Should Investors Follow the Action in Aeropostale?

The teen retail segment has been a tough place to invest lately, with a fickle customer base that seems more inclined to spend their dough on technology gadgets than expensive apparel. While clothing sales have risen in 2013, up 2.7% according to the U.S. Census Department's September report, some teen retailers have struggled to keep up, including former stars like Aeropostale (NYSE: ARO  ) and American Eagle Outfitters (NYSE: AEO  ) . 

However, investment firm Sycamore Partners bought a sizable stake in Aeropostale in mid-September, leading some investors to envision a buyout offer in the cards.  So, should investors take a position?

What's the value?
Aeropostale was started by retail giant Macy's in the late 1980s as a niche fashion brand for young men, but it has evolved into a casual teen brand that mostly caters to young women, accounting for roughly two-thirds of its sales.  Despite the company's current trouble with top-line growth, Aeropostale maintains high name-brand recognition among its middle school and high school cohort, according to data provider NPD Group. It is also spending heavily to expand its brand to the children's apparel arena through its P.S. by Aeropostale stores, with a long-term goal of 500 units nationwide.

In 2013, Aeropostale has performed poorly, with a 7.8% top-line decline, due primarily to a steep double-digit drop in comparable-store sales.  More important, the company has had to maintain heavy promotions in order to drive those sales, resulting in a weak gross margin and an overall operating loss.  Undaunted, management has continued opening stores, focused on the P.S. by Aeropostale concept, as the company tries to develop a meaningful secondary revenue stream to offset weakness at its namesake stores.

Unfortunately, Aeropostale's performance doesn't seem to be an outlier, given similar trouble for like-minded competitor American Eagle. Like Aeropostale, American Eagle relies heavily on an assortment of denim and logo apparel items that seem to have lost favor with a customer base that is finding better bargains at so-called "cheap chic" clothing purveyors, like Forever 21 and H&M.

In 2013, American Eagle also reported weak results, with a 2.9% decrease in revenue that was the byproduct of lower comparable-store sales.  The company has similarly suffered a contraction in gross margin during the current period, due primarily to markdowns, although its more balanced product portfolio, including its Aerie intimates unit, has allowed it to remain in the black.  Unlike Aeropostale, though, American Eagle has chosen to selectively prune its operating footprint, while reinvesting its resources in its existing stores to enhance productivity.

A better way to go
Rather than gambling on an Aeropostale turnaround, investors should focus attention on the sector player that is continuing to win customers at its competitors' expense, namely Urban Outfitters (NASDAQ: URBN  ) .  Unlike Aeropostale and American Eagle, Urban Outfitters has reported a solid comparable-store sales gain in 2013, although the disclosure of a downshift in the size of future sales gains led to a sell-off in its stock price in early September.  In addition, the company has continued to get mileage from its wholesale unit that has been generating solid double-digit sales increases through an expansion of its department store network.

In its current fiscal year, Urban Outfitters has reported solid top-line growth, up 13%, with comparable-store sales gains across its segments, led by a 41% jump at its Free People unit.  The company's constantly changing, eclectic mix of apparel and home goods merchandise has allowed it to maintain its pricing discipline and benefit from reduced product markdowns, leading to a slight expansion in its overall gross margin.  More important, stronger profitability is also leading to solid operating cash flow, allowing it to expand its retail concepts, while some of its competitors have been forced to retrench.

The bottom line
Aeropostale is an intriguing story, given its relatively debt-free financial profile and name-brand recognition among its customer base. Its expansion in the children's apparel area is also interesting, although the company doesn't currently break out results for the unit separately. 

On the whole, however, Aeropostale's current risks outweigh its rewards, except for investors like Sycamore that have the patience and fortitude to hold for the long run. Most other investors might be wise to avoid this story and stick with the category king, Urban Outfitters.

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