It Probably Wasn’t the Plan; Abercrombie & Fitch’s November 3rd Quarter.

Back in 2012 A&F had 946 U.S. stores.  They ended the most recent quarter with 684 (plus 195 international stores).  In the immortal words of Gary Schoenfeld in his first earnings conference call as CEO of Pac Sun however many years ago it was, “Nobody needs 900 Pac Sun stores.”

Nobody needed 946 A&F stores either.  Given how the retail market is changing, the 28% reduction was probably a great thing, if not part of the plan.  It’s even more interesting to note that 400 of the U.S. stores are Hollister and only 284 are A&F branded.  Those of you who have been around a while may remember, when Hollister opened (the first store was in 2000), that as an industry we were pretty dismissive of the concept.  Don’t know if that’s because we didn’t think it would work, were afraid of it, or wished we’d thought of it first.

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Fun Times at Other Industry Retailers

At almost the same time Abercrombie & Fitch (owner of Hollister), Tilly’s, The Buckle, and Genesco (owner of the Journeys chain) released, in early June, 10-Qs for their quarters that ended April 30th.

I was going to do my usual thing and review each one separately.  But I was busy, too much time passed and honestly, there’s so much sameness to what our industry’s retailers are saying that I wasn’t sure anybody would want to read four separate reports.  Hell, I didn’t even want to.

So what I’ve done is gone through the 10-Qs and collected a few observations and some summary data.  It is, I think, enough.

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Abercrombie & Fitch’s October 31 quarter; Will it Be Enough to Try the Same Things as Everybody Else?

A&F (owner of the Hollister brand) had a pretty good quarter. I’m thrilled that their sales fell a bit and want to start by reminding you why I’d think like that (though they tell us it was mostly caused by exchange rates).

Here we sit over retailed as an industry and a country with a cautious consumer, a lack of product differentiation and a still weak economy. Here’s how A&E describes what they are doing to improve their business in their 10Q for the quarter ended October 31.

“Our ongoing efforts to improve our business are focused on:

  • Putting the customer at the center of everything we do.
  • Delivering a compelling and differentiated assortment.
  • Optimizing our brand reach domestically and internationally and optimizing our performance in each channel.
  • Defining a clear positioning for our brands.
  • Continuing to improve efficiency and reduce expense.
  • Ensuring we are organized to succeed.”

All good things. They’ve always been good things regardless of economic conditions. But regular readers will know we’ve seen similar to almost identical lists from other brands and retailers I’ve written about. Some of this stuff is expensive to do. Unless you believe that the management team at A&F is better than the team at other companies, there’s no reason they can be a better competitor doing the same stuff as everybody else.

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Another Industry Turnaround Continues; Abercrombie & Fitch’s Quarter

It was last December when A&F’s long time CEO was “resigned” by its board of directors. I posted a link last winter to an article about how that came to happen. Here’s that link.

That’s not to say he had complete responsibility for what went wrong at A&F. But, as the article made clear, it’s fair to say that his presence and management style delayed A&F acknowledging and dealing with its issues.

They are still looking for a new CEO. I agree with them when they say they want to do it right- not fast.

Sales in the quarter ended August 1 fell 8.2% to $818 million from $891 million in the same quarter last year. Abercrombie sales were down 9.5% from $421 to $381 million. Hollister fell 5.9% from $465 to $437 million. In the U.S., revenues fell 5.9% from$546 to $515 million. Europe, due partly to a strengthening dollar, fell 19.3% from $248 to $200 million. What they call “other” was up from $96 to $103 million, or by 7.4%.

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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.

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Abercrombie & Fitch at the Beginning of a Restructuring. A Look at Their Results and Plans.

Well, as you know, A&F is having some troubles. You may recall that they fired their long time CEO late last year and have retained seven new board of director members and two new brand presidents, all with significant retail experience. They are in the process of finding a new CEO. If you want to refresh your memory as to what got them to that point, here’s a link through my web site that tells the whole story.

The good news, I suppose, is that A&F is still profitable and has a balance sheet that supports their change efforts, unlike some other companies I’ve written about. Let’s take a look at just what their challenge is and then review the numbers.

