Abercrombie & Fitch: To Price Promote or Not To Price Promote?

At the beginning of the Great Recession, Abercrombie & Fitch (ANF) had a clear policy against price promotions.  By the end of the Great Recession, price promotions were clearly part of Abercrombie & Fitch’s retail strategy.  What changed?  Was Abercrombie & Fitch’s price promotion policy shift simply another shoot-from-the-hip shotgun response to declining sales, or was it a needed change to improve growth and profits?  Is it wrong for Abercrombie & Fitch to price promote or is it wrong for Abercrombie & Fitch to NOT price promote?

In this case study, we examine the strategy evolution of Abercrombie & Fitch between 2008 and 2011 in an attempt to uncover the conditions under which price promotions can have a positive role in corporate performance.  We find that the positive performance outcomes at Abercrombie & Fitch leading into 2011 are due to two co-entangled factors:  (1) the development of a disciplined price-promotion policy and (2) the international (non-US) growth to serve customers which demonstrated a higher willingness to pay.

Nuances of the Value of Price Promotions

Price promotions are neither universally good nor universally bad for a firm.  To their credit, price promotions are generally effective at taking market share, growing revenue, and garnering customer attention. To their deficit, price promotions will reduce margins and can reset price expectations lower as well as erode brand positioning and brand loyalty.  In the recent history of Abercrombie & Fitch, we see all of these factors influencing decision calculus.

Resisting Price Promotions

In the 2008 to 2009 time frame, Abercrombie & Fitch held onto their historic position against price promotions.  This was at the beginning of the Great Recession when it was not unreasonable to expect the economic downturn would be soon followed by recovery.  Because Abercrombie & Fitch held a premium brand position and sufficient cash, Chief Executive Michael Jeffries made a reasonable strategic decision to not follow competing retailers into deep price promotions.

Abercrombie & Fitch’s competitors used that opening to steal share.  Same-store sales at Abercrombie & Fitch, an indicator of the continued brand relevance, were down 7% for July 2008, continued downward during the Christmas shopping season by 28% for November 2008, and went down further during the 2009 Christmas shopping by 19% for December 2009.

True, during the Great Recession most other retailers had similarly poor same-store sales, but most hits were generally not as bad as Abercrombie & Fitch’s and some retailers even performed well.  For July 2008, same-store sales at competitors American Eagle Outfitters Inc. declined 13%, at Hot Topic Inc. declined 2%, and at Pacific Sunwear of California Inc. declined 4%, while those at Aeropostale grew 13%.  For November 2008, same-store sales at competitors Pacific Sunwear of California Inc. declined 10% and at American Eagle’s declined 11%.  All of these competitors used heavy price promotions to retain customer traffic.

Supporting Abercrombie & Fitch’s strategy of holding prices strong rather than using hefty price promotions was the readily observed margin shrinkage of their competitors compared to decent margin preservation at Abercrombie & Fitch.  In the third quarter of 2008, gross margins at American Eagle declined 6.4 percentage points to 41% and those at Pacific Sunwear fell 4.9 percentage points to 28.7%.  Meanwhile, gross margins at Abercrombie & Fitch fell only 0.2 percentage points to 66%.

Crises and Change

If the story ended here, we might be able to defend Mr. Jeffries belief that price promotions were inappropriate for Abercrombie & Fitch.  Yet the story doesn’t end here.  A crisis loomed – one that would force a change.

In November 2008, Mr. Jeffries responded to calls from shareholders for price promotions with “We hear your concerns…, [but] promotions are a short-term solution with dreadful long-term effects.”  He went on to explain that marking down clothes now could lead to the brand being seen as something cheap, an anathema for the aspirational brand.  Echoing his position, Abercrombie & Fitch’s general counsel David Cupps stated that the company was “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 says.

In its fiscal-fourth-quarter 2008, Abercrombie & Fitch reported a 68% drop in earnings.  As shoppers began to spurn Abercrombie & Fitch in favor of competitors with deep price promotions, Abercrombie & Fitch found itself needing to clear inventory with price reductions as high at 90%.

(Price reductions to clear inventory should not be evaluated in the same manner as price promotions used to drive volume.  Price promotions used during the regular selling season should be evaluated with breakeven incremental sales models since these discounts are used to drive sales volume above a baseline expectation on goods which may be replenished.  Price reductions after the regular selling season should be evaluated according to their efficiency in removing a wasting asset with high inventory carrying cost since all costs on these goods are sunk and no further marginal costs will be incurred.)

