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.

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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.

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