APPAREL RETAIL                                                                               August 27, 2003

                                                                                          APPAREL RETAIL

 INDUSTRY RATING: MARKET PERFORM                                                       August 27, 2003
 Ling Mei

Investment Summary

The apparel retail industry is a large and mature industry whose average growth rate was about 3-5% a
year over the past decade. With low barriers to entry and lack of dominant fashion trends, this industry is
full of price competition. Difficult to build store-loyalty among consumers, apparel retailers are facing
threats of consolidation by other retailers and vertical integration by manufacturers. However, no matter
how unattractive this industry is, there are still some star companies who have succeeded in generating
double-digit growth in the past few years. Their success is, in large part, attributed to their understanding
of consumers’ changing tastes, preferences and priorities.

The apparel retail industry is an early-cycle industry and often a harbinger of what economic climate lies
ahead. Sales usually lose its momentum before an economic recession and picks up before the economic
recovery. Macro economic factors, such as GDP growth, personal disposable income and consumer
confidence, have a great influence on the overall performance of this industry. Further, since offshore
sourcing has become an industry wide trend in the past two decades, change in exchange rate affects
profitability of the whole industry as well. Other macroeconomic factors like interest rate and consumer
price index also have a significant effect on this industry.

Although understanding the macroeconomic condition is important, finding the “star” by analyzing
company specific factors is of more importance and, of course, with more difficulty, given the ever
changing fashion trends and consumer tastes. Our recommendation is to follow the companies, which
target customers with growing purchasing power, select the right merchandise, manage inventories
efficiently, employ promotions skillfully, and locate and design the stores appropriately. According to our
analysis, we give our outperform rating to Pacific Sunwear of California (PSUN) and Abercrombie and
Fitch (ANF).

APPAREL RETAIL                                                                            August 27, 2003

I.      Industry Overview

The apparel retail industry is a large, mature and highly fragmented industry. In the past decade (1993-
2002), the annual growth rate of the market was about 3-5%. The number of US apparel stores reached
324,752 outlets in 2001. Low growth rate and high fragmentation make this market very competitive,
where price pressure is always intensive.

Market Size

According to data released by the Department of Commerce, US consumers spent $334 billion in apparel
and footwear in 2002, up 2.9% from $315 billion in 2001. With an estimated US population of 288
million, the 2002 expenditures in apparel and footwear equaled roughly $1,125 per person, about 4.5% of
personal disposable income. However, expenditures on apparel and footwear as a share of total personal
consumption declined over the past decade.

                                       Personal Consumption Expenditures for Apparel
                                                      and Footwear

           Billions of Dollars

                                       1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Source: US Department of Commerce

APPAREL RETAIL                                                                           August 27, 2003

                          Apparel and Footwear as a Share of Total
                            Personal Consumption Expenditures

                     1993    1994   1995   1996   1997    1998   1999   2000   2001    2002

Source: US Department of Commerce

In 2002, total US apparel sales was $163 billion, falling 1.8% from $166 billion in 2001,according to the
NPD Group, a market re-search firm in Port Washington, New York. Compared to 2001, women’s
apparel sales fell 6.1% to $84 billion whereas men’s apparel sales fell 1.7% to $52 billion. Despite the
decline in sales of adult clothing, children’s segment climbed to $27 billion, achieving a 6.0% year-on-
year growth. These results were an improvement over 2001, when sales slid 5.9% from $176 billion in
2000. That year, all sectors saw declines, with sales down 7.0% in men’s, 6.7% in women’s, and 4.7% in
children’s apparel.

APPAREL RETAIL                                                                             August 27, 2003

                      2002 Apparel Sales Breakdown by Demographic

                          4%     8%
                     4%                                      32%                Mens
                           52%                                                  Toddlers/Infants

Source: NPD Fashionworld

Market Segmentation

The four major market segments in the apparel retail industry are specialty stores, department stores,
general merchandise chains and discount stores. Other retailers include direct order, Internet vendors and
other formats. According to data from the NPD Group Inc., discount store accounted for 31% of total
purchases by consumers in 2002, making it the largest sector of the market. Specialty stores followed the
discount stores as the second largest segment, accounting for 25% of the total sales, up from 24% in 2001.
Department stores continued to lose ground to discount stores as the third largest segment when
customers were more price-sensitive. This segment accounted for 19% of the total sales, down from 20%
in 2001. The fourth largest segment is national chains, whose share climbed to 16% from 15% in the
previous year. Other retail channels accounted for 9% of the total sales.