A change in price promotion strategy was needed.

By August 2009 following a further quarterly loss, Mr. Jeffries knew he needed to allow greater price reductions.  In an earnings call, he cautiously signaled a plan to incorporate promotional pricing in stating “consumer spending patterns domestically continue to be dictated by cost and value propositions, and this is clearly a headwind for our premium brands. … [In response] we are planning to deliver greater reductions in [average retail prices] for the fall season, but we will continue to review pricing on an ongoing basis”

These price promotions didn’t provide immediate relief.  Sales continued to decline through the 2009 Christmas shopping season.  Stock analysts suspected that prices were no longer the problem, but rather the style had lost its market.  This strategy analyst suspects that the challenge faced by Abercrombie & Fitch was a loss of market relevance.

Teen brands like Abercrombie & Fitch are subject to a stiff requirement of remaining relevant to their market every year.  If they lose their market one year, it is tough to regain that teen market the next year.  Each year, the teen market gains a new crop of teenagers and loses an old crop as kids grow up and eventually mature.  By losing sales in 2008 due to having prices too high, they lost relevance not only with a year’s worth of teenagers but also the interest of those teenagers that look to their immediate peers for fashion ques.

To regain relevance, Mr. Jeffries planned for a continued use of uncharacteristically high levels of discounting according to a February 2009 statement.   Shortly thereafter, in an earnings call of March 2010, he stated “While we have never and do not ever plan to be a promotionally led business, we are getting better at figuring out something that was completely alien to us 18 months ago.”

By May of 2010, Mr. Jeffries had clarified its price promotion policy:  Price promotions at Abercrombie & Fitch as well as its kids brand, abercrombie, would be limited in the future. Price promotions would continue at Hollister, the lowest-priced brand in the Abercrombie portfolio.

Clearly, despite an earlier indication that Mr. Jeffries would not lead Abercrombie & Fitch into price promotions, Mr. Jeffries had now decided that price promotions were necessary.

Mr. Jeffries new strategy to support price promotions in a disciplined manner is a sound approach to support both market and finance performance.

From an economic vantage, price promotions are simply a form of price segmentation.  If they can be used to segment the market between those willing-to-pay the full price from those that aren’t, economic arguments show that price promotions can improve profitability.  However, if price promotions are overly extended, they lose their ability to price segment the market and enable all customers to purchase at a lower, discounted price.  In these circumstances, price promotions are effectively a resetting of the price to a lower, less profitable, position.  The corporate capability that Mr. Jeffries was alluding to was likely the ability to differentiate between profit-eroding promotions and profit-enhancing promotions.  This is no small feat.  Furthermore, Mr. Jeffries was indicating that price promotions would be focused on its lower-valued brand and not its premium brand as noted in an analysis by John Jannorone of the Wall Street Journal.  This is a significantly wise strategic move.

Rationalizing Price Promotions across Brands

When considering price promotions across brands, firms have one of three choices: constant, convergent, or divergent price differentials.

Assume that list prices across brands are set to optimize overall firm profits.  Thus, any difference in list prices between brands reflects a difference in value as perceived by customers.  Moreover, any divergence of this price difference will cause one brand to cannibalize the sales of the other brand.

In a constant price differential promotional policy, the firm is acknowledging that prices which were set to optimize profits across brands reflect valuation differences.  Thus, if the lower value brand is dropped by $5, then the higher value brand should also be reduced by $5 to avoid encouraging customers that would have bought the higher value brand to switch down to the lower value brand due to a favorable increase in the price-to-value tradeoffs.  From a strictly economic-tradeoff viewpoint, firms should practice a constant price differential promotional policy.

In a convergent price differential promotional policy, the firm is discounting their premium brand heavier than its lower value brand.  Firms often execute a convergent price differential promotional policy for three short-term performance reasons.  One, the premium brand typically has a higher margin which enables price promotions to be deeper without reducing prices below marginal costs.  Two, firms often profit from encouraging customers to upgrade to premium brands from lower value brands.  And three, price promotions on premium brands are known to have stronger influence on encouraging customers to switch brands from competitors’ to the firm’s.  However, this policy comes at a heavy cost as we will see with the third policy choice.

