Abercrombie & Fitch’s May 4th Quarter; There’s a Lot Going On

I’ve gotten out of the habit of reviewing A&F’s results, but a cursory look at their 10Q intrigued me. You don’t typically see sales fall 9% while pretax income for the quarter improved (if that’s what you want to call it) from a loss of $30 million in last year’s quarter to a loss of $15 million. Most of this loss reduction is explained by a rather significant improvement in gross margin from 58.7% to 65.9%. 

At May 4, A&F had 1,053 retail stores. 909 were in the U.S. and 144 in other countries. 283 were Abercrombie & Fitch stores, 149 Abercrombie and 28 operated under the Gilly Hicks brand. The remaining 593, representing 56% of the total, is the ever popular Hollister. To be honest, while I don’t really like what Hollister represents to some of us, I admire what the company accomplished in building the brand and think there’s an object lesson there. Basically, it’s that authenticity (in the eyes of their target customer at least) can be manufactured by marketing. Whether it can be maintained is what we’re finding out.
 
Anyway, obviously things aren’t going all that well right now. Sales fell from $921 to $839 million. A&F store sales fell 13% to $325 million. Hollister was down 18% to $421 million. Interestingly, ecommerce sales fell 6% from $148 to $133 million. U.S. sales fell from $544 to $449 million while international rose from $229 to $258 million. Overall, comparable brick and mortar store sales fell by 17%. The international growth was the result of opening new stores. Looks like they expect to open 20 to 30 international stores during the year and close 40 to 50 in the U.S. 
 
The Stuff That’s Going On
 
Let’s start with an accounting change. How’s that for excitement? The company “…elected to change its method of accounting for inventory from the lower of cost or market utilizing the retail method to the weighted-average cost method effective February 2, 2013.”
 
They had to restate last year’s quarter ended April 28, 2012 to reflect the change. The numbers I’ve given you above include the impact of that restatement. Prior to the restatement, they showed a pretax profit of $5.2 million. The change reduced their pretax income by $35.3 million to the pretax loss of $30 million noted above.
 
That’s quite an accounting change. They did it because, “The Company believes that accounting under the weighted-average cost method is preferable as it better aligns with the Company’s focus on realized selling margin and improves the comparability of the Company’s financial results with those of its competitors. Additionally, it will improve the matching of cost of goods sold with the related net sales and reflect the acquisition cost of inventory outstanding at each balance sheet date.”
 
Any of you CPAs out there who want to chime in on this, please do. They make the explanation sound so benign and reasonable. But that’s a pretty big change in reported results and, as we’ll see, they’ve had some problems with inventory.
 
They tell us in the 10Q that “Sales for the quarter were lower than expected due to more significant inventory shortage issues than anticipated, added to by external pressures, including unseasonably cool weather conditions, and the macro-economic environment in Europe.” The gross margin improvement “…was driven by a mix benefit from selling a higher proportion of current season merchandise and lower product costs.”
 
I’m sitting here wondering how the inventory shortage impacted the gross margin. For the complete year, they expect the gross margin to be in the mid-60s and total dollar gross margin rose 2% in the quarter.   As you know, I’m a believer in controlling your distribution and inventory with the goal of improving sell through and perceived value. Very hard to do as a public company, however, when the market wants revenue growth. Still, I can’t help but note that A&F improved their bottom line performance on lower sales.
 
In the conference call, we find out from CEO Michael Jeffries that “…inventory accounted for approximately 10% of the comp sales decline due to both lower levels of fall carryover and delays in spring deliveries.”
The analysts were a bit uncertain how to think about the inventory as well. One asked, “… just trying to understand the connection between the lower inventory, the comp at Hollister and the gross margin. It sounds like, was it really a factor — you mean to say lower fall clearance inventory — or fall carryover. Does that mean lower clearance inventory? And really, you need that clearance inventory to drive the comp at Hollister, which is why the comp at Hollister was low, and that’s why gross margin was high. Is that an accurate statement?
 
CFO Jonathan Ramsden responded “Broadly, yes” and CEO Jeffries said, “Yes. Yes. I think that’s right on.”
 
Let me see if I’ve got this. They had problems getting the inventory they needed but if they’d had it, they would have had higher sales, but a lower grow profit margin? I’d love to know if total gross margin dollars earned would have been lower instead of 2% higher. But they are in the process of fixing this and are going to have a gross profit margin in the mid-60s for the whole year, they tell us.
 
The analyst, of course, is worried about sales comps at Hollister, because that’s kind of what analysts do. But I’m sitting here screaming, “But they earned more total gross margin dollars without those sales!” I’m not sure they should fix anything.
It needs to be pointed out that their store and distribution expenses as a percentage of sales rose from 49.5% to 53.5% and marketing and general and administrative expense went up from 12.7% to 14.2%. Still, they cut their loss in half selling less at higher margins.
 
Meanwhile, A&F is busy, like so many other companies these days, trying to cut costs and run more efficiently. Also from the 10Q: “We have also made progress on our profit improvement initiative, which includes a detailed review of our operational processes to identify investments that we have made in our business that may have had a return in the past but no longer do today. The initiative is divided into seven work-streams covering general non-merchandise expense, marketing, supply chain, merchandise planning and allocation, home office, store operations, and real estate and construction.”
 
They’ve identified annual savings of $35 to $55 million in general non-merchandise expense and marketing, but don’t expect most of that to be realized until next year. In the supply chain, home office and store operations work streams they have “…completed the diagnostic phase but still need to validate the process-driven savings opportunities through testing and further analysis.” They expect savings in those areas to be “substantial.” They are still in the diagnostic phases for the remaining work streams.
 
They are also involved in a “…cross-functional AUR [average unit retail] optimization initiative” where they “…have identified a number of specific opportunities to date that we anticipate will yield a meaningful gross margin benefit…” Those benefits should start to show up next year. They are also revisiting their overall strategy.
 
There’s not any part of their business they aren’t touching. If I may reiterate one of my favorite points of pontification, they’ve acknowledged the close connection between operations and competitive positioning.
 
Okay, I’m stopping here. A&F earned more gross margin dollars on lower sales and cut their loss in half. True, their operating expenses rose as a percent of sales, but they are in the middle of a top to bottom evaluation process to cut costs and increase operating efficiency including inventory management. If they can create a more cost effective and responsive company structure and keep their gross margin around 65% by managing product and distribution to improve brand perception, who cares if their sales don’t increase as fast as they used to? They’ll make more money.
 
The conference call and some of the discussion in the 10Q kind of waltzes around these issues. Maybe that’s because you can’t tell the analysts that revenue growth isn’t going to be as important as it was. But if they’ve bought into the same analysis as I’ve suggested, the company might do well regardless off what you think of Hollister.