Abercrombie & Fitch and Aeropostale Are Making the Same Mistake

When a company is unwilling to change its business model even in the face of clear problems, investors should avoid the shares.

Mar 24, 2014 at 12:00PM

It's all too easy for certain retailers to suggest that harsh weather or changing buying patterns are the cause of their current troubles. However, it's more likely that some of these retailers are struggling because they refuse to accept that their business model is flawed.

In a recent report by USA Today, two of the top nine retailers closing stores were Abercrombie & Fitch (NYSE:ANF) and Aeropostale (NYSE:ARO). In both cases, the companies are making the same mistake. Neither company will admit it must drastically change its ways to become relevant again.

Video killed the radio star
In the same way that video may have killed the radio star, a popular idea is that Internet shopping is killing physical retailers. There is just one problem with that theory -- it's wrong. According to the Census Bureau, only 6% of 2013 sales were conducted online.

A bigger problem for many retailers is that customers have changed their habits. As a result, mall shopping isn't what it used to be. Years ago, the mall was also seen as a meeting place or a hangout spot for teenagers and adults alike. With the rise of companies like Target and Wal-Mart coupled with multiple ways to connect to people online, meeting at the mall doesn't happen as frequently as before.

When you combine the lack of interest in going to the mall with the rise of social media and online shopping, you have a nasty cocktail for physical retailers to swallow.

Abercrombie & Fitch is moving in the wrong direction
Abercrombie believes it can update its business model and make a shift to lure in older shoppers. In addition, Hollister will reportedly adopt a "fast-fashion" approach.

Unfortunately, the only thing happening fast at Abercrombie is the company's sales decline. In the most recent quarter, Abercrombie's U.S. sales declined by 13%, and same-store sales declined by 15%. By comparison, Gap (NYSE:GPS) witnessed a total sales decline of 3.2%, but same-store sales increased by 1%.

The challenge for Abercrombie is that the company must undo everything it has done to build its brand. A visit to the company's main website shows perfectly fit models wearing jeans that cost $35 or tops that cost $29. If the point is to attract older shoppers, they are likely to be more value conscious and $35 for jeans or $29 for a top may be considered too expensive. Keep in mind this is the same demographic that is used to stopping by Target and picking up these items for half the price or less. In addition, Gap's Old Navy website various items for $5, $10, and $15.

Old Navy is a value brand for everyone in the family, which helps explain why this business' same-store sales stayed flat while other companies saw declines. Gap shows a similar discount model with clothes for everyone; it witnessed a 1% global same-store sales increase. The Gap seems to understand that the economic challenges of the last several years has made the vast majority of shoppers less willing to pay a premium for clothing.

The big problem for Abercrombie is that the company can't afford to change its strategy from a high-end and limited audience retailer to an every-man type store and maintain its 59% gross margin. The company believes its same-store sales will decline by high single-digits in 2014; this just seems to confirm Abercrombie isn't willing to make the wholesale changes necessary to turn the company around.

A mall-based retailer
Considering what we know about mall shopping, it is a huge problem that Aeropostale describes itself as "a mall-based retailer." The turn of phrase alone should cause investors to run for the hills as shoppers are running from the teen retailer.

Aeropostale is focused on 14 to 17 year-olds, and the demographics of the industry don't favor this intense focus. With just 10% of total clothing sales occurring in the children's clothing business, Aeropostale must get its merchandising right to succeed.

The company saw adjusted sales decline 9.5% and same-store sales drop by 15%. Clearly Aeropostale is missing the mark. Further proof of Aeropostale's challenges are seen in the company's online sales decline of 4.8%. Considering that the struggling Abercrombie witnessed an 18% online sales increase, Aeropostale seems to be lagging with customers both in person and online.

Even more disturbing is that Aeropostale's gross margin of just 13% pales in comparison to Gap's 38%. Given that The Gap, Gap Kids, and Old Navy all cater to the same customers as Aeropostale, it seems the trouble is with Aeropostale's extremely narrow focus.

They are who we thought they were!
When Dennis Green coached the Arizona Cardinals, he famously shouted in a press conference, "They are who we thought they were!" He was angry that his team gave up a lead near the end of a game.

This is very similar to the Abercrombie and Aeropostale stories. Both companies had promise. Both companies were growing and offering clothing that customers wanted. However, now in the all-important fourth quarter, when it's all on the line, these companies are resting on their laurels. Without major changes they will continue to struggle. Until these companies change their core strategies, investors would be advised to avoid the shares.

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Chad Henage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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