Directly from the 10K (which you can see here) are their descriptions of their three brands.

“Abercrombie & Fitch. Abercrombie & Fitch stands for effortless American style. Since 1892, the brand has been known for its attention to detail with designs that embody simplicity and casual luxury. Rooted in a heritage of quality craftsmanship, Abercrombie & Fitch continues to bring its customers iconic, modern classics with an aspirational look, feel, and attitude.”

“Abercrombie kids. Abercrombie kids stands for American style with a fun, youthful attitude. Known for its made-to-play durability, comfort and on-trend designs, Abercrombie kids makes cool, classic clothing that kids truly want to wear.”

“Hollister. Hollister is the fantasy of Southern California. Inspired by beautiful beaches, open blue skies, and sunshine, Hollister lives the dream of an endless summer. Hollister’s laidback lifestyle makes every design effortlessly cool and totally accessible. Hollister brings Southern California to the world.”

I’ll leave it to you to decide if those are reasonable brand positioning statements in our current market for a large public retailer. Hollister, as you’ll see below, is their largest brand. Their Hollister positioning statement sounds a bit like PacSun’s “Golden State of Mind” concept, but the brand is way more surf specific.

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Abercrombie & Fitch’s Quarter: Now You See Him, Now You Don’t

When CEO Michael Jeffries is on the conference call on December 3rd, then “retires” on December 8th, you kind of figure out there are issues. The 10-Q can be viewed here. On page 24 you can read some of the details of his retirement, though not the reason for it. The recent financial performance of the company probably has something to do with that.

As always, I’ll get to the financial details. But let’s start at the 10,000 foot level and hear how Abercrombie & Fitch (A&F from now on) describes their market positioning on page 24 of the 10-Q. The quote is a bit long, but I’d like you to read it carefully and see how it feels given what you think about our market.

“The modern Abercrombie & Fitch is the next generation of effortless All-American style. The essence of laidback sophistication with an element of simplicity, A&F sets the standard for great taste. From classic campus experiences to collecting moments while traveling, A&F brings stories of adventure and discovery to life. Confident and engaging, the Abercrombie & Fitch legacy is rooted in a heritage of quality craftsmanship and focused on a future of creative ambition. abercrombie kids is the next generation of All-American cool. The essence of fun and friendship, a&f kids celebrates each moment by sharing its effortless great taste with the world. From documenting school spirit days and team sports to

traveling abroad and experiencing new cultures, a&f kids tells stories filled with youthful excitement and a touch of mischief. Confident and independent, abercrombie kids stands for quality, on-trend style, and creative imagination. Each day brings a new discovery, a chance for adventure, and the opportunity to make history. Hollister is the fantasy of Southern California. Inspired by beautiful beaches, open blue skies, and sunshine, Hollister lives the dream of an endless summer. Spontaneous, with a bit of edge and a sense of humor, it never takes itself too seriously. Hollister’s laidback lifestyle is naturally infused with authentic surf and skate culture, making every design effortlessly cool and totally accessible. Hollister brings Southern California to the world.”

I am not saying that’s not a valid market position and maybe that’s truly what they are aiming for. But it doesn’t feel like the customer group I associate with our target market in action sports, youth culture, outdoor or whatever we’ve become. There certainly ain’t no “authentic surf and skate culture” there.

I hate to say this, but there are a few things in that positioning statement that appeal to me and my generation (boomer). You probably already know how incredibly uncool I am. I only buy new clothes when my wife starts to hem and haw when she sees what I’m wearing. Sometimes, in desperation, she throws out pieces I’ve got and hopes I won’t notice. I think the lapel width on the emergency suit I own is back in style again, but I’m not sure.

Fundamentally, then, this is their strategic problem. For lack of a better word, A&F is preppie. That’s where their roots are. But that’s a shrinking market if only because those customers are aging. Growth, then, requires some new customers. How do you change your positioning to attract those new customers without alienating the old ones?

It’s not a new or unique problem, but it’s a hard thing to do. They seem to recognize this. I think it’s related when they note as a risk factor that,”Our inability to transition to a brand-based organizational model in a timely fashion could have a negative impact on our business.” I’d add that transitioning could have at least a temporary negative impact.

