Abercrombie & Fitch (ANF -2.49%) recently attracted a lot of attention with an ugly second-quarter report. The apparel retailer's revenue declined 7% year over year to $805 million and missed analysts' expectations by $38 million. It posted an adjusted net loss of $15 million, compared to an adjusted net profit of $109 million a year ago, as its adjusted net loss of $0.30 per share broadly missed the consensus forecast by $0.53.

That earnings miss was disappointing, but a deeper dive reveals several other strong red flags for its future. Let's see if A&F can overcome those challenges and turn around its struggling business.

Three friends shop together at a mall.

Image source: Getty Images.

What happened to Abercrombie & Fitch?

A&F had been struggling for years before the pandemic hit. But under CEO Fran Horowitz, who took the helm back in 2017, A&F downsized its weaker namesake brand -- which had been struggling against fast fashion competitors like H&M and Inditex's Zara -- and expanded its higher-growth Hollister brand. Horowitz also rebooted its aging ad strategies, launched aggressive social media campaigns, and courted older shoppers to reduce its dependence on teen shoppers.

That strategy gradually stabilized A&F's top-line growth, but persistent markdowns squeezed its gross margin. Net sales rose 1% in fiscal 2019 (which ended in February of the calendar year), but gross margin declined 80 basis points to 59.4%. The pandemic subsequently derailed that fragile recovery with temporary store closures, and net sales fell 14% in fiscal 2020. However, gross margin rose to 60.5% as A&F incurred lower expenses throughout the pandemic. 

A&F's net sales rose 19% to $3.7 billion in fiscal 2021, with 17% growth at Hollister and 21% growth at Abercrombie, as it reopened its stores. On a two-year basis, net sales increased 2%. Its gross margin also expanded to 62.3% for the year as it reined in its promotions and raised its prices again.

Inflation killed its post-lockdown recovery

Unfortunately, A&F's brief post-pandemic recovery hit a brick wall in the first half of fiscal 2022 as Abercrombie's growth cooled off and Hollister's growth stalled out. The company mainly blamed that slowdown on inflation, which throttled consumer spending on new clothes and other discretionary products.

Period

Q1 2022

Q2 2022

Hollister sales growth (YOY)

(3%)

(15%)

Abercrombie sales growth (YOY)

13%

5%

Net sales growth (YOY)

4%

(7%)

Total gross margin

55.3%

57.9%

Data source: Abercrombie & Fitch. YOY = year over year. 

A&F expects that slowdown to continue in the second half of the year. It expects its sales to decline by high single digits in the third quarter, and to drop by mid single digits for the full year.

That represents a big reduction from its prior forecast for 0%-2% growth for the full year. It also expects margins to decline as it keeps inventory levels under control with lower prices and markdowns.

Can it still achieve its "Always Forward" goals?

Back in June, A&F unveiled its "Always Forward" growth targets. It expects to generate $4.1 billion to $4.3 billion in annual revenue by the end of fiscal 2026, which implies its top line will grow at a compound annual growth rate (CAGR) of at least 2% from fiscal 2021 to fiscal 2026. It also expects to keep annual operating margin at or above 8%.

A&F believes that over the next three years, it can expand Abercrombie and Abercrombie Kids at a combined CAGR of 6%-8%, Hollister at a CAGR of 0%-2%, and its smaller Gilly Hicks brand at a CAGR of 15%. Over the long term, the company believes it can generate over $5 billion in annual revenue and keep operating margin at or above 10%.

A&F's revised outlook for a top-line decline this year could make it tougher to achieve those goals. But during the second-quarter conference call, Horowitz said A&F still "made progress" toward its Always Forward goals by growing its brands, expanding its digital platforms, and exercising better financial discipline even as it faced "well-documented consumer headwinds." CFO Scott Lipesky also said he was "confident in the strategies" A&F had put in place toward achieving its Always Forward goals.

Is Abercrombie & Fitch an undervalued stock?

A&F is struggling, but it's arguably in much better shape than Gap, which is still trying to stabilize its business after the abrupt dismissal of its CEO in July.

While A&F trades at just nine times forward earnings, Gap's deteriorating profits have boosted its forward price-to-earnings ratio to 35. A&F and Gap both suspended their dividends during the pandemic in 2020, but A&F hasn't reinstated those payments yet. Gap reinstated its dividend last May and currently pays a forward yield of 5.9%.

A&F might look attractive if it reinstated its dividend, but its lack of near-term catalysts makes it a lackluster investment in this tough market. Investors should only buy "best in breed" stocks in the cutthroat retail apparel sector, and A&F simply doesn't fit that description yet.