The Internet sales accounted for less than 5% of total apparel sales in 2002. Although it may have strong
growth potential in the future, shopping apparel on the Internet faces challenges now: consumers cannot
see, touch, and try out the product. Sales through direct order has declined since the use of Internet and
this trend continues.

Industry Dynamics

Apparel retail is a early cycle industry. Overall industry demand changes ahead of general economic
trends, including changes in disposable personal income, consumer confidence, and consumer spending.
When the consumers believe that the economy is going to expand, they are inclined to spend a lot of
money in updating their wardrobes. When they are not confident about the economy in the future, they
usually postpone apparel purchases and or update their wardrobes with less expensive items.

APPAREL RETAIL                                                                                August 27, 2003

Demand is also driven by population growth and demographic trends. When the number of people rises,
so does overall demand for apparel. The fact is that US population only grows at 1% a year, so many
apparel manufacturers are seeking overseas opportunities. However, for apparel retailers, overseas
expansion requires deeper understanding of the local market, such as customer taste and the real estate
market, which makes overseas expansion more risky for apparel retailers than for manufactures.
Demographic trends also play an important role in affecting demand since different age groups have
different priorities and preferences in spending money.

In such a mature, low growing domestic market, apparel retailers exist in a highly competitive
environment. Consolidation and vertical integration have been prevalent in the past few years, as larger
companies strive to lower their costs by gaining leverage in buying from suppliers and selling to
customers and achieving economies of scale in manufacturing as well as marketing. It is not surprising to
see that many brand name manufacturers sell clothes in their own retail stores. For instance, Gap Inc., a
vertical retailer manufactures its own brand apparel and sells it in its own stores.

Despite consolidation and vertical integration, this industry is still highly fragmented. This is in large part
because of the low barriers to entry: simple technologies and small fixed investment are required to open
a retail store. Although getting into this business is relatively easy, stay in it is much more difficult
because it is extremely difficult for a retailer to build customer loyalty simply on its stores rather than the
apparel’s brand. Further, it is much easier for a brand name manufacturer to open a retail store than the
vice versa. So both customers and suppliers (apparel manufacturers) have considerable power over
apparel retailers.

II.     Industry Trends

Most trends affecting the apparel retail industry are driven by customer tastes, shopping pattern,
purchasing power and demographic change. Below are the major trends in the apparel retail industry
showed in the past few years.

Casual Look

The lack of dominant fashion trend in the past decade is a great concern to apparel retailers. However,
casual look has been on a rise since early 1990s when less rigid dress policies became popular in
corporate America. Although formal wear has not totally lost its luster, casual apparel has seen a steady
growth in sales in recent years. According to NPD Group, total sales of men’s casual apparel grew to $44
billion in 2000, up 10% from the 1999 total, while, in the same period, men’s dresswear declined 1% to
$13 billion.

In the teenage market, streetwear has made rapid strides in recent years. The main themes in this market
are hip-hop music inspired designs, and surfing and skateboarding styles. Retailers that sell those young,
urban fashions, such as Urban Outfitters Inc. and d.e.m.o. (a division of Pacific Sunwear of California
Inc.), generated double-digit sales growth in 2002, though a weak year for apparel sales due to the weak

Price Deflation

In the past decade, although the overall apparel sales have risen, the average selling price has declined
five years in a row, according to the Bureau of Labor Statistics. In 2002, the apparel CPI dropped 1.8% to

APPAREL RETAIL                                                                              August 27, 2003

121.5 (1982–84=100), from 123.1 in 2001. The drop was greatest in men’s and boy’s apparel, with prices
down 2.9%.

