Why Aeropostale Shows Signs of Caution

This review of Aeropostale's (NYSE: ARO  ) earnings quality is the third in a series of commentaries about specialty retailers listed in the S&P400 index -- specifically, retailers that have income statement and revenue issues. This group of retailers includes ANN Inc. (NYSE: ANN  ) , American Eagle Outfitters (NYSE: AEO  ) , and Foot Locker (NYSE: FL  ) .

Earnings quality is reflected in the financial statements
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash-flow and revenue-recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important for investors to understand before hard-earned money is lost.

The EQ Score database assigns an index rank to the company from one (lowest quality) to five (highest quality). As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward.

EQ trends for specialty retailers with revenue recognition issues

Retailer

EQ Score January 2012

EQ Score February 2012

EQ Score March 2012

Trend

Likely Issue

ANN 3 4 2 Down Revenue
American Eagle Outfitters 2 2 1 Down Revenue
Aeropostale Not Ranked Not Ranked Not Ranked Flat Revenue
Foot Locker Not Ranked Not Ranked Not Ranked Flat Revenue

Source: Fool EQ Score (week ending March 16, 2012).

ANN's and American Eagle Outfitters' EQ scores have trended down, and Aeropostale and Foot Locker have shown no trend. All exhibit income statement and revenue-recognition issues. I have already posted commentaries on ANN and American Eagle Outfitters, and I'll discuss Foot Locker next, but here is a brief look. ANN's revenues have increased year over year almost 10%, but the company's cost of goods sold, or COGS, has increased 16%, and the gross margin has decreased 5% YOY.

Inventory levels have increased from $169.14 million in FY 2010 to $213.45 million, or 26%. Revenue has not kept pace with increases in the cost of goods sold, and inventory remains on hand longer. I expect price reductions at the register to further depress margins and net income. American Eagle Outfitters shows increasing revenue YOY, up 14%, but its gross margin is down 14% and its COGS is up 24%; this translates to decreasing gross profit levels, which have been negative the last six out of eight quarters, and net income that is down 41% YOY. Foot Locker saw its revenues rise 8% YOY but its COGS increased markedly to 68% from 22% a year earlier, and it gross margin dropped from 78% to 32% YOY.

Aeropostale is a company that only mothers could love
Aeropostale is a specialty retailer of casual apparel and accessories targeting those aged 14 to 17. The company also sells apparel, outerwear, casual clothing, and accessories for children ages 7 to 12. As of Aug. 1, 2011, there were 916 Aeropostale stores in 49 states and Puerto Rico; 63 Aeropostale stores in Canada; and 64 P.S. from Aeropostale stores in 17 states.


Aeropostale Revenues Chart

Aeropostale Revenues Chart by YCharts

The chart above shows Aeropostale's revenue and gross margin for the past two years, and the extent to which revenue is tied to seasonal and holiday sales. Revenue was down 4% YOY, while its COGS was up 51% and its gross margin down 51% YOY. Gross profit was down 53% from last year, and net income and EPS were down 69% and 66%, respectively.

More importantly, the chart indicates relatively flat revenue YOY but declining gross margins, a sure sign of rising inventories and input costs. Remember, revenue minus cost of goods sold equals gross profit margin. Aeropostale must move more merchandise each year via discounting, so revenue remains flat despite increased sales volume. Merchandise costs have been growing, further depressing margins and income.

Aeropostale Inventories Chart

Aeropostale Inventories Chart by YCharts

The second chart highlights inventories and general and administrative, or SG&A, expenses that are subtracted from revenue to derive operating income. Inventory levels have increased YOY from $132.92 million in 2010 to $163.52 million in 2012. SG&A expenses are also increasing YOY in order to move the increased inventories. Note the inventory deltas YOY are increasing, requiring more store staffing to move inventory during each peak selling season.


Aeropostale Net Income Chart

Aeropostale Net Income Chart by YCharts

As with the other specialty retailers reviewed, Aeropostale has repurchased stock to reduce shares outstanding ("the float"). This tactic boosts net income and EPS, but here the effect on net income is only temporary -- but just in time to meet analysts' expectations? As earlier noted, net income and EPS are trending down. Lower net income translates into lower cash flow. Aeropostale had net income of $231.34 million and capital expenditures of $100.81 million, providing FCF of $130.53 million. However, the company spent $250.51 million to repurchase stock and ended the year with $81.42 million less cash on hand.

Since Sept. 22, 2011, shares have increased from $9.31 to $21.66 currently. Aeropostale's share price and net income reflect a significant divergence, but this could close going forward. As with other specialty retailers exhibiting weak earnings quality, review the underlying trend data and select a suitable entry price before taking a position in Aeropostale.

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Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article. The Motley Fool owns shares of Aeropostale. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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