Clothing retailers are not typically included in lists of cyclical industries, but I would challenge investors to look at the long-term performance of companies like American Eagle (NYSE:AEO), Buckle (NYSE:BKE) or Aeropostale (NYSE:ARO) and not conclude that sizable up-and-down swings are just part of the fabric of this business.

With that in mind, it was tempting to argue during Abercrombie & Fitch's (NYSE:ANF) recent struggles that "this too shall pass," and that the company will eventually turn around its operating performance. While Abercrombie's third quarter performance was certainly surprising, and stimulated a major move in the stock, investors may want to be cautious in assuming that the worst is now past.

Credit Card Comparison: Find the credit card that is just right for you

A Surprisingly Good Third Quarter
Abercrombie hasn't been doing all that well of late, and that was reflected not only in declining analyst expectations, but also in the abnormally large expected comp decline for this quarter. Although the company did surpass estimates, it's worth asking if the performance was as strong as the stock reaction suggests, as decoding an earnings report is an important skill.

Revenue rose 9% for the quarter, as U.S. sales were flat and international sales jumped 37%. U.S. store comps declined 3%, while direct-to-consumer sales rose 20% (15% in the U.S. and 31% for international). Given that the average sell-side estimate was calling for a 9% decline in comps, this was a surprisingly positive result and likely a sign that the company's promotional activities worked well.

Although heavy promotional activity is usually bad for margins, Abercrombie's gross margin actually improved almost two and a half points from last year. Lower unit costs helped (passing through the anniversaries of higher cotton costs last year), as did an improving mix from overseas. Operating income was also quite strong - up 41% from last year - but that strength largely came from the sizable gross margin improvement.

Back in the Groove with Merchandising?
One of the key skills for any retailer is merchandising - predicting what its customers want to buy and responding quickly to whatever is proving popular (or unpopular). For reasons that go beyond this article, retailers seem to just periodically fall out of step with their merchandising - it has happened to American Eagle (more than once), Buckle, Gap (NYSE:GPS), Chico's (NYSE:CHS) and likely every retailer that has been in business for 10 years or more.

Is Abercrombie back in the groove? I'm not sure. Inventory dropped 21% (against the 9% overall sales growth and 3% U.S. comp decline), as the company aggressively stepped up promotions. That said, while fourth quarter management guidance was more positive, it was a move from an expected negative comp of -10% to the negative mid-single digits. With the Christmas shopping season on the way, that's not exactly my idea of a strong recovery.

Margins Good, Would an LBO Be Better?
With weak U.S. comps apparently likely to continue, I have to wonder how much more Abercrombie can do with its margins. The company's above-average overseas growth could continue to be helpful, but I don't think the company can repeat the boost from lower unit costs much longer. At the same time, I don't know if the European macro picture is healthy enough to expect these high growth rates to continue. Consequently, I have my doubts that Abercrombie & Fitch can keep this up absent a real (and sustained) improvement in U.S. same-store sales.

I also wonder if Abercrombie & Fitch management is going to consider taking the company private. This stock long enjoyed a premium multiple relative to other clothing retailers, but that has since disappeared. Given the valuation on the stock, the basic volatility of the business, and the debt markets, a leveraged buyout (LBO), could make a lot of sense. By my estimates, Abercrombie & Fitch could probably offer at least a 30% premium (if not more) even after this big post-earnings jump and still generate a solid double-digit return from going private.

The Bottom Line
Buying a stock in the expectation of a buyout (or LBO, as the case may be) is usually not a good idea. That said, Abercrombie's clean balance sheet does make it possible and that option could offer some downside protection to the shares.

At today's price, I'm inclined to think that Abercrombie is a worthwhile idea as a long-term turnaround idea, but I'd frankly want to hear more from management about how they're going to reposition their U.S. merchandising and reignite same-store sales growth before buying shares. Given the huge pessimism on this stock going into earnings (and the large short position), I'd be wary of a short squeeze here and I'd probably wait for things to settle down a bit before starting a position.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  2. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  3. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  4. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  5. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  6. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  7. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  8. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  9. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  10. Stock Analysis

    The Biggest Risks of Investing in Amazon Stock

    Find out which risks are most important to Amazon's shareholders. Learn which operational risks impact share prices and which financial risks affect investors.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!