Sales for the quarter ended November 1st fell 11.8% compared to last year’s quarter from $1.033 billion to $911.5 million.

Sales in the United States fell 11.9% to $595 million. Europe was down 18.2% to $223 million. Other rose 9.2%, but only to $94.1 million, representing 10% of the quarter’s total revenue. Direct to consumer rose 7.4% from $174.6 to $187.5 million.

This is probably a good time to remind everybody that the strengthening dollar, a trend I see continuing, is going to cause revenues translated from other currencies to decline. It reduced A&F’s sales for the quarter by $8 million. I hope that’s the worst it causes.

Below I’ve pulled out of A&F’s 10-Q the changes by brand and for comparable sales during both the quarter and the first nine months of the fiscal year. I think the numbers speak for themselves from a revenue perspective. They expect fourth quarter revenues to be down “…by a mid-to-high single-digit percentage.”

A&F 11-1 10q 12-14
















The company ended the quarter with 1,000 stores, down from 1,049 a year ago. They expect to close a total of 60 this year, and a similar number in each of the next several years.

The gross profit margin fell from 63.0% to 62.2%. They describe the decline as “…primarily driven by increased promotional activity.” Store and distribution expense fell 13.9% from $481 to $414 million. It fell as a percentage of sales from 46.4% to 45.4% even with the decline in sales. That’s good work.

There’s also a 17.2% decline in marketing, general and administrative expenses from $126.7 to $105 million. It also fell as a percentage of sales from 12.3% to 11.5%. Again, good work. They characterize the decline as the result of decreased compensation expense offset by an increase in marketing expense.

Okay, now we have to get to the part where in last year’s quarter, they had restructuring and asset impairment charges totaling $88.3 million. In this year’s quarter, they “only” reported charges of $16.7 million. That’s a $71.6 million difference. In addition, they had other operating income in last year’s quarter of $9.9 million. In this year’s quarter, it was $1.5 million.

As you can imagine, this resulted in quite a change in operating income. In last year’s quarter it was a loss of $35.4 million. This year, it was a gain of $33.4 million. That is quarter over quarter improvement, but with huge impact from the various charges. If you eliminate all those charges and the other income in both quarters, you find their operating income rose from $43.1 to $48.5 million.

As you know, I don’t take at face value any management’s cry that “It’s a one-time charge” or “It’s noncash!” and the implicit suggestion that I just ignore them. The need to take those charges tell you something about the future of the business and its cash flow. That doesn’t mean you shouldn’t be aware of the difficulties those charges cause in interpreting the financial statements.

Interest expense rose from $1.7 to $5.6 million. Net income for the quarter improved from a loss of $15.6 million to a profit of $18.2 million. However in last year’s quarter they had a tax benefit of $21.4 million compared to a tax expense of $9.6 million this year.

On the balance sheet, the current ratio is mostly unchanged, hovering around 2.2. Long term debt to equity has risen from 0.34 to 0.48. Inventory has fallen consistent with the sales decline (down 20%), but cash is up. However, long term debt has risen from $123.7 to $292 million, explaining the increase in interest expense. Total equity has fallen from $1.68 to $1.4 billion. If you want to argue the balance sheet is a bit weaker than a year ago, I guess you can, but there is no fundamental problem here. In last year’s nine months, cash used in operations was $230 million. This year, it’s been a positive $29 million.

Last thing on the financials; the 10-Q included a review by PricewaterhouseCoopers, their independent public accountant. You don’t normally see that in a 10-Q. I think it’s due to the fact that the company had some accounting issues that, while not significant in their overall scheme of things, requires the restatement of prior year financials. Not a good thing to have happen when the company is having issues as it calls your other numbers into question at the worst possible time.

CEO Jeffries summarizes the changes they are making this way in the conference call.

“These changes include; first, shifting to a branded organization; second, making major changes in our assortments including faster speed-to-market and lower AUC; third, engaging how we — changing how we engage with our customer; fourth, introducing new store designs; fifth, aggressively investing in DTC and omni-channel; sixth, closing domestic stores; and seventh, taking well in excess of $200 million of expense out of our model.”