In a divergent price differential promotional policy, the firm will discount the lowest-value product more than its premium brand.  There are four key consumer behavior issues favoring this policy.  One, premium brands tend to target customers with a higher willingness to pay, or more utility-sensitive customers.  Utility-sensitive customers tend to be relatively price insensitive and therefore price discounts to utility-sensitive customers are somewhat unnecessary for capturing their sales.  Thus, any discount to utility-sensitive customers is an unnecessary, profit eroding, price give-away.  Two, lower priced brands tend to target customers with a lower willingness to pay, or more price-sensitive customers.  Price-sensitive customers respond strongly to price promotions, and therefore discounting lower valued brands are effective in capturing more price-sensitive customers.  Three, research has demonstrated that utility-sensitive customers are unlikely to switch to lower-valued goods, even in light of price discounts on lower-valued brands.  In other words, the cross-brand elasticity between premium and low-valued goods is asymmetric, having a smaller effect on the sales volume of high-value goods when the price of low-valued goods is decreased than that observed on sales volume of low-valued goods when the price of high-valued goods is decreased.  And four, price-promoting a premium brand is known to erode the brand’s premium position, thus destroying future pricing power.

In short, firms tend to practice convergent price differential promotional policy because it is easy to justify with short-term performance metrics, but from an economic viewpoint they should at least be practicing constant price differential promotions, and if we consider consumer behavior we would argue for the stronger divergent price differential promotional policy.

An example of a firm which practices a divergent price differential promotional policy is Volkswagen.  Its premium brand, Porsche, is almost never discounted and instead can be found sold at many dealers well above its manufacturer’s suggested retail price (MSRP).  In contrast, Volkswagen namesake brand is often discounted at dealerships in the US while its Skoda brand can often be found on sale in Europe.

The price promotion policy outlined by Mr. Jeffries for Abercrombie & Fitch follows this guideline.  Its premium namesake brand would have the fewest promotions while its lower priced brand would receive the most price-promotional attention. Abercrombie & Fitch were wisely choosing a divergent price differential promotional policy.

Moving Into Markets that Value the Product

Simultaneous to the challenges Abercrombie & Fitch faced in the US, they were uncovering opportunities internationally.

As early as August 2008, Mr. Jeffries noted that Abercrombie & Fitch garnered greater interest internationally then it did in the US.  Stores opened in London; UK proved profitable.  One year later, men’s polo shirt that retailed for $60 in New York sold for GBP 60 ($99) in the London store.  Moreover, the London outlet continued to post year-over-year increases in same-store sales.

In light of this success, Abercrombie & Fitch planned store openings in Milan, Italy and Tokyo, Japan.  By December 2009, each of these outlets was performing well despite prices nearly double those found in New York City outlets.  A real estate portfolio rationalization was in order.  In February of 2010, Mr. Jeffries stated that international expansion “is the future of our brands.” In March of 2010, 200 underperforming stores in the US were identified and vacating plans were underway.

Further expansion internationally was planned to include Madrid, Spain; Paris, France; Copenhagen, Denmark; and Fukuoka, Japan.  In forward-looking statements, Mr. Jeffries held hopes of opening 15 additional stores internationally through 2012.

Abercrombie & Fitch international expansion strategy fits well with a sound pricing strategy.  A basic tenant of pricing is that a firm should seek to serve and capture customers that are willing to pay for the product, and eschew customers that aren’t.  Rather than wallowing in lost sales in the US, sales lost from customers that demonstrated a lack of willingness to pay for their product, Abercrombie & Fitch increased their efforts to serve international customers, customers that valued their products and were willing-to-pay premium prices to attain them.

Co-entangled Pricing Strategy

Abercrombie & Fitch’s US pricing policy cannot be examined without considering its international pricing policy.  International customers would visit New York City during holiday shopping sprees and browse US based shopping websites.  A large differential between US prices and international prices would encourage parallel importing, or international customers to purchase from the US and then export them to their home country.  Hence, price promotions in the US would encourage greater parallel importing, and therefore erode pricing power internationally.

Again, we see from the facts that Mr. Jeffries limited this effect by limiting the price promotions in the US.  In an analysis in the Wall Street Journal, John Jannorone noted the importance of their US promotional restraint in supporting their international growth.

