Abercrombie & Fitch's Growth Flatlines as Its Margins Crumble

Abercrombie & Fitch (ANF 0.31%) and its Southern California-inspired Hollister label were hot brands in the late 1990s and 2000s. However, sluggish mall traffic, competition from fast fashion retailers, and evolving tastes -- which rejected A&F's cologne-filled stores and logo-emblazoned apparel -- caused its business to wither.

A series of PR gaffes by then-CEO Mike Jeffries alienated shoppers further, and the retailer endured eleven straight quarters of negative comparable store sales growth before he resigned in late 2014. That post was left vacant for over two years until Fran Horowitz, who previously served as Hollister's president and the company's chief marketing officer, took the top job in early 2017.

Image source: Abercrombie & Fitch.

Under Horowitz, A&F scaled back its namesake brand and expanded its higher-growth Hollister brand. It launched more inclusive ad campaigns, engaged teens with social media campaigns on Instagram and YouTube, renovated its dated stores, and revived Hollister's Gilly Hicks lingerie brand to compete against L Brands' Victoria's Secret PINK and American Eagle Outfitters' (AEO 1.37%) Aerie.

Those efforts paid off, and A&F's comps grew for ten straight quarters through the first quarter of 2019. However, A&F's recent second-quarter report -- which shattered that streak with flat comps growth and declining margins -- indicated that turnaround was losing its momentum.

Why did A&F's turnaround hit a brick wall?

A&F's total revenue fell 0.2% annually to $841.1 million during the quarter, missing expectations by $6.6 million. On a constant currency basis, its revenue rose 1%.

Its total comps were flat, with zero growth at Hollister and A&F. That slowdown indicated that interest in Hollister, which served as the company's growth engine in previous quarters, was peaking.

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

It attributed Hollister's flat growth to weak sales of girls' apparel, where healthy demand for bottoms, swimwear, and Gilly Hicks products failed to offset soft sales of tops. The weakness of the girls' segment offset its "record" growth in guys' apparel, which was buoyed by strong sales of bottoms.

Abercrombie, which generates less revenue than Hollister, tread water with decent sales of men's wovens and knits, and women's dresses and soft bottoms. The company claims that its new kids' brand and women's jeans, and the relaunch of its Fierce brand, could boost the banner's future growth.

A&F made progress in its core U.S. market (65% of its revenue) with 2% comps growth, but that growth was offset by a 3% drop in its international comps, which was mainly caused by macro headwinds across multiple regions.

A&F expects its total comps to stay "approximately flat" for the third quarter, and be "flat to up 2%" for the full year, indicating that the current headwinds won't fade anytime soon. For comparison, A&F's rival AEO expects to post its 18th straight quarter of comps growth when it reports its second-quarter earnings on Sept. 4.

Image source: Abercrombie & Fitch.

Markdowns and crumbling margins

A&F tried to boost its sales with markdowns during the quarter, which caused its gross margin to fall nearly a full percentage point annually to 59.3%. Its operating margin also dropped nearly five percentage points to negative 4.7%, which resulted in an operating loss of $39.5 million, compared to a slim operating profit of $223,000 a year earlier. On the bright side, its adjusted net loss of $0.48 per share beat analysts' estimates by four cents.

Unfortunately, A&F's guidance indicates that there's more pain ahead: It expects markdowns, currency headwinds, and incoming tariffs to reduce its gross margin by about 100 basis points annually in the third quarter. It also expects its operating expenses to rise 1%-2% annually.

For the full year, it expects its gross margin to decline 50 to 90 basis points annually, and for its operating expenses to rise 2%-3%. In other words, investors should expect flat sales growth and declining margins for the foreseeable future.

A&F still isn't a "best in breed" retailer

A&F's business is improving under Horowitz, but it's slipping into the classic trap of using markdowns to boost sales. It's also trying to catch up to AEO in several key categories -- including denim and lingerie -- but generating less impressive growth.

A&F isn't doomed, but it still isn't a "best in breed" retailer that can roll with the punches. Therefore, I'd personally stick with stronger apparel retailers like AEO or more defensive consumer stocks until the storm blows over.