Shades of PacSun. Closing bunches of stores over a period of years and changing their market positioning. The difference is that PacSun had lost their market position and needed to get one back. A&F has one, but needs to change it. Their balance sheet better positions them to accomplish the task and the reduction in expenses over the last year is good progress.

But damn, it’s a hell of a challenge when the evolution of your target customer is involved.

A & F’s Annual Report: Like Other Teen Retailers, But Not.

As I just noted in my last post on Tilly’s and expect to note as I get to other retailers, the teen market is sort of lousy right now. People seem a bit perplexed as to why it’s fallen so hard, but I believe it’s as simple as a lack of money and jobs for teens. And I suppose I’d add a lack of product differentiation and very broad market with way too many competitors and retailers.

A & F’s results for the year reflect that and some of their responses are interesting, though consistent with what other retailers are doing.  But remember that, unlike many retailers they compete with, they only sell their own brands.  Let’s start with the numbers after which it will be easier to explain their reaction to market conditions.

The Results
Net sales for the year ended February 2, 2013 declined 8.7% from $4.51 to $4.12 billion. Be aware that 2012 had a 53rd week in it, which happens from time to time. That’s about a $63 million difference caused by the extra week. Below are the sales by brand and geography for both years.
 You can see that most of the sales decline was in the U.S. and split between the Hollister and Abercrombie & Fitch brands. Gilly Hicks stores are by now all closed, though certain of the product is going to be sold in their other stores. Total Hollister sales, including direct to consumer, were down 14%. Abercrombie & Fitch fell by 10%.
Note that the U. S. stores delivered sales of $2.16 billion and operating income of $195 million. The international stores had sales of $1.18 billion and operating income $249 million. And direct to consumer’s revenues of $777 million generated operating income of $295 million. Of the three segments, guess which two they will be focusing on.
Here’s what they say about online sales. “Total net sales through direct-to-consumer operations, including shipping and handling revenue, were $776.9 million for Fiscal 2013, representing 19% of total net sales. The Company operates 46 websites including both desktop and mobile versions. In addition, the websites are available in nine languages, accept seven currencies, and ship to over 120 countries.”
Like other retailers, they are big on the omnichannel, and are enthusiastic about growing online business. And, like other retailers, they really don’t talk about whether said online sales are incremental or taking away from brick and mortar sales. That to me is the big question nobody seems to be addressing publically. Amazing the analysts don’t ask. Especially since brick and mortar comparable store sales fell 16% during the year while direct to consumer was up 13%.
The company ended the year with 843 stores in the United States and 163 stores outside of it for a total of 1,006. That’s down from 1,041 at the end of the prior year. They opened 24 international stores but closed a net of 59 in the U.S. 21 of the closed stores in the U.S. were Hollister. They expect to close 60-70 stores in the U.S. during 2014. They’ve got 500 leases expiring between now and 2016 so they’ve got a lot of flexibility in term of what they do with existing stores.
Gross profit at 62.5% was up just one 0.1%. Store and distribution expense went down a bit from $1.981 to $1.908 billion but as a percentage of sales rose with the sales decline from 43.9% to 46.3%. Marketing, general and administrative expense rose from $474 to $482 million. As a percentage of sales, it was up from 10.5% to 11.7%.
To add to the fun, there were restructuring charges of $81.5 million and asset impairment charges of $47.7 million. That was offset a bit by $23 million of other operating income. The $81.5 million was for closing the Gilly Hicks stores.
Operating income got whacked by the double whammy of lower sales and higher charges, falling 78% from $374 to $81 million. Net income for the year was down a similar 77% from $237 to $55 million.
Fourth quarter sales were down 11.5% to $1.3 billion. The quarter’s gross margin was down 4.4% from the same quarter in the prior year. We learn in the conference call that the decline “…reflected an increase in promotional activity during the high volume holiday season, including shifting promotions in the direct-to-consumer business and an adverse effect from the calendar shift.”   Net income fell from $157 million in last year’s quarter to $66 million in this year’s.   Note that net income for the whole year was $55 million.
The balance sheet is fine, with a current ratio that’s improved though equity has fallen in spite of still earning a profit from $1.82 to $1.73 billion. I’m particularly interested to see inventory rise 24.4% from $427 to $530 million while sales fell. I would note that the reserve for inventory at February 1, 2014 was $22.1 million, up from $9.9 million a year ago. They remind us that inventory is down 22% from two years ago.
Cash at year end is down slightly from $643 to $600 million. There are also some borrowings of $135 million of which there were none last year. Cash provided by operating activities took a tumble, falling from $684 to $175 million.
Okay, here’s a fun financial fact. During the year they spent $115.8 million to buy back their own common stock. In addition, in March 2014 they entered into an Accelerated Share Repurchase Agreement with Goldman, Sachs & Co., paid them $150 million, and received 3.1 million shares of A & F common stock. There will be some more shares bought under the agreement.
Here’s what CEO Michael Jeffries said about that: 

