Is This California-Inspired Brand the Way to Play Teen Retailing?

According to the U.S. Census Bureau, Americans are doing more shopping at the nation's clothing and accessories stores, with sales up 3.6% to $133.8 billion in the first seven months of 2013. However, the teen-retail segment has been a tough place to find value, with the stock prices of former stalwarts like American Eagle Outfitters and Aeropostale hitting 52-week lows due to declining sales for their product mix. While Quiksilver (NYSE: ZQK  ) has also generated lower sales in FY2013, investors smell a turnaround story and have bid the shares up sharply over the past year. So, is this retailer a good bet?

What's the value?
Quiksilver is primarily a wholesale designer of casual clothing and accessories for its teen demographic, with a product mix of boardshorts, hoodies, and shirts inspired by its surfing and skateboarding heritage.  It complements its wholesale operation with a retail store network that is predominantly positioned in overseas markets. Due to its tight link to the action sports of surfing and skateboarding, the company is a heavy marketer of related sporting events and is a sponsor of athletes, despite the costs of maintaining those relationships.

In FY2013, Quiksilver has reported declining sales, down 4.7% for the period, as well as a steep drop in its adjusted operating income. The primary cause of the profitability slump has been a decline in gross margin, a consequence of the discounting required to move inventory, especially in the company's European and U.S. markets. However, what has investors excited is Quiksilver's uptick in adjusted profitability in the most recent quarter, due to the company's reduction of its overhead costs as part of management's profit-improvement plan that was announced in May.

Another data point
Despite its lack of overall sales growth, Quiksilver's California-inspired lifestyle brand seems to be resonating with the current teen generation. Tilly's (NYSE: TLYS  ) , another West Coast-inspired teen retailer that sells to active sports enthusiasts, has nearly doubled its retail-store network over the past four years, as customers have been attracted to its assortment of leading brands, including Quiksilver, Billabong, and Hurley.

In FY2013, Tilly's has continued to report solid growth, with double-digit increases in revenue and adjusted operating income. Its top-line growth has been aided by a strong pace of retail-store openings, as well as a 22% increase in its online sales. More importantly, Tilly's focus on profitable operations has led to consistent operating cash flow that is allowing it to build out a national store footprint, which should ultimately benefit its suppliers like Quiksilver.

A better idea
Given Quiksilver and Tilly's somewhat narrow focus on the active-sports subset of the teen segment, investors might find better returns with the more diversified, best-of-breed player in the teen segment, Urban Outfitters (NASDAQ: URBN  ) .  The company targets the teen crowd with its namesake stores that offer an eclectic mix of apparel, accessories, and home wares.  It also enhanced its vertical integration with its 2002 introduction of the Free People brand of value-priced women's apparel, which is sold in its stores, as well as through a wholesale network of 1,400 independent stores.

In FY2014, Urban Outfitters has generated double-digit increases in revenue, aided by a high single-digit gain in comparable-store sales and a further expansion of its retail-store base.  More importantly, the company's higher gross margin, due to reduced markdowns, stands in stark contrast to the negative effect that discounting has had on Quiksilver's gross margin. The net result is that Urban Outfitters generates strong operating cash flow, $396 million in its latest fiscal year, which it can use to build inventory for additional store expansions or can return to shareholders through dividends and share repurchases.

The bottom line
Quiksilver's name still has selling power among its teen cohort, as judged by the growth of Tilly's business, where Quiksilver is one of its important brand partners.  However, Quiksilver has a significant debt load, over $800 million at last count, and generates a level of operating cash flow that is insufficient to support its current capital expenditure needs. Until the company is able to shore up its financial position and produce consistent operating income, investors should stick with Urban Oufitters in the teen retail sector.

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