Results

By February 2011, the corporate change was beginning to payoff.  Profits jumped 95% for the fourth quarter of 2010.  Same-store sales had risen 7% for 2010 in the US.  Moreover, international sales were up 79% for the year.  First quarter 2011 delivered similarly positive results.  For the second quarter 2011, we expect further positive results, though strategically strong and positive results are not always satisfying to stock analysts.

Abercrombie & Fitch has successfully reversed its loss of relevance in the US, avoided a shoot-from-the-hip approach to price promotions by instead enacting a targeted and disciplined promotional policy, and identified customers who valued its offering internationally.

This won’t be the last strategic shift Abercrombie & Fitch needs to make.  But it does serve as a strong case study on how to manage a brand or brand portfolio in the face of price competition.  Restrained reactions that lead to observance and analysis of the facts required to make intelligent strategic decisions are the key to leading ships through storms and into safer waters.

References & Notes

• Amy Kaufman, Nicholas Casey and Jennifer Saranow.  2008. Retailers Catch Teenage Blues; Niche Apparel Stores, Long Thought Resistant to Downturn, Suffered With Others in July. Wall Street Journal, August 8, Eastern Edition. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Andria Cheng.  2008. Earnings Digest: Abercrombie Posts 4.2% Drop in Profit. Wall Street Journal, August 16, Eastern Edition. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Nicholas Casey.  2008. Abercrombie Fights Discount Tide — Clothing Retailer Accepts Lower Sales in Its Strategy to Protect Margins and Hip Reputation. Wall Street Journal, December 8, Eastern Edition. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Nicholas Casey, and Karen Talley. 2009. Corporate News: Abercrombie Profit Drops 68%. Wall Street Journal, February 14, Eastern Edition. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Elizabeth Holmes.  2009. Skimpy Profits Pressure Abercrombie. Wall Street Journal, August 14, Eastern Edition. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Karen Talley.  2009. Corporate News: Abercrombie Plans To Cut More Prices. Wall Street Journal, August 15, Eastern Edition. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Elizabeth Holmes.  2010. Abercrombie & Fitch’s Style Sense Wears Thin With Some Shoppers. Wall Street Journal, February 3, Eastern Edition. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Karen Talley.  2010. Abercrombie & Fitch’s Profit Declines 31%. Wall Street Journal, February 17, Eastern Edition. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Elizabeth Holmes.  2010. Abercrombie Will Keep Discounting. Wall Street Journal (Online), March 10. http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).
• Elizabeth Holmes.  2010. Abercrombie & Fitch Loss Narrows as Sales Improve. Wall Street Journal (Online).  May 18. Retrieved July 2, 2011, from ABI/INFORM Global. (Document ID: 2035548781).
• Elizabeth Holmes, & Rachel Dodes. (2010, May 19). Cotton Tale: Apparel Prices Set to Rise. Wall Street Journal  (Eastern Edition),  p. B.8.  Retrieved July 2, 2011, from ABI/INFORM Global. (Document ID: 2036123951).
• U.S. Retailers Weathered a Bumpy June. (2010, July 8). Wall Street Journal (Online).  Retrieved July 2, 2011, from ABI/INFORM Global. (Document ID: 2075254791).
• Ann Zimmerman, & Karen Talley. (2010, August 6). Corporate News: Retailers Suffer Lazy Days of Summer — Hot Weather and Cool Economy Combine to Produce Mixed Results as Same-Store Sales Rise a Disappointing 2.9%. Wall Street Journal  (Eastern Edition),  p. B.3.  Retrieved July 2, 2011, from ABI/INFORM Global. (Document ID: 2102008981).
• John Jannarone.  (2010, November 3). A Case of Dr. Abercrombie and Mr. Fitch. Wall Street Journal  (Eastern Edition),  p. C.16.  Retrieved July 2, 2011, from ABI/INFORM Global. (Document ID: 2178579921).
• “Abercrombie & Fitch Profit Nearly Doubles on Sales Growth.” Wall Street Journal (Online),  February 16, 2011,  http://www.proquest.com.ezproxy1.lib.depaul.edu/ (accessed July 2, 2011).

Note of Interest and Holdings: At the time of writing, the author is not currently a direct consultant to nor investor in any of the firms listed in this article.