Why Abercrombie's Second Quarter Sales Increase Isn't Impressive

Second-quarter sales rose 17% at Abercrombie & Fitch (ANF) and for once, the market didn’t jump the gun on the headline news.

Perhaps investors finally learned a lesson on temporary retail sales euphoria. After all, many got burned earlier this year when a few months of same-store sales sent the Retail XRT Index up 45% from beginning of the year through mid-April, only to come crashing down and bottoming out 35% below the peak when it became more clear that sales increases weren’t as meaningful as first interpreted.

As I’ve been saying for nearly a year (see Five Reasons to Sell Abercrombie Now), Abercrombie is a lost soul in niche retail world. Sales did rise 17% to $745.8 million. But seeing that second quarter comps fell 30% and 4% in 2009 and 2008 respectively, the increase was less than impressive. In fact, sales in 2007 were $804.5 million.

Breaking down sales data uncovers an even less flattering picture:
 

• Average transaction value fell 4% YOY and is down 4%YTD.
  
  
• Average unit retail sold fell 15% YOY and is down 15% YTD.
  
  
• Gross margin slipped 150 basis points YOY to 63.9%.

That didn’t stop CEO Mike Jeffries from boasting about results. From the conference call, “Next, we believe that our marketing and promotional activities for the quarter were effective and appropriately timed. We also believe that the promotions were effective in driving overall gross profit dollars.”

A quick trip down memory lane reveals that Abercrombie’s gross margin has historically hovered around 67% since 2005. Furthermore, the gross margin declined from last year’s second quarter. Am I missing something?

The bottom half of the income statement doesn’t appear any more attractive. Sure, a $0.22 profit was recorded. But cost-cutting played a large a role in achieving that -- operating costs declined 410 basis points from 2009 -- meaning it will only produce temporary results. Furthermore, a cash-flow statement wasn't included, so earnings quality cannot be fully assessed.

Like its apparel, margins across the board are getting slimmer and slimmer. In addition to a lower gross margin, the second-quarter operating margin was just 0.1% compared to 5% in 2009, 13% in 2008, and roughly 19% from 2003 through 2007.

The balance sheet was dressed up with $250 million more in cash and decked out in 48% more inventory in comparison to last year. However, the $614 million in cash is lower than the $680 it had at the end of the year. And as for inventory, management appears overzealous about its recent sales increases because inventory grew far more quickly than sales. It’s only a matter of time before this will catch up and result in further markdowns. It also proves worrisome that management will overestimate holiday inventory orders.

There’s a reason Interbrand’s 2010 Brand Value assessment calculated an 81% drop in Abercrombie’s brand value. Abercrombie’s moose is no longer relevant in today’s US teen retail market. And other growth avenues appear limited.

Not much is happening on the international front as international sales as a percentage of total sales remained the same. Although, as I’ve suggested before (see Why Abercrombie's Future Doesn't Look Pretty), this could potentially help buoy sales in the future. And performance at Gilly Hicks has yet to be revealed even though the concept was launched over a year and a half ago. Not surprising as American Eagle’s (AEO) Aerie and Limited Brand’s (LTD) Victoria’s Secret PINK dominate the teen lingerie and sleepwear market. I find it doubtful that Gilly Hicks will find a meaningful place in this space.

Like Gap (GPS) and other previously hot niche retailers, store contraction is necessary for Abercrombie. Management announced it plans to close 60 locations in 2010 and another 50 in 2011. This is certainly a positive point, as a lower store base count will help drive store efficiency.

But it’s just too late to ever rejuvenate Abercrombie back into the teen idol brand it once was (see Abercrombie Is Worn Out and Quickly Fading.) Brand erosion is, for the most part, irreversible. And retailers like Buckle (BKE) that have executed years of conservative growth, and Urban Outfitters (URBN) which offers distinct value with unique differentiation, are quickly pushing over-expanded retailers with redundant merchandise out of the picture.

Wall Street is valuing the company with projected earnings growth of 60% in 2011 and 40% in 2012 based on 14.2% and 11.1% sales growth respectively. I’m assuming this is what’s driven the stock up 140% since bottoming in 2008 at $14 per share. But I’m completely stumped on where this growth will come from.