Aeropostale: A Story of Turnaround or Defeat?

Whether it be the underdog story or the excellent buying opportunity, I love the potential turnaround for a battered company. However, not all battered companies come with a turnaround story. Those unable to face their challenges wait with numbered days to be purged by the forces of the free market. Suffering declining sales and being part of an industry that is merciless to all but the most competitive, Aeropostale (NYSE: ARO  ) is at a fork in the road between these two fates.

The background
Aeropostale's share price has declined by a third over the past year and now sits at about a third of its all-time high of $31.88. From the fiscal year ending Jan. 29, 2011 to the same time in 2013 net income declined 85% from $231 million to $35 million, this is despite net sales declining only 0.6%, or about $14 million. The company's lackluster performance reached a climax after a string of disappointing reports last quarter among teen retailers with its share price being halved in just over a month. Competitors American Eagle Outfitters (NYSE: AEO  ) and The Gap (NYSE: GPS  ) have each suffered over the past three months, seeing their share prices fall a respective approximate 20% and 3%.

With all this what makes Aeropostale so interesting? In the period of a week the company's shares surged 10% on news that private equity firm, Sycamore Partners purchased an 8% stake in Aeropostale. While much of this rise was because of speculation over a potential buyout, that is not what interests me. Buying shares in a company based solely on the hope of a single rumor coming true is akin to playing the lottery. What I find interesting is the influx of smart money into an apparently struggling company. While you should never base investment decisions off of the decisions of others, if the smart money is moving into a company, that company at least deserves a second look. So lets take that second look and try to make out what the future holds for Aeropostale and how it compares to the competition.

What needs to be done
For the most part two screaming words: cost control! Looking at the quarter ending Aug. 3 and the same quarter last year net sales declined 6.4%, but the cost of sales actually rose 2.8%, causing the company's operating margin to drop to 17.8%. The cost of sales (or cost of goods sold) are the variable costs directly involved with producing and selling a product. They generally rise as sales rise and vice versa; something that doesn't seem to be the case for Aeropostale. The company is attributing this to rises in buying expenses and changes in depreciation. Meanwhile American Eagle saw their net revenue fall a much less staggering 1.7%, with cost of sales rising 4%, leaving an operating margin of 33.8%. The Gap actually saw their net sales rise 8.2%and operating margins increase to 40.5%.

Much of the 2.3% rise in SG&A costs are because of increased spending on marketing and promotional activities. The primary advantage Aeropostale relies on is its relatively lower prices to its peers and these promotional activities strengthen this advantage, but as many of the company's peers use the same strategy, doubling down on this one advantage will be less effective. If Aeropostale is going to prosper then the company must find something new that sets them apart from their competitors. Not only this, but it will further reduce margins that are already well below that of the competition.

What's being done
Much of Aeropostale's efforts have been focused on expanding their other brands. The company plans to expand their P.S. from the Aeropostale (the company's brand focusing on 4 to 12 year olds) brand from 100 stores to 160 by the end of fiscal 2013. The company is also hoping to use their GoJane.com (the company's brand focusing on women's fashion and footwear) acquisition to strengthen their e-commerce presence. The company's brand diversification efforts are a great starting point in increasing the company's competitiveness.

The Gap utilizes this same strategy and operates six distinct brands (Gap has four sub-brands), covering a range of demographics and price points. The Gap has become one of the S&P 500's best performing stocks.  While this strategy isn't the sole contributor to the company's success, it gives The Gap the advantage of diversification within the apparel market. Aeropostale has not forgotten their primary brand and are expanding their Aeropostale stores into Mexico. American Eagle is using the same strategy and has listed penetration into Mexico under the growth strategy of their most recent 10-K. The Gap leads the pack with company operated stores in 8 countries, franchises in 40 countries, and an estore available to over 80.

The company is taking steps to control costs, having identified 100 stores they wish to close over the next several years with 15-20 of them planned to close throughout 2013, as well as making numerous IT investments.

The Foolish bottom line
The question of whether Aeropostale is heading for a turnaround or the ranks of previous failed retailers has a two-part answer. In the short term I believe that Aeropostale will be able to return to profitability and turn around. The company is taking steps to control costs and increase sales, but while these measures seem to be adequate the company's multi-year declines are unnerving.

Aeropostale is free of long-term debt, has $100 million in cash, and another $175 million in available credit, so the company still has time to make their efforts work. However the company's long-term success will depend upon being able to find a new competitive edge. The company's brand diversification and international expansion efforts are encouraging, but at this point only serve as a starting point as the company still has a long way to go until they have an empire of strong, wide-encompassing, international brands. For the time being it looks like American Eagle Outfitters is on a similar path but with a head start and The Gap sits well ahead, serving as a great model.


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