“Our capital allocation philosophy remains to return excess cash to shareholders.  To that end, on February 27, we entered into a $150 million accelerated share repurchase agreement pursuant to the existing open share repurchase authorization of 16.3 million shares.  The accelerated share repurchase agreement reflects our confidence in our ability to achieve significantly improved performance and create sustainable value for shareholders.  We anticipate additional share repurchases over the course of the year, utilizing free cash flow generated from operations in addition to utilizing existing or additional credit facilities.”

Okay so I’m confused. I’m not a shareholder but if I heard that I’d probably ask Mr. Jeffries why he didn’t just pay me a dividend. I know the concept is that reducing the shares outstanding increases the share price, but I don’t think shareholders feel any “excess cash” in their pockets as a result of the share buyback. And I might wonder how many shares had been issued to executives and other employees in the form of options or grants and the extent to which that offset the buy back. I might even wonder why it was that the company couldn’t find anything better to do to with that cash to increase the value of my shares.    And I wouldn’t just wonder that for Abercrombie & Fitch, but for a whole bunch of other companies.

A little off the topic, but an interesting thing to think about.
Issues of Strategy
Under the Long Term Strategic Plan section of the 10K, A & F tells us their priorities to improve operating margins:
• Recovering productivity and profitability in our U.S. stores
“…we are focused on continuing to improve our fashion, particularly in our female business, and increasing brand engagement. We are taking steps to evolve our assortment, improve our product test capabilities, shortening lead times and increasing style differentiation across all classifications. In addition, we will be launching global marketing campaigns….While we expect that a number of initiatives will improve average unit retail over time, we believe we will need to be more competitive on average unit retail in the current environment and will look to aggressively reduce merchandise average unit cost in order to give us that flexibility.”
• Continuing our profitable international growth
They will be focused on Japan, China and the Middle East and would like to see international reach 50% of revenues. They don’t say by when.
• Increasing direct-to-consumer penetration
They’d like to see that be 25% of sales.
• Reducing expense
They’ve got programs in place to reduce costs by $175 million on an annualized basis, though that will be offset by $30 million in new marketing programs. They don’t say this, but I wouldn’t be surprised if the program includes some consolidation of vendors. They note that they’ve got more than 175 vendors, none of which made more than 10% of their product. As described above, their online presence also seems a bit complicated, and I can imagine some consolidations of their web sites as well.
• Maintaining capital expenditures at approximately $200 million
• Returning excess cash to shareholders
This is where they further discuss their share buyback program. You already know how I think about that.
A lot of this seems like goals rather than strategies to me. And, as I’m finding myself saying for most every retailer I review, they don’t seem particularly different from their competitors.
They go on to describe how important their employees are in creating the store atmosphere and how they are “evolving” their consumer engagement strategy “…to further develop leading digital experiences.”
They note that the in-store experience “…is still viewed as a primary means of communicating the spirit of each brand.” Not “the” primary means but “a” primary means. Well, just how does mobile and online interface with brick and mortar? We’re all going to find out how that works together.
And, correctly in my judgment, but once again like pretty much everybody else, A & F “…continues to invest in technology to upgrade core systems to make the Company scalable and enhance efficiencies, including the support of its direct-to-consumer operations and international expansion.”
A & F, you need to remember is different from other retailers in our space as all their product is their own brands. If those brands are strong enough, that’s a major point of differentiation and competitive advantage. But it requires spending marketing dollars on brand building in excess of what other retailers have to spend. I noted above that they are going to spend more marketing dollars this year.
Then of course there’s the minor problem that if a brand isn’t working out, you can’t just say, “Screw it, let’s go get another brand” like retailers who sell third party product can do. Recognizing this, A & F announced during the conference call that they are “…looking at selling third party brands through our channels and selling our branded merchandise through third party channels.” They don’t give any details.
If this happens, it will be very interesting to watch. I’m wondering what channels would carry Abercrombie & Fitch or Hollister and what impact that will have on consumer perception of the brand. I have a hard time imaging Zumiez, just to pick an example, carrying their brands. Why would they help validate the brands of a competitor?
And then I wonder why an established brand would want to be in a Hollister store where 80% of the merchandise, to pick a number, would still be Hollister. I’m not against this. I don’t even think it’s necessarily a bad idea and I applaud A & F for thinking some out of the box kinds of thoughts. I’ll be interested to see what the details are and how it works out.
Management also talked about the Hollister brand moving more towards fast fashion, and its average unit retail (AUR) price coming down. They talk about the competitive environment that requires it. CEO Jeffries put it’s like this:
“We think that the opportunity in AUC reduction is in the Hollister brand, and we think that we have an opportunity to reengineer some of that product, take some costs out of the products, which is still maintaining the quality level that is appropriate for that customer and that brand. Most of the cost initiatives will come from Hollister. But as we compare A&F for the rest of our competition, and Hollister, as we are looking at that brand and who the core customer is, we will be better quality than the competition, but there will be some reengineering of that product.”
There’s a lot going on at A & F. Much of it is consistent with what other retailers are doing. Like all of the teen retail space, A & F is having to be reactive in a hard market. As it always does, a strong balance sheet will help them. I’m intrigued by how carrying other brands and offering their own brands to other channels will work out. Not doing that has been a source of differentiation for the company and has given them some control of brands that other retailers don’t have. It’s a big change, and for it to meaningful it may be hard to do just a little. The devil, as they say, is in the details. But as I’ve always encouraged risks, thinking that doing nothing is the biggest one, I’m pretty much for trying it.


