Abercrombie & Fitch's (ANF 2.70%) stock recently plunged after it released its first quarter earnings report, erasing its year-to-date gains and stoking concerns about the apparel retailer's turnaround efforts. CEO Fran Horowitz, who took the top job in early 2017, had been downsizing A&F's namesake brand, focusing on the growth of Hollister, launching fresh marketing campaigns, and renovating its stores.

Those efforts boosted A&F's comparable store sales, expanded its margins, and improved its reputation with U.S. teens. Those improvements brought back the bulls, and the stock rallied 25% this year before its post-earnings plunge erased those gains. Is the retailer's turnaround really losing its momentum?

A&F's Fierce clothing line.

Image source A&F.

A&F's growth engine is losing its mojo

A&F's core strategy is to leverage the strength of Hollister, its Southern California-inspired brand, to offset the weakness of its namesake brand, which has been struggling with competition from fast fashion retailers like H&M and mall-based rivals like American Eagle Outfitters (AEO -1.54%).

However, Hollister's comps growth decelerated significantly during the first quarter, causing A&F's total comps to rise just 1%, which missed expectations for 1.4% growth. For comparison, AEO posted 6% comps growth in the fourth quarter, and anticipates low single-digits comps growth in the first quarter.


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Comparable store sales growth. Source: A&F quarterly reports.

Hollister's comps rose for the tenth straight quarter, but it faced a tougher comparison to its 6% growth last year. The brand was buoyed by robust demand in guys' bottoms, fleeces, sweaters, and outerwear, as well as strong sales of girls' outerwear and bottoms.

The company believes that Hollister's new swimwear and Gilly Hicks lingerie brand -- which competes against AEO's Aerie and L Brands' PINK -- will support Hollister's future growth. It's also ramping up its Instagram marketing campaigns, particularly for swimwear, and engagement campaigns with teen shoppers, including a recent high school tour that discussed shopping habits with over 100,000 teens.

Abercrombie rebounded from its negative comps growth in the fourth quarter by launching new tops and dresses. Women's jean shorts, skirts, and pants sold well, as did men's knits, joggers, and outerwear. Abercrombie recently updated its digital marketing campaign to focus on older shoppers in their mid-20s, and notes that the effort is boosting its year-over-year traffic.

An A&F marketing campaign.

Image source: A&F.

That progress in the U.S. boosted the company's total domestic comps 4%. However, its international comps declined 4% as its growth in Asia -- once a key growth market for Abercrombie -- dried up and offset its slight growth in Europe.

Steady margins and store closures

A&F's gross margin remained flat year-over-year at 60.5%, but its operating margin improved from -5% to -3.7%. Those steady margins indicate that it didn't abuse markdowns to drive sales or throw too much cash at traditional marketing campaigns. A&F's gross margin also compares favorably to AEO's gross margin of 34.6% in the fourth quarter.

A&F also announced the upcoming closure of three more flagship stores -- Hollister SoHo in the second quarter, Milan A&F by the end of fiscal 2019, and Fukuoka A&F in the second half of 2020 -- following the recent closures of its A&F Copenhagen and Hong Kong A&F flagship stores. The elimination of those five stores reduces its flagship count to just 15, which could reduce the brand's visibility.

It finished the quarter with 857 stores. It closed four stores in the U.S. -- three Abercrombies and one Hollister -- and one overseas Abercrombie, while opening a single new Hollister location in the U.S. This gives it a smaller brick-and-mortar footprint than AEO, which finished last quarter with 1,055 locations.

An uninspiring outlook

For the second quarter, A&F expects its comps to stay flat, its net sales to rise just 0%-2%, and its gross margin to dip annually and sequentially to 59.2%. It blames that margin contraction on currency headwinds and upcoming promotions, which doesn't inspire much confidence in its turnaround efforts.

That guidance also doesn't account for future tariff hikes, which could take a bigger bite out of its margins and disrupt its ability to generate profits in the second half of the year.

For the full year, A&F expects low single-digit comps growth with 2%-4% revenue growth. That top line growth is stable, but we'll need to see if A&F's margins hold up over the next few quarters to see if it falls into the trap of feeding sales with markdowns.

More work to do

A&F's business isn't headed off a cliff, but it still faces tough year-over-year comparisons, gross margin headwinds, and brutal competition. I'd steer clear of this stock until it can boost its comps growth and gross margins again.