1 Smaller Retailer With a Big Future

In one of its recent presentations (link opens PDF file) to the investing community, Gap (NYSE: GPS  ) lays out the retail landscape as it sees things. The company charts itself among competitors based on revenue and footprint. In the middle. Gap places its own brand moving up toward the higher-revenue brands, like H&M. Then, down at the bottom, are the small-footprint, low-revenue companies that Gap has already motored past.

On the slide, Abercrombie & Fitch (NYSE: ANF  ) , Aeropostale (NYSE: ARO  ) , and American Eagle (NYSE: AEO  ) all seem to be fighting it out in the smaller space, labeled "Single- to low-double-digit operating margins." That group may have a smaller footprint and lower revenue than Gap, but that doesn't mean that investors should overlook it completely.

The thin black line
The grouping that Gap has laid out isn't unfair. Of the three retailers, only American Eagle managed a positive move in comparable-store sales over the last year. American Eagle is also the only one to manage that low-double-digit operating margin, with Aeropostale hitting just 2.5% and Abercrombie coming in at 8.3%. As a reference point, Gap's operating margin was 12.4% -- which actually wasn't much higher than American Eagle's margin.

In fact, when you dive into the details, the line that Gap draws between itself and American Eagle starts to look more perforated than solid. Operating margins for both came in between 12% and 12.5% last year, and American Eagle managed stronger comparable-store growth than Gap -- 9% versus 5%. Maybe this isn't the scrum that Gap portrays, but is instead a set of two losers and a clear winner -- a winner in hot pursuit of Gap's territory.

Pulling away from the pack
On some fundamental basis, that might be a fair way to talk about it, but if you pull back, things become a bit clearer. Gap lumped American Eagle into the pile in part because American Eagle made $3.5 billion in revenue last year. Abercrombie and Aeropostale managed $4.5 billion and $2.4 billion, respectively. Gap cranked out $15.7 billion in revenue for the year, putting a huge piece of real estate between it and the other three retailers.

But the distance shouldn't preclude investors from looking into American Eagle. The company managed a strong showing last year, and it has every opportunity to continue playing to its strengths this coming year. The company is going to focus on growing brand strength in the U.S., increasing the value it generates form its intimates line, and launching a personal care line in time for the holidays.

While I've been a big Gap fan for the past year, American Eagle is quietly expanding its offerings, giving it a potentially broader customer base. Even after its good showing, the company's P/E hasn't pulled ahead of Gap's, with both companies trading at just over 16 times earnings.

With Abercrombie posting a 5% drop in comparable sales last year, and Areopostale running at a 2% decline, it seems that American Eagle is having the most success pulling customers in. While the company doesn't have the size or brand value that Gap has, American Eagle has a lot going for it right now. Investors looking for another apparel retailer should expand their horizons, and look at this smaller winner.

Another set of retail winners
The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.


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