Is ‘Fast Fashion’ Hollister Triggering A Turnaround In Abercrombie’s Growth?

Abercrombie & Fitch‘s (NYSE:ANF) shares opened up by almost 10% after its Q2 earnings release on August 26th, as it comprehensively beat market expectations on revenues and profits. While the namesake brand remained weak, Hollister exhibited tremendous strength with its updated merchandise mix and store environment. For more than a year, the retailer has been trying to transform Hollister into a ‘fast-fashion’ brand by replacing its logo merchandise with fashion-focused products, dialing down the steamy ‘sex-appeal’ aura of its stores and overhauling the back end of the brand to improve the speed to market. These efforts are beginning to show promising results now, as Hollister’s comparable sales fell only 1% in Q2, which is a significant improvement over 6% decline in Q1. Although some of the visible improvement in Hollister’s comparable sales can be attributed to a weak comparable, Abercrombie believes that the brand’s advancement is sustainable. This suggests that Hollister, contributing over 50% to net revenues, may indeed be triggering a turnaround in the company’s growth. In fact, Hollister’s success with its fashion overhaul can set the precedent for other struggling casual apparel retailers as well.

On the other hand, A&F is still struggling in its quest to become a classic premium brand, recording a comparable sales decline of 7% during the quarter. Abercrombie said that its mainline brand transition is taking longer than expected, which can keep its growth at bay in the near term. Nevertheless, we believe that it is headed in the right direction and a turnaround seems attainable, though it can take some time.

Our price estimate for Abercrombie & Fitch stands at $29, implying a significant premium to the current market price.

See our complete analysis for Abercrombie & Fitch

Earnings And Guidance Were Encouraging

Abercrombie’s net sales for the second quarter declined 8.2% to $818 million, but was still ahead of the consensus estimate. Gross profits margins improved 110 basis points to 62%, as the retailer was able to reduce its average unit costs despite the rapid infusion of fashion-forward products in its portfolio. Another reassuring factor for the company was that its average unit retail in the U.S. continued to stabilize, implying a marginal decline in the level of promotional activities. ^[1]

Marketing, general and administrative expenses, excluding the impact of lawsuit settlement charges, declined $6.2 million year over year, indicating robust progress on cost cutting efforts. Overall, the company reported adjusted profits of $8.6 million or $0.12 per share, way ahead of the consensus estimate of a loss of $0.04 a share. ^[2]

For the second half of the year, the company expects further improvement in comparable sales and gross margins on a constant currency basis, which is an encouraging sign for the investors. ((Abercrombie & Fitch Reports Second Quarter Results, Abercrombie & Fitch, Aug 26 2015)) Most of the improvement so far and the expected rise going forward is attributable to Hollister, where the company has made tremendous progress.

 Hollister’s Comeback Holds Upside Potential

Hollister’s performance has improved considerably over the past several quarters driven by Abercrombie’s consistent efforts to reinvent the brand. Once know for its casual apparel infused with laid back lifestyle of Southern California, the retailer has now affixed a ‘fast-fashion’ tag on it, having made significant changes in its product portfolio and shopping environment. Executive chairman, Arthur Martinez said that Hollister has gained quick traction, thanks to the company’s efforts of replacing basic logo inventory with fashion-forward merchandise and creating a relevant store and web environment.

In almost 100 stores, shutters on the store windows have been replaced by video screens and signature scent has been dialed down by 75%. Five remodeled stores, which are lighter and brighter with subtle interiors that no longer have artificial trees, leather sofas and oriental rugs, have been performing very well. We believe that once these formats are rolled out on a larger scale, Hollister will be able to record even better results and drive the company’s growth. The management stated that customers have so far responded positively to the updated Hollister, indicating an impending recovery for Abercrombie.

We currently estimate Hollister’s revenue per square feet to decline about 5% this year to $338 and increase at an average annual rate of 1.3% thereafter for the next five-six years to reach $366. However, low-mid single digit rise in comparable sales over the next three-four quarters, can reduce the intensity of decline this year and bolster the growth in the metric thereafter. If revenue per square feet of ‘fast-fashion’ Hollister reaches $390 by the end of our forecast period and e-commerce growth accelerates a little, there could be about 5% upside to our price estimate for the company.

But, A&F Still Needs Some Work

While Abercrombie has been seamlessly developing the ‘fast-fashion’ version of Hollister, progress on A&F has not been as healthy. Over the past three quarters (the product transition phase), while the fall in A&F’s comparable sales has slowed down marginally, the magnitude of decline remains high, at -7%.  It has improved notably over that past two quarters, however, as seen in the illustration below.

The company’s management indicated last year that they plan to turn A&F into a classic premium brand, but it appears that it is still struggling to find its place in the market. This is where the new leadership structure comes in. Abercrombie has completely overhauled the brand leadership structure for A&F in order accelerate its recovery. Knit category has been the most challenging for the brand, and perhaps that is where the new leaders should focus initially.

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1. Abercrombie’s Q2 fiscal 2015 earnings transcript, Aug 26 2015 [↩]
2. Abercrombie & Fitch Swings to Loss, But Hollister Shows Improvement, The Wall Street Journal, Aug 26 2015 [↩]