                                               CPI: Apparel

               1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Source: Bureau of Labor Statistics

Several factors contributed to this downtrend. The most influential factor is offshore sourcing. Many
apparel manufacturers have moved their production to low-cost regions, such as Mexico, the Caribbean,
Central America, Asia and Sub-Saharan Africa. Meanwhile, in order to survive in an industry under high
price pressure, many apparel retailers begin to purchase their merchandise directly from those low-cost

Further, extremely tough job market, which reached a record nine-year high unemployment rate of 6.4%
in June 2003, aggravated price deflation in the past 2 years. Contrary to offshore sourcing, which
ultimately results in an increase in the overall purchasing power of US consumers, high unemployment
rate has a negative effect on the overall purchasing power of US consumers. But this is more of a short-
term effect. With the recovery of the US economy, job market will finally pick up. So will the purchasing

The last but not least factor is consumer attitude. Consumers are addicted to promotional pricing as a
result of industry wide heavy promotion climate in 2002. In the past, retailers usually charged full price
for the preseason merchandise. Now they have resorted to discount it from the start. Shoppers, thus
accustomed to bargains, tend to forgo making purchases until the items they want go on sale.

Offshore Sourcing

As consumers demand better value, apparel retailers have increasingly turned to offshore sourcing
particularly in low-cost regions including Mexico, the Caribbean, Central America, Asia and Sub-Sahara
Africa. In 1975, only 12% of the apparel sold by US retailers was imported; by 1984, retailers had
doubled their use of imported garments, according to American Apparel Manufacturers Association. In

APPAREL RETAIL                                                                              August 27, 2003

1993, retailers accounted for 48% of the total value of imports of the top 100 US apparel importers in

According to US Department of Commerce, US imported $63.8 billion of apparel in 2002. Mexico,
China, Honduras, Bangladesh and Vietnam are the five largest suppliers based on import data of April,
2003. Imports from China were up 60% in April (compared with the same month of 2002) while, during
the same period, imports from Mexico declined 8.22%. We believe that, with low labor cost and highly
skilled laborers capable of producing complex garments, China’s share will increase dramatically and
finally surpass Mexico to become the number one apparel sourcing country for the US market.

Rise of Discount Stores

As consumers become more and more price sensitive, department stores have continued to lose ground to
discount stores. In 2002 discount stores held steady a market share of 31% of the total apparel sales while
department stores’ share dropped from 33.4% in 1997 to 19% in 2002. Discount stores have made the
largest gains over the past five years, mostly at the expense of department stores by offering low prices
and what shoppers perceive as good value.

                                        Apparel Sales By Channel

                                                                                 Specialty Stores
      Billion Dollar

                                                                                 General Merchandise
                       10                                                        Chains
                                                                                 Department Stores
                                                                                 Discount Stores
                        4                                                        Other

                            2002-2Q 2002-1Q 2002-3Q 2002-4Q 2003-1Q

Source: NPD Fashionworld

Growth Pattern

In a mature, low growing industry where promotions and discounts are prevalent, apparel retailers are
difficult to raise profit margin. In most cases, they depend mainly on opening new stores (both
domestically and abroad) to meet growth targets. This is also the only way for the retailers to diversify
risk while leveraging efficiencies across a great number of stores and products.
APPAREL RETAIL                                                                                 August 27, 2003

III.       Customer Analysis

Demographic Trends

Among the important demographic trends in the United States, baby boomers purchasing focus is
diverting from fashion products, while the younger generations are an emerging, though elusive, source of
demand, and the plus-size segment is growing fast.

•      Baby Boomers. Baby boomers, born between 1946 and 1964, constitute 77 million Americans. As
       they became adults and formed households, they fueled much of the boom in retail sales in the 1970s
       and 1980s. However, despite their rising spending power, the baby boomers’ changing attitudes,
       priorities, and time obligations have dampened their enthusiasm for apparel shopping. Today,
       Americans in their 40s and 50s have shifted their priorities to tuition payments for children, saving for
       retirement, and caring for elderly parents. Other needs and desires, such as healthcare and leisure
       activities, also compete for their dollars. Although this age group continues to spend on furnishings
       and accessories for their homes, fashion has been, and will continue to be, an area that gets less
       attention. Yet while they spend a declining percentage of their disposable income on apparel, baby
       boomers remain the biggest per capita purchasers of apparel. Since apparel is not their first priority,
       they are more price sensitive and in favor of bargains. According to the NPD Group, the 50-plus
       market spent about $27 billion in 2001 on women’s apparel. Base on population projections reported
       by US Census Bureau, 55 and over group is the fastest growing age group, whose size will grow by
       19% from now to 2010. However, this is an under-served market, which has just begun to gain some
       attention from apparel manufacturers and retailers as well. Consumers of this age group favor
       clothing lines that are more conservatively styled and more generously sized.

