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This Retailer Isn't Out of the Woods Yet

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Last week, a miracle happened for Aeropostale (NYSE: ARO  ) investors. After falling by more than 50 percent over the past year, shares surged 20 percent. On the same day, arch-nemesis Abercrombie and Fitch (NYSE: ANF  ) saw its shares plunge 20 percent. So what the heck happened? Is Aero the new king of fashion and Abercrombie merely the king of pain?

There's a little black spot on the sun today
As one of those Aero investors, I'd love to say yes, but sadly the answer is no. Aero's stock shot up Thursday because the company released a preliminary earnings report ahead of the official release on Nov. 30. The company had previously expected earnings per share in the range of $0.09 to $0.15, but updated its guidance to a range of $0.27 to $0.28 per share, which the market took to be extremely encouraging.

However, the report also indicated that net sales were down 1% year over year, and same-store sales were down 9%. That's certainly an improvement over last quarter's 5% hit to net sales and 14% drop in same-store sales, but it's not much to cheer about either.

Because of the recession, Aero was seen as a market darling, catering to cash-strapped customers by undercutting its many competitors with deeply discounted merchandise. But higher-end competitors like Abercrombie were eventually able to lower their own prices, stealing much of Aero's advantage. As a consequence, Aero's sales growth has been steadily falling since the first half of 2009 -- from a peak of 21% revenue growth and 12% same-store sales growth -- to last quarter's dismal numbers.

The very fact that the soon-to-be-reported quarter will break the trend and finally start to show numbers that are less bad is a positive, but it doesn't explain the jump in earnings guidance, nor the jump in the stock price.

Not quite the same old thing as yesterday
The reason for the much-improved earnings outlook is that the company has seen better-than-expected margin improvement this quarter. And the reason for that isn't because strong demand has given Aero more pricing power, nor is it necessarily because Aero has run a tighter ship. It's largely because the price of cotton has fallen close to 8% since the initial earnings guidance and about 57% from its high for the year.

Even if sales are continuing to fall, a drop like that in one of a company's most important input costs can be an incredibly strong tailwind. But make no mistake, Aeropostale doesn't control the cotton market, and its margin improvement is more a matter of luck than of business improvement.

Most retailers raised prices to cope with the record rise in cotton, and most of them don't plan to lower prices now that cotton is finally falling. Aero and its cotton-hungry competitors will get the same tailwind in their margins, keeping the playing field mostly level. American Eagle Outfitters (NYSE: AEO  ) , The Gap (NYSE: GPS  ) , VF (NYSE: VFC  ) , and Nike (NYSE: NKE  ) have all already told investors that their margins should start to improve in the second half of 2012 as a consequence of this strategy.

Aero is in a difficult position because its core focus is on selling bargain-priced clothing. While it can eke out a higher margin by raising prices, it may compromise its brand image. VF, which also operates on the bargain side of the retail spectrum with its Wrangler and Lee jeans, can testify to this. After a round of price increases, jeanswear sales were up in the recently reported quarter, but actual units sold were down by several percentage points.

There has to be an invisible sun
The bright side is that with its competitors planning to keep their price hikes and with the cost of goods sold having fallen, Aero might be able to get some market share back by once again undercutting the competition. But that will be hard to manage, given that Aero's profit margin is already much tighter than others' -- and is still likely to come in far below its five-year average.

The company says it is improving its inventory management, which will help ease the pain of markdowns, but clearly it isn't out of the woods yet. This is one company to add to My Watchlist and see whether it manages to turn its fortunes around.

Fool contributor Jacob Roche owns calls on Aeropostale but holds no position in any of the other stocks mentioned. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. The Motley Fool owns shares of Aeropostale and Gap. Motley Fool newsletter services have recommended buying shares of and creating a diagonal call position in Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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