For every Abercrombie & Fitch (NYSE:ANF) or Guess? (NYSE:GES), apparel retailers that have become icons in their respective genres, there seem to be an equal number that have fallen on hard times in the fickle fashion world. Gap (NYSE:GPS), the subject of a recent Folly Volley, is one such company hoping for a turnaround. Today we'll look at another, Ann Taylor (NYSE:ANN). The difference? This turnaround actually appears to be working.

Ann Taylor has focused its efforts on merchandise, both in content (how it can be differentiated from competitors) and quantity (inventory management). The plan continues to pay off, as evidenced by a solid second quarter. Net sales were up a healthy 19.9% compared to the same period a year ago, with same-store sales contributing nicely, higher by 10.3%.

In this latest version of Folly Volley, Hank Schofield, Bodhi Zappa, and I will tackle the company's latest quarterly earnings conference call. We're looking for specific successes in Ann Taylor's strategy, in both fashion and inventory.

Fashion right
Jeremy: CEO Kay Krill wasn't bashful about singing the praises of the performance for Ann Taylor and the LOFT division during the call. "At both divisions, we have all the key trends this season," she said of the second quarter. That's music to shareholders' ears. Bodhi, elaborate further on these trends.

Bodhi: How technical do you want me to be? We can talk about shoppers' positive response to such items as skirt silhouettes, woven tops, or layered necklaces.

Hank: You lost this old cowboy at silhouette.

Bodhi: Exactly. The bottom line regarding Ann Taylor's merchandise assortment is that right now, it's found the right balance between professional and special-occasion attire on one end, and business casual on the other. In the quarter, the company also focused on keeping the assortment fresh by bringing in a new flow of merchandise "every two to three weeks."

More with less
Hank: Keeping it fresh and fashionable was just one piece of the puzzle, however. Much of its success had to do with perception. In the past, when Ann Taylor relied on end-of-season sales and slashed prices, the deep discounts sent a certain message contrary to the "premier destination" image to which Ann Taylor aspired.

To combat this problem, the company has sought to become more efficient and effective in inventory management. The second quarter really highlighted its efforts in this area. Ann Taylor was able to achieve the strong comps and double-digit revenues while maintaining, on average, 19% less inventory, according to its earnings report.

Jeremy: Since sales were strong and inventory was lean, there wasn't a need for markdowns. And full pricing contributed to the perception that Ann Taylor is a destination for premium quality professional and business attire.

Hank: You got it.

Bodhi: Full pricing also helped the company achieve a dramatic improvement to gross margins. Second-quarter gross margins were 54.2%, considerably greater than the 47.5% it achieved in the year-ago period.

Hank: So far, Ann Taylor has been successful in doing more with less, in terms of inventory. But there's a danger that this strategy could prove treacherous. A company can run inventory too lean, then find sales of its nice, trendy lineup capped by insufficient inventory. We've seen that happen before, most recently at Pacific Sunwear (NASDAQ:PSUN), when it had too little of the fashion-right novelty styles in store to meet demand.

A full-pricing danger
Jeremy: A valid point, and one worth monitoring. While we're talking about potential pitfalls with Ann Taylor's lean inventory and full-price strategy, we should also note that the company will need to strike a careful balance of keeping full prices without scaring away too many potential customers. Comps for the quarter were driven almost entirely by dollars-per-transaction, while in-store traffic was "flattish," according to Krill.

Right now, it doesn't seem to be a concern, but we will want to keep a lookout to see whether traffic goes negative in the upcoming quarters.

Bodhi: If I may, I would like to add that in the call, we do get the sense that management realizes there is a danger in being too lean with inventory. During the Q-and-A portion of the call, CFO Jim Smith indicated that they "do not see a lot more reduction in inventory levels as we go into '07," adding, that we will see a "flattening of the [inventory] curve." It appears management has found what it believes is the right inventory level for its projected growth.

Hank: That doesn't mean it's done making improvements to its inventory management. Krill states that it will soon be rolling out its assortment-planning system, improving its ability to "have the right inventory in the right store in the right size."

Overall, a lot to like
Jeremy: We've highlighted some potential pitfalls to look out for, based on our experience of watching so many other apparel retailers in similar situations. This potential red flag, however, should not discolor the checkered flag Ann Taylor has waved in recent quarters. The company has so far found the right balance of inventory levels and product assortment to maintain present traffic levels while benefiting from a full pricing strategy.

While management remains cautious about the short-term outlook, based purely on external, economic factors, it's absolutely glowing about in-house efforts. CEO Krill resolutely stated that "we feel really positive internally about everything we're doing." These are words of comfort to current shareholders and potential investors. If Ann Taylor isn't already on your watch list, it may be time to add it.

Can't get enough of Ann? Try these on for size:

Gap is both a Stock Advisor and an Inside Value pick, while Pacific Sunwear is also a Stock Advisor selection. Try any of our Foolish newsletters free for 30 days.

Fool contributor Jeremy MacNealy has no financial interest in any company mentioned.