                             US Population Projections of Different Age Groups

       Age Groups           2001           2002           2003           2004          2005          2010
       5-24                78,894         79,539         80,130         80,596        80,904        82,165
       25-39               58,862         58,158         57,564         57,137        57,015        58,872
       40-54               61,535         62,249         63,130         63,935        64,525        64,921
       55 and over         59,613         61,416         62,962         64,499        66,060        75,145

    Source: US Census Bureau

                              US Population Growth by Different Age Groups

            Age Groups        2002/2001      2003/2002      2004/2003      2005/2004 2010/2003*
           5-24                 0.82%          0.74%          0.58%          0.38%         2.54%
           25-39               -1.20%         -1.02%         -0.74%         -0.21%         2.27%
           40-54                1.16%          1.42%          1.28%          0.92%         2.84%
           55 and over          3.02%          2.52%          2.44%          2.42%       19.35%

          Source: US Census Bureau
          * Percentage change of 2010 projections over 2003 projections.

•      Teens and Tweens. Teens are the demographic group comprising people born between 1977 and
       1994. This cohort comprises 75 million individuals, or 25% of the US population, and spends (or
       influences the spending of) approximately $200 billion a year. In addition, this group establishes

APPAREL RETAIL                                                                           August 27, 2003

    trends that influence future product design aimed not only at its members, but also at the slightly
    older Generation X (people born between 1965 and 1976). According to a 2002 study conducted by
    Harris Interactive, a market research firm in Rochester, New York, teenage girls spend 75% of their
    earnings on clothing and related accessories on average, while boys spend 52% of theirs. The
    “tweens” group is generally understood as comprising preteens aged 7 to twelve, of whom about 27
    million currently live in the United States. Tweens follow fashion trends, and they influence almost
    $200 million in annual family spending. In addition, they spend about $520 a year of their own
    money on average, according to Roper ASW, a New York City–based market research firm. These
    two groups share the similarity: both group exhibit high brand loyalty. According to a survey
    conducted by Forrester Research, based in Cambridge, Massachusetts, 69% of the teenagers said that
    when they find a fashion-forward brand they like, they stick with it. Although teenagers are perceived
    as fickle, there are some long-favored fashion themes such as cargo, surfing and skateboarding styles.
    Back-to-school items are designed to target these two groups and sales in back-to-school season
    usually have a great influence on the overall sales of the year.

                                  Average Spending Per Family
                                    on Back-to-School Items*

                                                                              Total Spending

                   300                                                        Spending on
                                                                              Clothes and Shoes
                         1999   2000      2001     2002      2003

      Source: National Retail Federation
      *Survey of households with children aged 6-17

•   Plus-size Segment. Two of the fastest-growing apparel industry segments have been the women’s
    plus (sizes 16 and up) and men’s big-and-tall (sizes XXL and larger) segments. The average weight of
    the Americans is increasing. According to the latest survey conducted by the National Center for
    Health Statistics, over 60% of adults and 14% of adolescents (most of whom are female) are
    considered overweight. For women, the average size in 2002 is 12, up from a size 8 in 1985.
    Approximately 52 million plus-size women live in the United States, or about 37% of the nation’s
    female population. Similarly, the men’s big-and-tall market comprises about 20.1 million individuals,
    or roughly 15% of the US male population, with $5.6 billion in annual sales. Compared with other
    shoppers, plus-size women buy more slacks and woven shirts and fewer knit shirts, according to data

