Abercrombie & Fitch’s May 2nd Quarter: Another Turnaround in Progress

I guess what I’d like to do is start with the list from their 10-Q of where the company will be focusing their turnaround efforts.

“• Putting the customer at the center of everything we do

• Defining a clear positioning for our brands in a rapidly changing and highly competitive marketplace
• Delivering a compelling and differentiated product assortment
• Optimizing our brand reach domestically and internationally
• Continuing to improve our efficiency, pare under-performing assets, and reduce expense
• Ensuring we are organized to succeed”

All good, essential, stuff. The conference call describes precisely how they are doing this in more detail. As you read it, you think, “Yeah, no kidding. Why didn’t you all this before?” This takes us back to their “resigning” of their long time CEO at the start of this year. Here’s the article I pointed you to previously that explains how that came about.

Last time I wrote about A&F was on April 15^th, after their 10K came out. I referred to what they called there 2015 “strategic priorities” which were:

As you would expect and can see, their focus has evolved since their 10-K came out. As it should. Remember, they just started trying to fix things in December.

What I wrote then referring to the above list, which is still true, is that there was, “Nothing bad there, but also nothing particularly differentiating. It says something about the retail environment that all retailers seem to be trying to do mostly the same things.”

Too many brands and retailers are hoping to prosper, or maybe even survive, by doing all the same things all their competitors are doing, but doing them better.   This is not Lake Wobegon, where all the children are above average. Not everybody can be above average. That’s just what the math tells us.

For the quarter ended May 2^nd A&F reported revenue of$709 million, down 13.75% from $822 million in the same quarter last year. Exchange rates accounted for about $46 million of the decline.

The Abercrombie brand was down 11.9% from $386 to $340 million. Hollister fell from $421 to $370 million, or by 12.1%. Below is the table showing the result by regions.

They are planning to close 60 U.S. stores during the year by natural lease expirations. They say they will open nine here and a total of 17 in China, Japan and the Middle East. Apparently, most of their U.S. leases run off between now and 2017, so they have a lot of flexibility in managing their U.S. stores without incurring the cost of getting out from under leases. They ended the quarter with 956 total stores- 387 were Abercrombie and 569 Hollister. The numbers in the U.S., respectively, were 354 and 432.

Comparable store sales were down 9% for Abercrombie and 6% for Hollister. U.S. comparable store sales fell 7% with international down 9%.

The gross margin fell from 62.2% to 58%. Most of the decline was due to an inventory write down of $27 million, discussed below.

Store and distribution expense as a percent of revenue rose from 50.8% to 55.2%. This was mostly the result of the decline in comparative store sales, but was offset to some extent by expense reductions.

Marketing, general and administrative expenses were 15.2% of revenue, up from 15% in last year’s quarter.

A&F reported an operating loss of $90 million for the quarter, up from $32 million in last year’s quarter. Net interest expense rose from $2 to $4.6 million “…due to a higher principal balance and a higher interest rate on debt outstanding…”

The net loss was $63 million, up from $24 million in last year’s quarter. The reason this quarter’s loss is so much less than the operating loss is due to a $32 million tax benefit. In last year’s quarter, the tax benefit was $10 million.

The balance sheet still looks fine, though equity has fallen from $1.55 billion a year ago to $1.3 billion due to the losses. Leverage is a bit higher, but there’s nothing about their financial positon that will keep them from pursuing their turnaround strategy. I would point out that they used $94 million of cash in their operations for the quarter compared to $40 million in last year’s quarter.

The inventory has fallen 9.3% from $486 to $441 million. However, that includes a write down of $27 million “…of the carrying value of certain inventory to its estimated net realizable value as the Company elected to accelerate the disposition of certain aged merchandise that does not support the Company’s prospective brand positioning strategy.”

It’s interesting inventory is down just 9.3% including that write down with a 13.75% reduction in sales. Wonder if we’ll see more of these write downs in future quarters.

This write down is one of the numbers they try and get us to ignore by providing “adjusted” earnings. I’m cautious about these adjusted numbers in any event, but when they involve an inventory write down, I really can’t figure out why any company figures they are entitled to a “do over” as we used to say on the playground. I was gratified that one of the analysts questioned this treatment of the inventory as well. Remember, now that they’ve written that stuff down it will show up as higher gross profit in future quarters when they do sell it.

Strategically, A&F management tells us that they have had to reduce some average unit retail prices. It brought a smile to my face (maybe a guffaw) when they actually called these “price investments.”

Nice try putting lipstick on that pig. My read is that they had to reduce some prices to be competitive because neither their product nor branding supports higher prices. And hence, A&F is a turnaround.

They tell us that average unit retail (AUR) has now stabilized in the U.S., but was down in Europe. They expect to make up for that those declines through reductions in theirs average unit cost, which improved “…mid-single digits for the first quarter.”

Hollister Brand President Fran Horowitz-Bonadies notes that the turnaround “…will be led by product.” The Brand President for A&F brands, Christos Emilios Angelides, says the same thing but is a little more specific.

“…our focus really is on offering more variety to customers through several avenues, through pricing architecture, through trends and color analysis, and also through fabrication and the fit of the product. Rather than just offering a one dimensional collection, we’re looking at offering several dimensions within that collection.”

I wonder if they see the price reductions as a temporary measure for managing inventory and getting customers back in the stores until the turnaround takes hold, or if it’s a long term strategy supported by cost reductions. What does it mean to lead through product in our industry? Can you actually make better stuff that’s fundamentally different from all the competitors on a regular basis?

You can see in the conference call that the flood gates of change have opened since the former CEO moved on, and I like what they are doing operationally. Strategically, it’s a crowded space and I don’t see what they are trying to do as fundamentally different from what their competitors are trying. But A&F has the balance sheet to try. That’s a big competitive advantage.