Abercrombie & Fitch: Sustainable Recovery or Short-Term Bounce?

Source: Abercrombie & Fitch.

Teen fashion retailer Abercrombie & Fitch (NYSE: ANF  ) is up by an impressive 28% year to date as investors seem more confident about the company's ability to turn its business around. However, despite some encouraging signs, it is hardly out of the woods yet. Besides, competitors such as American Eagle Outfitters (NYSE: AEO  ) and Aeropostale (NYSE: ARO  ) are facing considerable difficulties, so the competitive landscape will most likely remain challenging.

Beating a low bar
Abercrombie & Fitch reported better-than-expected financial performance for the first quarter of fiscal 2014, but that doesn't mean that the company is necessarily on a sustainable path to recovery.

Total sales during the quarter ended on May 3 declined 2% to $822 million. This was better than the $797.9 million in revenues expected on average by Wall Street analysts, but Abercrombie & Fitch still suffered a big decline of 11% in comparable-store sales at its stores.

Direct-to-consumer sales buffered the decline to a considerable degree, increasing 27% during the quarter. All in all, total comparable sales including both store sales and direct-to-consumer revenues declined 4% versus the same quarter in the prior year. Comparable sales including direct-to-consumer revenues decreased 1% for the main Abercrombie & Fitch brand, fell 6% for abercrombie kids, and declined 7% for Hollister.

Gross profit margin declined to 62.2% of revenues versus 65.9% in the first quarter of 2013, as a higher mix of fall merchandise clearance selling and an increase in promotional activity weighed on profitability.

Abercrombie & Fitch reported a net loss of $23.7 million during the quarter, considerably wider than the net loss of $7.2 million it registered during the same period in the prior year. Earnings still came out ahead, though, as the company reported a net loss of $0.17 per share versus forecasts of a net loss of $0.19 per share.

The company surpassing expectations should not be underestimated, especially since it happened during a challenging period for the industry. In the words of CEO Mike Jeffries: "In what remains a difficult teen retail environment, we are pleased that earnings for the quarter were in line with our expectations."

However, sales are still declining, both on a total basis and when looking at same-store sales. Profit margins are falling, and Abercrombie & Fitch is still losing money. The company is clearly not out of the woods at this stage, and industry conditions remain remarkably challenging, so things won't be easy for management over the coming quarters.

Tough times to be a teen retailer
The teen apparel industry has always been cyclical and very competitive, and things are not getting any easier lately. Far from that, competitors such as American Eagle and Aeropostale are confirming that teenagers are not willing -- or able -- to spend much on these kinds of products, and profit margins are under heavy pressure due to competitive discounts.

American Eagle reported a 5% decline in sales to $646 million during the first quarter of 2014, while comparable-store sales fell by a worrisome 10% versus the same period in the prior year. Gross profit margin declined to 34.9% of sales versus 38.8% of revenues in the first quarter of 2013 due to the deleverage of rent on negative comparable sales and increased markdowns.

The company produced razor-thin profit margin on the bottom line; net income was $3.87 million during the last quarter, or 0.6% of revenues. According to management: "Results were consistent with our expectations. The quarter reflected weak sales and increased markdowns."

Aeropostale is doing considerably worse than both American Eagle and Abercrombie & Fitch, as it delivered a 12% decline in sales to $395.9 million during the quarter ended on May 3. Comparable sales including e-commerce revenues fell 13% during the period.

Gross profit margin declined from 22.4% of sales to 17.8%, and Aeropostale reported a net loss of $76.8 million during the period. CEO Thomas P. Johnson confirmed in the earnings press release that industry conditions have been remarkably challenging lately: "As other retailers experienced, the macroeconomic environment was challenging during the first quarter with aggressive promotions, lower mall traffic, and unseasonable weather."

Recent financial performance from American Eagle and Aeropostale show that Abercrombie & Fitch is not alone in facing falling sales and scarce profitability. Turning a business around is always a difficult task, and it can be a herculean challenge when facing heavy industry headwinds.

Foolish takeaway
It's good to see Abercrombie & Fitch performing better than expected, but investors should keep in mind that analyst expectations were already quite low leading to the report. Sales are still falling and profit margins continue to decline as of the last quarter. In addition, financial reports from competitors American Eagle and Aeropostale confirm that industry conditions remain savagely competitive. It's probably, therefore, too early to bet on a sustainable turnaround from Abercrombie & Fitch.

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