APPAREL RETAIL                                                                             August 27, 2003

      from STS Market Research. The percentages of apparel purchases allocated to slacks and woven
      shirts by plus-size consumers were 46% and 18% higher, respectively, than the percentages allocated
      by other consumers. Plus-size women are also significantly more concerned with quality than other
      women. About 70% prefer to buy clothing that is higher in quality rather than more fashionable,
      compared with 57% of other respondents. Although many apparel manufacturers and retailers are
      now entering this plus-size game to cater to large-size men’s, women’s and teen’s market, this market
      is still under-served in both quantity and quality. According to a survey conducted by Cotton
      Incorporated, a research and marketing company for textile goods, two-thirds of larger-size customers
      state that current styles do not flatter their shapes, compared with 51% of other consumers. This
      percentage of women is within the same statistical range as in 1998, indicating that while plus-size
      retailers may be benevolent with offerings, they are not meeting the ultimate need of the plus-size

Shopping Habits

Consumers are shifting their shopping habits from wandering the malls to shopping at local power strips
where they can get a wider variety of goods in the shortest amount of time. During the past few years,
fundamental changes have occurred in the way Americans are shopping, how often they do so, and why
they favor particular brands, stores, and products. People are better educated and have greater access to
information, and thus have become more demanding of the goods and services they purchase. Consumers’
newfound craving for goods that afford excellent value and design, is often overcoming their taste for
pricey status symbols. An increasing willingness to cross-shop retail channels is bringing a new elasticity
to people’s budgets. They are saving money at discount stores on some items, while spending more for
others bought elsewhere. There has been a decline in shopping as a leisure time activity. Americans made
an average of 36 shopping trips for apparel in 2001, down 8% from 39 shopping trips in 2000, and down
16% from 43 trips in 1999.

Preference of shopping places differs for different types of productlines. For example, more women’s
apparel than men’s is purchased in specialty and department stores. Men’s apparel is more prevalent in
discount stores and general merchandise chains. In the children’s segment, a considerably higher portion
of apparel is purchased in discount stores. Because children quickly outgrow their clothing, parents are
less inclined to spend a lot of money on a single item and therefore more inclined to shop at discount

IV.       Macroeconomic Indicators

The macroeconomic indicators that are important to apparel retail industry are gross domestic product
(GDP), disposable personal income, consumer confidence and consumer price index (CPI) foreign
exchange rate and interest rate.


Reported by the US Department of Commerce, GDP is the broadest measure of the aggregate economic
activity. Since apparel retail is a cyclical industry, it prospers when the economy expands and deteriorates
when the economy contracts. Comparing the retail sales and real GDP growth, we can find a strong
positive relationship between them.

APPAREL RETAIL                                                                                      August 27, 2003

                                       Apparel&Footwear Expenditures
                                               and Real GDP
    Billion Dollar Dollar                                                    Billion Dollar

                       350                                                       10000

                       250                                                       7000                Footwear

                                                                                         Real GDP
                       200                                                       6000                Sales

                                                                                 5000                Real
                       150                                                       4000                GDP
                       100                                                       3000
                        0                                                        0
                             1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Source: US Department of Commerce

Disposable Personal Income

Reported by US Department of Commerce, disposable personal income is the measure of consumer’s
after-tax income. It is closely related with unemployment rate and GDP growth. In case of high GDP
growth and low unemployment rate, disposable personal income will increase, thus leaving more money
for consumers to spend on apparel. Plus, when government cut income tax, disposable personal income
will increase too. When incomes are rising, consumers are willing to spend more than previously, which
bodes well for apparel sales. Conversely, when incomes are declining, consumers are more likely to defer
spending and save their money.

APPAREL RETAIL                                                                                                                 August 27, 2003

                                                      Apparel&Footwear Expenditures
                                                      and Disposable Personal Income
              Billion Dollar                                                                   Billion Dollar

                        350                                                                    8000

                                                                                                      Disposable Personal


                        250                                                                                                 Apparel&Footwear

                        200                                                                                                 Expenditures
                        150                                                                                                 Disposable
                        100                                                                                                 Personal Income
                        50                                                                     1000
                         0                                                                     0


























                                                             Year                       20

Source: US Department of Commerce

Consumer Confidence

The Conference Board, a private research organization, conducts a monthly poll of 5,000 representative
US households to gauge consumer sentiment, and compiles an index of consumer confidence based on the
results. The index represents a relative measure of how Americans feel about the strength of the economy,
business trends, their job security or employment prospects, and their future earning prospects. When
consumer confidence is high, it’s usually accompanied by increased spending and borrowing.
Conversely, when it is low (usually due to uncertainty about the future), personal expenditures are likely
to be cut back or postponed. Because consumer spending accounts for about two-thirds of the nation’s
economic activity, this measure is widely watched. The monthly index of consumer confidence fell to
76.6 in July 2003, down from 83.5 in the previous month. This shows that a sour job market is weighing
on consumer confidence, even as forecasters predict an imminent economic rebound.

