Abercrombie tries to buck the trend
Six months ago, I wrote an article highlighting the dangers of seeing a retailer running sales called, “Discounts – Good or Bad?” Little did I know that in the six months following the article, we’d see almost all consumer discretionary retailers discounting more aggressively than we’ve seen at any time in the last decade.
Just to summarize the aforementioned article, promotional mark downs are typically used in an attempt to entice a higher volume of purchases to juice declining revenues and clear inventory. The main pitfalls to such a strategy include:
- Increased volume at lower margins not translating into higher revenues. Few buyers will buy a poor product even at a discounted price.
- Reliance on discounting is often a result of structural weakness in a Company’s merchandising decisions.
- Repeated use of voluntary discounts run the risk of turning into a permanent loss of pricing power through what I call “the sale spiral.” Customers become accustomed to bargain basement prices and lower their reservation price for the Company’s products altogether.
In my previous article, I assumed discounting was the direct result of difficulty enticing customers to buy product. But, what about discounting in the face of a recession and overall tightening of wallets? If the industry as a whole begins discounting, do the same principles of loss of pricing power, profitability, and brand image apply? One company, Abercrombie and Fitch, believes so and has chosen to stay away from running promotions in addition to their annual clearance in hopes of maintaining its brand image and, more importantly, pricing power.
Throughout the last two years, Abercrombie has maintained gross margins at its historical (and astronomically high) levels of 66+% despite a significant consumer downturn. As expected, the company’s same store sales have collapsed and net income last quarter was down year over year for the first time in the last ten years.
Abercrombie is making a calculated bet in maintaining prices despite the fact that competitors have been slashing prices across the board. My assumption is that it hopes that by bucking the trend it can accomplish the following:
- Maintain its “casual luxury” image by not chasing its demographic down market.
- Magnify its brand appeal through its relatively “aspirational” pricing. The company hopes that empty handed teenagers will be walking out of the store thinking, “Someday when I have the money, I’ll buy tons of Abercrombie!”
- Capitalize on consumer surprise when competitor prices jump back up to pre-recession levels and Abercrombie’s “miraculously” stay flat.
The problem, however, is that for this strategy to work Abercrombie must prove to have a truly defensible luxury product. My contention would be that teen apparel is very subsitutable. It is, after all, difficult to establish “aspirational” status for ripped jeans and double entrendre t-shirts. In trading down or going to other similarly “aspirational” teen retailers like Urban Outfitters which are running sales, customers may find that that they don’t necessarily need to return to Abercrombie.
In addition to long term risk to the Company’s demographic appeal, the decision to maintain prices in the face of lower revenues has put some stress on the Abercombie’s balance sheet that will have to be dealt with. A quick look at Abercrombie’s inventory and cost of goods sold finds that the Company held $505 million in inventory at the end of last quarter, up from a typical $400 million-ish that are typically held through the last two quarters of the year. Assuming COGS as a proxy for inventory moved in a quarter, we find that Abercrombie typically purchases ~$300 million in inventory per quarter which would imply that the Company held almost two quarters’ worth of inventory at last check. In all likeliness, this backlog is mostly fall and winter clothing. Sooner or later the Company will have to clear this inventory, probably before summer. Knowing how quickly fashions can change, I wouldn’t imagine that it will be easy to move this build up without eventually succumbing to the so-called “promotional pied piper. “
Full disclosure: No positions held in any of the Companies mentioned in this article.
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Personally, I stopped shopping at Abercrombie a couple years back for the simple reason that everybody has it and there is not much product diversity. So you always see somebody wearing the same thing.
By the way, liking hte new layout.