While specialty apparel retailer Abercrombie & Fitch (NYSE:ANF) has struggled in the U.S. due to weak fashion, controversial brand image and improper inventory management, its few stores in China have performed exceptionally well. The retailer’s Hollister stores in the region continue to deliver meaningful comparable sales growth and its new flagship A&F store in Shanghai has drawn significant customer attention. Launched in April, the flagship store generated significant buzz, gathering 500 million social media impressions and 30,000 new Weibo followers. Abercrombie’s campaign to grow its brand awareness in the region has started strongly, and the retailer expects this to continue going forward. Additionally, Abercrombie’s direct-to-consumer business in China has grown at a tremendous pace over the past few quarters, which will only get better once the retailer comes out with local language websites and local fulfillment centers later this year. 
Although Abercrombie’s debut in the region has been pleasing, it remains to be seen if it can sustain this momentum in the long run. Since a company usually goes after the most lucrative regions when it enters a new market, its initial success cannot define its long term performance. However, it does lay a solid foundation for the company to build on. In case of Abercrombie, the retailer has started well in the second largest apparel market in the world, which is set to grow at a robust pace driven by a booming middle class and changing lifestyles with growing urbanization. Yet, there are several challenges that can prevent Abercrombie from taking advantage of this growth. The Chinese apparel market is highly competitive and consumers are extremely discerning with different needs and demands among different demographics. The recent pullback in the region’s consumer spending has discouraged retailers from expanding aggressively as it can easily lead to weak sales and inventory hangover. Apart from this, high operating costs in tier 1 & 2 cities and the dominance of low-cost local players in tier 3 & 4 cities is likely to create some roadblocks for Abercrombie’s expansion. The retailer plans to open four stores in China this year, and is preparing to accelerate its expansion fiscal 2015 onwards. 
Our price estimate for Abercrombie & Fitch stands at $39.72, which is just below the market price.
The Chinese Apparel Market Holds Tremendous Potential
Although the Chinese apparel market is struggling currently on account of a consumer spending pullback, it is set to boom in the long term. With rising disposable income and growing urbanization, the market grew from $110 billion in 2009 to $140 billion in 2012, and is expected to touch $220 billion by 2016.  Within the market, men’s and women’s casual wear are among the biggest and fastest growing apparel segments. A 2012 AT Kearney report estimated women’s casual wear market to be at $67 billion and men’s casual wear market to be at $56 billion. The same report projected their CAGR (compound annual growth rate) for the period of 2012-2016 at 15% and 17% respectively. Fashion casual wear sales account for about two-thirds of the overall casual wear sales, which suggests that the addressable market for Abercrombie is large at around $95 billion (estimated figure for 2013). The fashion casual wear market is expected to grow at a CAGR of 15% for the next few years, indicating that it will remain ahead of the overall market growth. 
During the 1990s, middle-aged Chinese consumers started switching from their work related formal uniform to casual outfits, which propelled growth in the apparel market. For over two decades, Chinese buyers exhibited great interest in lifestyle oriented clothing, due to the availability of wide range of products and brands. Additionally, with rising disposable incomes and growing urbanization, their budget for branded apparel stretched.  A substantial rise in the region’s labor costs on account of labor shortage, an ageing population and increased government regulations were the primary reasons responsible for increasing disposable incomes. Development of rural areas encouraged the local population to look for work opportunities in their vicinity, which prevented migration to urban areas, resulting in fewer workers and more expensive labor.
China’s population is aging and about 243 million Chinese are expected to be above the age of 60 by 2020, which will further add to the labor shortage.  The younger generation increasingly prefers college over factory work, which reflects increased awareness of education and the opportunities it affords. Apart from fueling labor costs, this trend is likely to enhance the youngsters’ living standards and likely increase the demand for specialty apparel.
However, The Market Is Challenging For Abercrombie
One of the biggest challenges for Abercrombie in China is to understand the shrewd consumer behavior. Between 2000 and 2005, top 500 domestic brands in China had an average life cycle of just 1.5 years. In addition to the fierce competition in the market, this was attributable to rapidly changing consumer tastes. Among different age groups, consumer preferences vary drastically, which makes it difficult for retailers to target a particular age group. For instance, a retailer specifically targets the age group of 18-25 years, several loyal customers will outgrow this age range within a few years. Subsequently, their needs will change and they might start shopping at other places. Ultimately, the retailer loses its loyal customer base due to the lack of merchandise relevant to different life stages of a customer. While companies usually operate multiple brands in China to encompass different age groups, doing so won’t be easy for Abercrombie, given that it has established itself strongly as a teen apparel brand.  On this front, Abercrombie can take a lesson from Gap Inc (NYSE:GPS), which has three different brands for three main demographics - Old Navy for cost and fashion conscious teenagers, Gap for young adults and Banana Republic for more affluent and relatively older customers.
Abercrombie is at its nascent stage in China and still has a lot to explore. While it may seem that there are several expansion opportunities at hand, identifying locations to open new stores will be an arduous task. Abercrombie might not want to target tier 3, 4 & 5 cities with more than 320 million households for its expansion since disposable income in these regions is low. Moreover, they are dominated by local players who have a superior understanding of the market and strong support from the local government.  This leaves six tier 1 cities and more than 60 tier 2 cities with over 54 million households for Abercrombie to target.  However, expensive real estate and high labor costs in developed cities can have a mitigating effect on Abercrombie’s aggressive expansion.  Going forward, the retailer will have to plan its expansion carefully as even small missteps can impact its profitability.
Fast-fashion brands Zara and H&M have troubled several apparel retailers including Abercrombie in the U.S., and they are on their way to do so in China as well. These brands have entered tier 1 cities and are planning to grow their business rapidly. Zara operated about 120 stores in China in 2012, which is likely to double in the near future.  Although Abercrombie has started very well in China, thanks to its strong international brand image, it will have to fight its way in the market from here on.Notes:
- Abercrombie & Fitch’s Q1 fiscal 2014 earnings transcript, May 29 2014 [↩] [↩]
- B2C Ecommerce Sales Climbs Worldwide, as Emerging Markets Drive Higher Sales, eMarketer, Jun 27 2013 [↩]
- Winning in China’s Apparel Market, AT Kearney [↩] [↩] [↩] [↩] [↩] [↩]
- China’s bid to provide care systems for elderly faces hurdles, warn experts, South China Morning Post, Sept 4 2013 [↩]
- China’s City Tier system, Osio China, Nov 16 2012 [↩]