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

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  2. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  3. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  4. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  7. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  8. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  9. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  10. Mutual Funds & ETFs

    ETF Analysis: Schwab US Broad Market

    Take an in-depth look at the Schwab U.S. Broad Market ETF, an incredibly low-cost fund based on a wide selection of the U.S. equity market.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Fast Fashion

    Definition of "fast fashion."
  3. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  4. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  5. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  6. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
RELATED FAQS
  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

COMPANIES IN THIS ARTICLE
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!