Another similar index is consumer sentiment, which is reported by the Survey Research Center at
University of Michigan. Different from consumer confidence index, which is a current indicator of the
economic situation, consumer sentiment is a leading economic indicator useful for understanding and
forecasting the change in national economy.

APPAREL RETAIL                                                                               August 27, 2003

                                     Consumer Sentiment Index

               2000                       2001                       2002                        2003

Source: the Survey Research Center at University of Michigan


Released monthly by the Bureau of Labor Statistics (BLS), this index measures changes in the prices of
commodities, fuel oil, electricity, utilities, telephone services, food, and energy. The BLS also releases
specific price indexes for the apparel industry. These inflation rates reflect and influence pricing decisions
of apparel retailer and their suppliers.

APPAREL RETAIL                                                                                   August 27, 2003

                                     CPI: Men's Apparel & Women's Apparel

       125                                                                                    Men's Apparel











Source: US Bureau of Labor Statistics

Exchange Rate

Since sourcing in the low cost regions outside US has become prevalent, change in foreign exchange will
affect the whole apparel retail industry. According to data released by US Department of Commerce,
Mexico, China, Honduras, Bangladesh, Vietnam, El Salvador and India are the major suppliers of the US
apparel market. Any significant change in exchange rates of their currencies to US dollar will change the
US imports in these countries and finally have an influence on the gross margin of the US apparel

Interest Rate

The level of interest rates influences management decisions regarding business acquisitions, new product
introductions, capital expenditures, dividends, and stock repurchases. High or rising interest rates increase
the cost of borrowing, making companies less likely to make capital expenditures. Since opening new
stores is a major way for apparel retailers to achieve growth, high interest rate will raise their cost of
expansion while a low interest rate will fuel its growth. The level of interest rates also affects consumers’
purchasing decisions. Higher interest rates will result in lower consumer spending, as people begin to pay
down their charges and reign in their expenses.

APPAREL RETAIL                                                                             August 27, 2003

V.      Company Specific Factors

The key company specific factors that will affect the revenue growth and profitability of an individual
retailer include target customer group, inventory-to-sales ratio, merchandise selection, promotion policy,
and store locations and display.

Target Customer Group

As stated in the customer analysis section, there are three important customer groups: baby boomers,
teenagers and the plus-size segment. Among them, baby boomers have the biggest purchasing power; yet
the percentage of their spending on apparel as a share of disposable income is declining. Also, they are
not fashion seeker and are more price sensitive. Retailer’s ability to use promotions to skillfully balance
margin and sales volume are essential in this market. In teenage market, the competition is very fierce
because everyone knows that customers of this group are growing and willing to spend more than half of
their disposable income on apparel. The ability to select proper merchandise is critical to build brand
loyalty among teenage consumers and thus achieve sales growth. Plus-size segment is a new but fast-
growing market. With more name brands enter this market, product differentiation will become more
important in this particular segment.

Inventory-to-Sales Ratio

The inventory-to-sales ratio is a ratio obtained by dividing inventories by net sales. It is expressed as a
percentage of inventories to net sales. This ratio is a measure of efficiency of inventory control and
supply chain management. Low inventory-to-sales ratio means not only lower inventory carrying cost but
lower future markdown cost as well. However, if it is too low, retailers may face out-of-stock risk. So the
retailer should set the inventory-to-sales ratio at a level so that there is enough merchandise at hand to
meet the customer needs, but not so much to markdown at the end of the season. This requires the retailer
to have an accurate forecast of future sales and good supply chain management.

