar to where Gap (NYSE: GPS  ) was this time last year: a brand down on its luck, implementing important changes to make it relevant once again. Abercrombie is changing its delivery model in order to cut down on the time it takes to move a product from design to sale. That should help its same-store sales, as products in the store will be trendier, and hopefully be on sale before competitors release similar styles.

CEO Michael Jeffries highlights the value of speedy delivery when talking about the company's ability to be current. He said, "[W]e've always paid attention to runway and street [fashion]. We're spending more time reacting to it more quickly than we ever have." That's a good move for Abercrombie, which, by its own admission, was doing a poor job of moving inventory earlier this year.

The bottom line
If Abercrombie can keep up its relevancy, and find a way to staunch the same-store sales bloodletting, then it should have a good run in front of it. Look at what Gap was able to do by moving clothes to the store faster and being more well-defined in its own brands. Last year at this time, Gap was trading at $20 per share, with earnings per share of $0.75 through the first half of the year. Now, it's trading at $34 per share, and earnings have increased over 30%.

Abercrombie could be moving into that same style of recovery, but investing on one quarter of goodness is a big leap of faith. I'd hold out until after the holiday season, when the company's new model has a chance to get tested while under fire. Until then, tide yourself over with our free report on 3 Companies Ready to Rule Retail. It's just for Motley Fool readers, and you can claim your free copy today, simply by clicking here.

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