Abercrombie & Fitch Quarter: Trends Impacting Us All

Consistent with other retailers, A&F’s numbers for their August 3 quarter were not so good. Let’s look at those numbers and then talk about the general trends I think are impacting most retailers in our space.

The Numbers
Net sales fell about 1% from $951 to $946 million. U.S. sales were down 8% compared to last year’s quarter, while international rose 15%. The impact of foreign currency rates benefited this quarter’s sales by about $3.4 million.
Direct from the 10Q, here’s how the sales number break down:
You might take a look at sales by brand in dollars and then at the comparable store sales change below that. You’ll note that overall comparable store sales fell 10% even though total sales were down just 1%. Including direct to consumer, they were down 11% in the U.S. and 7% internationally. Hollister comparable store sales fell 13%.
The comparable store sales decline was “…partially off-set by new international stores and the impact of the calendar shift, that resulted from the 53-week fiscal year in Fiscal 2012.”
Let’s talk about this calendar shift stuff. The retail calendar is divided into 52 weeks of seven days each. Simple enough. But that’s only 364 days and leaves an extra day each year to be accounted for. So every five to six years a week is added to the fiscal calendar.
In the words of VP of Finance Brian Logan, “…due to the calendar shift from the 53rd week in fiscal 2012, the prior year comparable 13-week period ended August 4, 2012, had approximately $44 million of additional sales versus the reported 13-week period ended July 28, 2012, which provided a benefit to second quarter year-over-year sales and earnings.” The point is that this quarter looks, comparatively speaking, better than it would have if the extra week hadn’t dragged sales from one quarter to another last year.
As you may have noticed, all the retailers are talking about it this year. Thank god we won’t have to deal with it again for another six years now.
Okay, still on sales, let’s look at how A&F did by region. Here’s another chart from the 10Q.
You can see the U.S. took a big hit. I’ve included the 26 week results as well just so you can see  the 5% sales decline over that period.
Saving their bacon for the quarter was an increase in gross margin from 62.3% to 63.9%. They tell us the improvement was “…primarily driven by lower product costs.” What they don’t tell us is whether the lower product was the result of epic, creative, insightful management efforts or pure dumb luck. If they’d done some good management things to make that happen, you’d expect they’d tell us. On the other hand, they are in the middle of a profit improvement plan that’s supposed to generate in excess of $100 million annually. But much of that isn’t supposed to be realized until 2014. Okay, let’s say it’s the profit improvement plan. May well be.
Store and distribution expense rose from $592 to $604 million. As percentage of sales, it increased from 48.1% to 49.9% quarter over quarter. We aren’t really told why. Marketing, general and administrative expenses rose from $458 to $471 million and from 11.7% of sales to 12.4%. The increase was “…primarily driven by increases in consulting and other services.” It includes “…$2.6 million related to the implementation of the ongoing profit improvement initiative.”
During the quarter, and reflective of some of this expense, A&F opened four international Hollister chain stores and two A&F outlet stores- one in the U.S. and one in the U.K. So far this fiscal year, they’ve closed seven stores in the U.S. and one in Canada. They expect that by the end of the year they will have closed a total of 40 to 50 U.S. stores. The remainder of the closures will all happen at the end of the year as leases expire.
