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Abercrombie & Fitch‘s (ANF) stock fell by almost 10% as its Q1 fiscal 2013 earnings remained below expectations. The retailer’s revenues and comparable-store sales (CSS) slumped by 9% and 17%, respectively due to the impact of cold weather, weakness in women’s business and inventory shortage. [1] Even its direct-to-consumer channel saw a sharp revenue decline of 10%. On the flip side, the international business did well, growing its revenues by 10% despite the unfavorable economic environment in Europe.

The weakness in Abercrombie’s business is likely to persist this year. The company lowered its full year guidance and expects the comparable store sales decline to continue through the remaining quarters. Having said that, the longer term outlook doesn’t look too bad. Abercrombie’s store consolidation strategy in the U.S. and targeted expansion abroad are likely to aid its growth. In addition to this, the direct-to-consumer channel and disciplined inventory control will also play a vital role.

Inventory Control - It Went The Other Way!

In recent times, Abercrombie has faced problems in sustaining its growth due to superfluous inventory at its stores, which prevented the launch of new fashion and weighed on CSS growth. As a solution to this problem, in Q3 fiscal 2012, the retailer increased its inventory at a much slower pace than the sales growth, and started sourcing goods from within the U.S. and low-cost destinations of Central America. [2] [3] In Q4 fiscal 2012, the retailer maintained a low carryover of fall inventory and reduced its overall inventory by almost 35%, as compared to the previous year. [4] However, Abercrombie & Fitch seems to have gone tad too far.

The company’s inventory levels dipped too low in the first quarter of fiscal 2013, leading to a sharp decline in its comparable store sales. According to Abercrombie’s management, about 10% of the 17% decline in comparable store sales was due to inventory issues. [1] Abercrombie has become a good example of how important it is for any retailer to maintain optimum inventory levels. Although the company might face similar issues in the upcoming quarter, its inventory management should improve over a longer run.

Direct-To-Consumer Business Will Remain The Key

Even Aeropostale (ARO), which has been struggling to keep up its growth, reported strong growth in its direct-to-consumer business during Q1 fiscal 2013. [5] On the flip side, Abercrombie’s direct-to-consumer revenues declined by 10% during the quarter. We believe that this is just a temporary weakness and the business should be back on track once the industry improves and Abercrombie sorts out its issues.

Online apparel sales in the U.S. have grown at a rapid pace due to growing Internet usage and the proliferation of smartphones and tablets. Major players such as Urban Outfitters (URBN), American Eagle Outfitters (AEO) and Gap (GPS) have thrived due to this trend, and Abercrombie is no different. [6] The table below shows how the retailer’s direct-to-consumer revenue growth has trended over the past few years. [7]

Year -> 2010 2011 2012
Direct-to-consumer Revenues ($Bil) 0.41 0.55 0.70
% Growth 39.6% 36.4% 26.8%

We believe that Abercrombie’s direct-to-consumer business will perform better going forward, as it has more or less followed the industry growth in the past. The anticipated growth in the online apparel retail market further lends support to our outlook. eMarketer forecasts the online apparel sales in the U.S. to increase from about $45 billion in 2012 to $90 billion in 2016. [8]

The direct to consumer segment accounts for about 40% of the company’s value, according to our estimates.

Store Consolidation In The U.S. Should Help Productivity

Before the recession, Abercrombie had aggressively expanded its ANF stores in the U.S., including cities with relatively lower income demographics. This impacted store productivity as the retailer failed to attract sufficient store traffic. The economic downturn of 2008-2009 and fewer promotions also worked against the retailer. As a result, the number of transactions per ANF store (measure of store traffic) declined by 16% in 2008 and 14% in 2009. [7]

However, with the consolidation of underperforming stores and an improvement in the economy, ANF stores started to recover. The revenue per square feet surged from $365 in 2009 to $564 in 2012. In addition to this, EBITDA (earnings before interest, taxes, depreciation and amortization) per square feet also improved substantially during the period. Abercrombie plans to continue with its consolidation strategy in the U.S. with about 40-50 stores scheduled for closure this year. [1] It appears that store consolidation is becoming a prominent trend in the U.S. apparel industry. Several apparel retailers such as American Eagle Outfitters and Limited Brands (LTD) are following a similar strategy.

Targeted Expansion Abroad Will Support Growth

Contrary to the U.S. where Abercrombie operates more than 900 stores, the retailer’s presence in international markets is limited to about 140 stores. Although this presents a huge expansion opportunity, it needs to be strategically planned. Due to its over expansion in tourist locations in Europe, the retailer is facing a self-cannibalization problem. [2] Now Abercrombie has slowed down its expansion in the region and is looking toward other lucrative international frontiers. Additionally, it is planning to enter new markets with the Hollister brand, which offers value-based products.

Abercrombie’s initial stores in China have performed quite well, which is a good sign for the retailer given the region’s potential. [1] It will open an ANF flagship store in Shanghai later this year and will continue to expand in the world’s second largest apparel market. Abercrombie is also scheduled to open its store in Seoul, South Korea, towards the end of fiscal 2013. Additionally, about 20 Hollister stores are planned for international markets in the current fiscal year. The company recently came out with plans to expand Hollister in the U.A.E, Australia and Japan. Together, these plans hold a significant upside potential for the retailer’s stock.

Our price estimate for Abercrombie & Fitch stands at $51, which is slightly ahead of the market price. However, we’re in the process of updating our pricing model in the light of recent earnings.

Disclosure: No positions.

Source: Abercrombie & Fitch Misses Expectations And Lowers Guidance