Breaking the Promotional Cycle

Recently, U.S. apparel retailers have been battling a promotional environment that has pushed margins down. Last year's holiday season was a perfect example, with companies from Gap (NYSE: GPS  ) to lululemon athletica (NASDAQ: LULU  ) reporting more competitive pricing than anticipated. Abercrombie & Fitch (NYSE: ANF  ) has had a particularly difficult time, with the squeeze coming just as the company was turning a big corner on its operating margin.

In a presentation last week, the company said it was focusing on two major initiatives this year -- the first is a reduction in the company's operational costs and the second is a focus on increasing the average unit retail. Management said that increase is unlikely to stem from an increase in the number of purchases and should instead come from a decrease in the number of promotions that the company runs. Here's a closer look at what Abercrombie has planned, and what it still needs to do.

Less "on sale," more "big sale"
The problem at apparel retailers has been twofold over the past 18 months. First, companies have been fighting the aforementioned promotional environment. That's put all but the strongest brands in a bind, and even some of those brands have seen margin compression. Lululemon, which has been keeping gross margin over 55%, decided last quarter that it needed to drop the price of its mid-layer range to remain competitive. While that kind of move can often signal brand weakness, the overall strength of margin points instead to a competitive landscape. Abercrombie is in a similar boat, with a strong brand but a whole boatload of competition.

Last quarter, the company hit a gross margin of 65% but has reported that average unit retail is slipping because of the promotional environment it's operating in, especially in the United States. The company is worried that it's painting its promotions with an overly big brush. Right now, for instance, Abercrombie splashes its sales all over the front of its stores and puts signs up to draw customers in. That's a good way to generate foot traffic, and the tactic has been used to successfully drive up revenue. The problem is that it can also cause the average unit retail to drop, as customers come to expect sales.

Promote smarter
Abercrombie's first stab at fixing this issue is to be smarter and more targeted about the kinds of sales it runs. That means using its customer relationship data to send out targeted sales to customers that meet certain criteria. That should allow the company to draw in customers who will shop beyond the sale rack, buying sale items and regular priced items. As a result, the blended average unit retail price will increase, overall revenue will increase, and customers won't come to expect promotions.

If the company can make it work, it could be a big long-term payoff for Abercrombie -- not just because the average unit retail would increase, but also because it would mean customers went into the store not expecting a sale. Gap weaned customers off sales over the past year, and the result has been an increase in gross margin. That success has stacked on top of the benefits of dropping cotton prices to put Gap in a very strong place going into 2013.

The final puzzle piece
While targeted sales mean fewer sales, and while costs have declined, the one last hurdle to overcome in a promotional environment is inventory overabundance. That's the one place where analysts just haven't been happy with Abercrombie. Last year, the company had too much on hand, which led it to increase the number of promotions it ran to move through the excess. Now, Wall Street is worried that the company is running too thin.

Fourth-quarter inventory levels dropped 37%, but comparable sales remained flat in the United States. That means the company was probably selling less of that inventory at higher prices. That, in turn, points to a drop in foot traffic and may signal that the promotional environment is likely to come back later this year as the company needs more sales. To buck that cycle, Abercrombie is going to have to make its more targeted promotions stick.

That's a lot of "ifs" for the company to overcome, and it makes it a tricky time to invest. For now, investors should be on the lookout for big sales running in the stores, which could be a sign that the targeted marketing isn't working. That would be a real long-term problem.

lululemon athletica has the potential to grow its sales by 10 times if it can penetrate its other markets the way it has in Canada, but without question, the competitive landscape is starting to increase. Can Lululemon fight off larger retailers such as Gap and Nordstrom and ultimately deliver huge profits for savvy investors? The Motley Fool answers these questions and more in our most in-depth Lululemon research available for smart investors like you. Thousands have already claimed their own premium ticker coverage, and you can gain instant access to your own by clicking here now.