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Abercrombie's Sales, Margins Don't Mesh

The retailer offsets a comps drop by cutting costs, but trouble looms if demand keeps waning.

Abercrombie & Fitch's (ANF) - Get Abercrombie & Fitch Co. Class A Report first-quarter earnings report was a head-scratcher.

The teen-apparel retailer's earnings were

in line with estimates, though sales were below expectations. Gross margin improved despite an increased amount of inventory and a drop in same-store sales.

Either Abercrombie is incredibly well managed or its sales issues will cause some big headaches in the future. It could be both.

Investors clearly liked the report, as shares of Abercrombie recently were up $1.88, or 2.3%, to $82.68.

Despite a $7 million revenue shortfall, Abercrombie's first-quarter earnings of 65 cents a share matched analysts' average estimate, largely because of cost controls.

The company highlighted cuts in expenditures such as travel and payroll at the corporate office. Abercrombie's executives were particularly proud of how the company managed expenses so as not to disappoint Wall Street, since they realized the top line would be below forecasts.

I'm all for keeping a lid on costs and cutting fat, but companies shouldn't micromanage expenses in order to hit short-term targets. By cutting travel costs, I assume it didn't mean CEO Mike Jeffries flew coach. Hopefully, management didn't sacrifice long-term goals in order to save a few thousand dollars on various trips.

What impressed me most about Abercrombie's report was the 20-basis-point rise in gross margin to an all-time first-quarter high of 65.6%. That margin growth came despite a 4% drop in same-store sales, or comps.

Inventories were up, though they were in line with expectations. That begs the question, how did the company boost margin and keep inventory levels at the projected pace when same-store sales were negative?

On the company's conference call, Jeffries glossed over the subject when asked, stating, "We do a very good job balancing inventories with demand." Clearly, they must.

HSBC analyst Nora Kahn wrote in her earnings-recap report, "Quarters such as the one just past highlight the importance of square-footage-driven sales growth, with

companies dependent solely on comps often forced to act more promotionally, or face negative sales."

While her statement is accurate, I want to see positive comps as proof that a brand is resonating with customers. Abercrombie has posted same-store sales growth in just two of the past five quarters -- although to be fair, the company reported monster, double-digit numbers in 2005 that make comparisons tough.

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Nevertheless, I want stores to continue to excite and entice customers no matter what they did the year before or year before that. Abercrombie expects comps to be flat in the second quarter.

The company had the most trouble in terms of same-store sales with its Hollister brand, a trendy teen chain with California-inspired apparel.

"I love what's going on with Hollister," declared CEO Jeffries on the conference call.

He gives love a bad name. Same-store sales at Hollister tumbled 5%, making the chain the worst performer among the company's brands.

The chain will need to improve if Abercrombie wants to continue to be an appealing growth story. This year, 69 of the company's 107 planned new stores will be Hollisters.

The Hollister stores look great and are bursting with teenage attitude (at least to this thirty-something columnist). But if comps don't return to the plus-side soon, inventory and cost controls will become even more challenging.

Some Success

Abercrombie is doing several things extraordinarily well. A push abroad has so far been met with success, with sales at its first U.K. store booming.

The online business also has shown improvements. Jeffries said Abercrombie has tried to enhance e-commerce efforts through targeted email and better fulfillment.

Abercrombie & Fitch is also undertaking some major upgrades to its systems, particularly inventory optimization, merchandising and supply chains. While this process can be costly and have unexpected glitches, it should save the company time and money down the road.

So the company is managing its business probably as well as anyone in the industry. But retailing comes down to a very simple question: Do people want to buy the stuff you're selling?

I'm not ready to give up on Abercrombie just yet because I believe its brands, particularly Hollister, still have room to grow. But I'm not going to be patient about it. If the sales numbers don't improve in the next quarter or two, it will be time to get out while everyone is still singing management's praises.

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;

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