Net income for the quarter was $11.4 million, down from $17.1 million in last year’s quarter. For the fiscal year to date, they’ve got a profit of $4.2 million compared to a loss of $4.3 million in last year’s first half.
Net cash used for operating activities for the year to date is $209 million, compared to $24.3 million in the prior year. About $98 million of that increase is for shares repurchased. Inventory was down by 9% compared to last year’s quarter. They’d expected it to be down by more.
Trends and Strategies
A&F didn’t give any guidance as to future results beyond the current quarter “Due to the lack of visibility given the recent traffic trends…” CEO Mike Jeffries talked about the market this way:
“The reasons for the weak traffic we’ve seen in the U.S. are not entirely clear. Our best theory is that while consumers in general are feeling better about the overall economic environment, it is less the case for the young consumer. In addition, we believe youth spending has likely diverted to other categories. We assume that these effects will abate at some point, but until we have seen clear evidence of that, we are planning sales, inventory and expense levels on a conservative basis.”
He goes on to discuss their profit improvement plan (mentioned above) and ongoing long term strategic review. He notes, “…the plan emerging from this review will map out clear strategies covering our assortment, our real estate plans, direct-to-consumer, omni channel, technology, marketing and CRM and sourcing. We are confident that these plans will give us a clear roadmap for sustainable growth in sales, profitability and return on invested capital.”
To me, the most amazing part of his presentation is where he says, “We assume these effects will abate at some point” to which I respond, “Why?” If he really believed that- if he didn’t think things were changing dramatically- why is the long term strategic review necessary?
At one point an analyst asks, “I’m just wondering if you could maybe comment on the potential for maybe non-traditional competition within the teen space potentially driving some of the weakness that you’re seeing across the entire industry from you and some of your competitors. Is there perhaps a structural change that’s occurred? And is that what we’re seeing within the teen category?”
Mr. Jeffries answer is, “…I think you’re right on in terms of the potential for non-traditional competition. It’s happening and we’re — we want to be in the forefront of that. I think what we own is very powerful brands. And owning those brands, we think we’re going to be able to be in the forefront of the non-traditional brick-and-mortar part of the business.”
CFO Jonathan Ramsden, responding to a question about what won’t change in the business model, says “…the core aesthetic and what the brands stand for.”
There’s an understandable limit as to what I expect management to disclose in a conference call. And it’s certainly not a problem that’s unique to A&F. But assuming things will go back to the way they were when “…youth spending has likely diverted to other categories” and stating that the ”core aesthetics and what the brands stand for” won’t change seem like they could be incompatible statements.
In his excellent book The Black Swan, Nassim Taleb talks about the life cycle of the turkey. From the day it’s born, everybody takes really good care of him. They feed him, give him medicine, keep him warm and don’t ask him to do anything. If you asked the turkey what tomorrow is going to be like he’ll say, “Why just as good as today.” The turkey doesn’t know tomorrow is Thanksgiving.
We’re in a market where where you need to be particularly careful in examining your assumptions.


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.