Abercrombie Chooses Fewer, More Profitable Sales Over Lower Margin Bargain Bins

Last month I mentioned I thought Abercrombie and Fitch (ANF) stock looked undervalued. A December 8th Wall Street Journal article entitled “Abercrombie Fights Discount Tide” discussed ANF’s strategy to maintain its premium brand image by choosing to accept higher rates of sales decline, relative to lower priced competitors, in order to hold up profit margins and not risk losing pricing power when the economy recovers.

The company has taken some heat on Wall Street for employing such a strategy, but it worked just fine for Abercrombie in the last recession. As an investor, I much prefer fewer sales at higher margin to higher volume (and less profitable sales) because it minimizes the risk of a retailer falling into the red.

The WSJ cites November same store sales drops of 28% for Abercrombie versus only 10% for Pacific Sunwear (PSUN) and 11% for American Eagle Outfitters (AEO) as evidence that markdowns boost sales in the short term, which is certainly true. But the key here is margins. While gross margin collapsed for the latter two retailers (Pac Sun from 34% to 29%, American Eagle from 47% to 41%), Abercrombie’s held steady at a stunning 66%.

Gross margins of 66% are usually reserved for software and medical device companies, not mall retailers. With retail markups of 50% above cost, Abercrombie clearly has a premium brand. It is expected that during tough economic times that many of its customers will trade down to cheaper clothes, but that does not mean the company should completely rebrand itself. ANF is debt-free with 66% gross margins, so sales can drop pretty significantly without jeopardizing profitability.

“We hear your concerns,” ANF Chief Executive Michael Jeffries said during an earnings call, but “promotions are a short-term solution with dreadful long-term effects.” Abercrombie’s general counsel, David Cupps, added that the company is “well positioned to deal with a tough market,” adding that cutting prices would be cutting the quality of merchandise. “We’re not going to follow the promotional pied piper,” he said.

Given the amount of bad news already priced into ANF shares, they look very cheap even if sales continue to drop throughout 2009. Even if you assume earnings fall 50% from their 2007 peak level, never recover at all, and the stock only fetches a 10 P/E, investors buying today will make a 30% return from current levels. That is a risk-reward scenario that looks very favorable.

Full Disclosure: Peridot Capital was long shares of ANF at the time of writing, but positions may change at any time