APPAREL RETAIL                                                                             August 27, 2003

                                    Inventory-to-Sales Ratio*



































* Data are based on quarterly inventories and sales of specialty apparel retailers: The Gap, Inc., The
Talbots, Inc., Pacific Sunwear, The Limited, Inc., Ann Taylor Store Co., Abercrombie and Fitch.

Tied closely to the inventories to sales ratio is inventory turnover. Inventory turnover represents the
number of times that the retailer’s inventory is sold through during the year. It is calculated by dividing
the cost of goods sold by the inventories. From 1996 to 2001, average annual inventory turnover was 5.7
times for discounters versus 3.6 times for department stores. This partly explains why discounters are
more competitive in attracting increasingly price sensitive consumers.

Merchandise Selection

Since there was no dominant fashion trend in the past decade and such a situation continues, getting the
fashion is tricky. Selecting the appropriate merchandise is always a key to success for apparel retailers.
Yet selecting the wrong merchandise may be destructive, particularly for teen and tweens market where
fashion trends are more elusive. For instance, catching up with the streetwear trend, notably hip-hop
music inspired fashions, and surfing and skateboarding styles, Pacific Sunwear generated double-digit
sales growth in 2002 when total apparel sales declined by 1.8% from the year before. However, when Wet
Seal, another apparel retailer targeting teenage market, selected “bohemian” style as their main fashion
theme in the back-to-school season in 2002, it saw declining comparable store sales and lower-than-
expected financial results.

APPAREL RETAIL                                                                               August 27, 2003

Promotion Policy

Promotion is like a double-edge sword to apparel retailers: sales volume rises with price cut; but margins
may well be squeezed to razor thin. Also, frequent promotions will make customers unwilling to pay full
prices for the in-season items, as it happened in 2002. So for an apparel retail company, special attention
should be paid to the change in its promotion policy. This is important for us to analyze and forecast sales

Store Locations and Display

Although apparel sales on the Internet is growing, it accounted for less than 5% of the total sales in 2002.
Shopping in the local stores is still the first choice of most consumers. Major issues concerning store
openings include site leasing, store location, selling space, display of merchandise and in-store
environment. The correct answers to these issues are usually region specific and vary among different
customer groups. For instance, one of the key factors that contribute to Pacific Sunwear’s success is that
its d.e.m.o. stores set up a hip-hop music in-store environment, which is attractive to most teenage

VI.     Apparel Retail Stocks

According to the criteria stated above and the current valuation ratios, we give outperform rating to the
following two apparel retail stocks.

Pacific Sunwear of California, Inc.

Pacific Sunwear of California, Inc. (PUSN) is a leading teen lifestyle retailer of casual fashion apparel,
footwear and accessories. The company’s target customers are young men and women between the ages
of 12 and 24. Staying current with the fashion trends of hip-hop, skateboarding and surfing styles, it has
achieved over 20% annual sales growth in the past decade and sales growth continues to be strong this
year. Although its trailing P/E ratio is much higher than the industry average, the stock price is justified
by its strong earnings growth, which is projected to be 80% this year.

Abercrombie and Fitch Co.

Abercrombie and Fitch Co. (ANF) is a leading apparel retailer, selling high-quality merchandise that
compliments the casual classic American lifestyle. It targets customers aging from 18 through college.
Although its low double digit sales growth is much less spectacular than those of other young casual
brands, such as Pacific Sunwear and Hot Topics, its 20% operating margin is one of the highest in the
industry and a P/E ratio of 15 is much lower than the industry average of 22.

APPAREL RETAIL                                                                          August 27, 2003


10.   US Retailing Prospective Analysis: June 2003, A.G. Edwards, June 10, 2003
11.   Global Sourcing In the US Apparel Industry, Journal of Textile and Apparel Technology and
      Management, Vol. 2, Issue 1, 2001, Gary Gereffi
12.   Branded Apparel, Merril and Lynch, June 17, 2002
13.   Clothing Retailing In the USA, Euromonitor
14.   Back-To-School Is Getting High Marks, Business Week, September 1, 2003
15.   Industry Surveys: Apparel & Footwear, Standard & Poor’s, July 3, 2003
16.   2002 Annual Report of Pacific Sunwear of California, Inc.
17.   2002 Annual Report of Abercrombie & Fitch Co.


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