Better Buy: American Eagle Outfitters vs. Abercrombie & Fitch

American Eagle Outfitters (AEO -0.13%) and Abercrombie & Fitch (ANF -0.23%) both recently disappointed investors with dismal quarterly earnings reports and soft guidance for the rest of the year. Those poor results weren't surprising since inflation has been throttling sales of clothing and other discretionary goods while boosting labor and shipping costs.

However, some contrarian investors might be wondering if either one of these beaten-down apparel stocks is now a worthwhile turnaround play. Let's take a fresh look at both companies to decide.

Image source: Getty Images.

The similarities and differences 

American Eagle and Abercrombie & Fitch are both mall-based retailers that initially targeted teen and young adult shoppers, but they've gradually expanded beyond that core demographic over the past decade. They've also expanded their e-commerce platforms to reduce their dependence on brick-and-mortar stores.

American Eagle operates two main brands: its namesake banner, which sells jeans and casual apparel, and Aerie, which sells lingerie and activewear for younger shoppers. In recent years, the growth of Aerie has consistently offset the slower growth of the original brand, which competes against Abercrombie and Gap as well as a slew of fast-fashion competitors.

Abercrombie generates most of its revenue from its namesake banner, which also sells casual wear, and Hollister, which sells California-inspired apparel. It generates a smaller percentage of its sales from its Gilly Hicks banner, which competes against Aerie in the lingerie market. Just as American Eagle has largely pinned its future hopes on Aerie, A&F believes the growth of Gilly Hicks will eventually offset the slower growth of its namesake and Hollister brands.

Which apparel retailer is growing faster?

American Eagle and Abercromibie were both generating slow but steady growth prior to the pandemic. Under Jay Schottenstein, who became American Eagle's CEO in 2014, the retailer expanded Aerie, stabilized its namesake banner's sales, and upgraded its direct-to-consumer capabilities. Abercrombie CEO Fran Horowitz, who took the top job in 2017, downsized its struggling namesake brand while expanding Hollister and Gilly Hicks. She also expanded its e-commerce channel, closed weaker stores, and refreshed Abercrombie's dated marketing campaigns and dimly lit stores.

When the pandemic hit, both companies experienced steep sales declines throughout 2020 as they temporarily closed their brick-and-mortar stores. But as the following chart illustrates, American Eagle experienced a much milder slowdown than Abercrombie, and a stronger post-pandemic recovery. American Eagle also continued to open new stores throughout most of the past three and a half years, while Abercrombie significantly reduced its store count to cut costs and downsize its namesake brand.

Data source: AEO and A&F. YOY = Year-over-year.

For the full year, analysts expect sales to slip 1% for American Eagle and 5% for and for Abercrombie & Fitch. Both companies expect to struggle with inflationary headwinds and rising inventories in the second half of the year.

Which company will bounce back faster?

That slowdown has caused both companies' inventories to rise faster than their revenue. The imbalance was exacerbated by both companies increasing their inventories in anticipation of a post-pandemic recovery, which was cut short by soaring inflation.

Both companies saw their gross margins plummet this year as they attempted to reduce their inventories with markdowns. Unfortunately, inflation disrupted those efforts by keeping shoppers at home and driving up freight costs.

Data source: AEO and A&F.

American Eagle expects its gross margins to slip to the mid-30s in the third quarter and to the low 30s in the fourth quarter. It also paused its dividend to conserve more cash. Abercrombie already suspended its dividend back in 2020. It didn't provide an exact forecast for its gross margins, but warned investors that its operating margins would decline sharply.

For the full year, analysts expect American Eagle's earnings to decline 68%, and for Abercrombie's earnings to plunge 76%. Based on those gloomy estimates, American Eagle trades at 10 times forward earnings while Abercrombie has a higher forward multiple of 16.

Is either stock worth buying right now?

I wouldn't touch either of these struggling apparel stocks right now, especially when inflation-resistant peers like Lululemon Athletica are still reasonably valued. But if I had to choose one, I'd pick American Eagle Outfitters because its sales growth is more stable, it isn't aggressively shutting down its stores, and its stock is a lot cheaper.