Is Abercrombie's Business Model Broken?

Abercrombie & Fitch pre-empted its third-quarter earnings release with an announcement that same-store sales plummeted in the quarter.Abercrombie continues to struggle amid a slow U.S. economy and high youth unemployment. Other clothing retailers, such as Gap and L Brands , have also struggled mightily this year.

But Abercrombie's situation is different. While Gap and L Brands' problems are clearly tied to economic conditions, Abercrombie's problems are not as straightforward.

Gap and L Brands recover, Abercrombie falters
Abercrombie's high price points put it at a significant disadvantage during rough stretches for the economy. Its mid-60s gross margin is 25 percentage points higher than that of Gap and L Brands. Cash-strapped teenagers show a preference for less expensive brands when youth unemployment is high, so Abercrombie's sales get crushed.


When the economy goes south, Abercrombie has traditionally been able to discount its merchandise to clear inventory. Unfortunately, its promotional efforts have not driven sufficient sales volume over the last several quarters, leading to a worrisome buildup of inventory. It is not unusual for Abercrombie's inventory turnover (calculated by dividing cost of goods sold by average inventory) to be lower than Gap's and L Brands' due to its higher price points, but the sharp drop-off over the last four quarters is cause for alarm.

Data Source: Morningstar

The buildup of inventories brings into question Abercrombie's entire business model. Most apparel retailers carry limited inventory that can be sold quickly in case fashion trends change, thus minimizing damage caused by one poor quarter of merchandising decisions. Abercrombie, on the other hand, makes decisions based on the assumption that its brand is a competitive advantage -- that the company is immune from the whims of fashion trends because youths cannot accept any other brand.

That is turning out not to be the case. Gap's same-store sales increased 4% last month and L Brands' increased 8%. Meanwhile, Abercrombie's same-store sales plummeted 14% in October. Clearly, youths do not view Abercrombie's brand as the must-have "aspirational" brand that its CEO is intent on selling.

The holiday season could be a disaster for Abercrombie if it is unable to unload stale inventory to reposition itself for the fourth quarter. Chief executive Mike Jeffries has already warned that the company could experience a low double-digit decline in same-store sales in the fourth quarter (Abercrombie's fiscal year ends in January).

If Abercrombie is no longer a coveted brand among its key consumer base, then its high margin and low turnover business model is unworkable. The current model makes it impossible to be as responsive to changing consumer tastes as its higher-turnover competitors. Therefore, Abercrombie must accept reality and lower its prices in order to remain competitive.

Never to recover again?
There is no doubt that Abercrombie is in a worse position than its peers given the current economic environment. However, it traditionally earns higher profits during the good times due to its higher price points. So, the bulls say, investors need only wait for a recovery to average out the bad years. But one must wonder whether teens will return to pay higher prices for a brand that they so eagerly ditched during the slow economy once youth unemployment finally recovers. 

The company has endured intense scrutiny for its exclusionary policies in both its hiring practices and its marketing practices. Abercrombie finally relented and has committed to offering plus-size women's clothing beginning in 2014. However, the damage done to the company's image as a result of the bad publicity may not heal even with a recovering economy.

The only solution to Abercrombie's current woes is to start selling its clothes at a price point closer to that of Gap and American Eagle Outfitters. That means slashing its gross profit by 25% to 30% and accepting permanently lower profitability. Until the company is willing to do that, Abercrombie will continue to stall even as its peers rebound.

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The article Is Abercrombie's Business Model Broken? originally appeared on Fool.com.

Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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