Is Teen Retailer Tilly's a Buy at These Levels?

Times continue to be tough in the teen-retail patch, as fast-fashion leaders like Forever 21 and H&M have latched on to teen customers' desire for more affordable attire, leading to an unprecedented level of product-price compression, according to American Eagle CEO Robert Hanson.The trend has hurt the results of a wide swath of sector players, including West Coast lifestyle retailer Tilly's (NYSE: TLYS  ) , a fast-growing purveyor of apparel and accessories that targets an action-sports-loving demographic. 

Mr. Market dropped the company for a sharp loss in November after Tilly's announced weak comparable-store sales results and reduced sales expectations for 2014. So, should investors see the drop as a buying opportunity?

What's the value?
Tilly's has leveraged its customers' love for the mythical California lifestyle, no doubt inspired by the Beach Boys' songs, into a national footprint of roughly 190 stores that sell a range of apparel, footwear, and accessories for its teen and young-adult customer base. 

Unlike other competitors that focus solely on a proprietary brand, Tilly's reduces inventory obsolescence risk by offering products from a range of merchandise partners, including Billabong, Converse, and Hurley. In addition, the company has cultivated a loyal customer base through its friendly store selling experience, replete with pop music and an open layout, which has allowed it to expand rapidly, nearly doubling its locations over the past five years.

In FY 2013, though, Tilly's has been feeling the effects of an increasingly stingy customer base, which has required it to use heavy promotions in order to drive sales. While the company's top line has continued to rise, thanks to new store openings, its adjusted operating profitability has been negatively affected by the promotions' effect on its merchandise margin. More importantly, Tilly's operating cash flow growth has stagnated, causing it to have to go into its cash reserves to fund capital expenditures.

On the upside, though, Tilly's has built a business that is capable of earning a profit in a low-margin environment. Less-efficient competitors, like Pacific Sunwear (NASDAQ: PSUN  ) , whose business was predicated on a higher gross margin, have not been so lucky.  The company has had a particularly difficult adjustment to a lower pricing environment, as a weak financial position caused it to reduce its store network by nearly one-third over the past five years.

Pacific Sunwear is a particularly relevant case for Tilly's, given its similar focus on the California lifestyle and the action sports of surfing and skateboarding. The company enjoyed a generally favorable growth trajectory from inception until 2008, when its comparable-store sales trend turned south, leading to business financing problems. Despite a capital infusion from retail-focused investment firm Golden Gate Capital and a renewed focus on private-label brands, currently 48% of its total sales, Pacific Sunwear is still searching for an operating structure that allows it to turn a net profit.

A better way to go
Obviously, investing in the oft-changing teen sector requires a margin of safety, not to mention an iron stomach in order to withstand the roller-coaster ride. As such, investors looking at the sector might want to consider a turnaround story, like Quiksilver (NYSE: ZQK  ) .

Despite a host of well-known, action-sports clothing brands, some of which are not coincidentally sold at both Tilly's and Pacific Sunwear, Quiksilver has suffered from the high administration costs of an overly expansive business empire, which has seemingly eaten up more and more of its merchandise margin each year. Fortunately, management realized that its lenders' patience wasn't infinite and decided to embark on a profit-improvement plan in May 2012 that included headcount reductions and non-core asset sales. 

While Quiksilver didn't escape the sector's downdraft in FY 2013, reporting a 6.8% top-line decrease, its slimming efforts will hopefully allow it, over time, to translate its global brand popularity into an improved level of profitability and higher shareholder value.

The bottom line
Tilly's stock price has been plumbing a 52-week low lately, sitting roughly 25% below its initial public offering price from two years ago. While the current level seems enticing, more so given its debt-free profile, the company is fighting poor traffic and sales trends from its core customer base. Until Tilly's is able to improve those metrics, investors would be wise to let this opportunity pass.

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