Mr. Market has kept teen retailer Aeropostale (NYSE:ARO) on the junk pile, selling off its shares for a double-digit decline in March after the company's latest financial update. Aeropostale reported an operating loss for the period, which continues a business deceleration trend that dates back to at least 2011. Yet in the midst of the carnage some investors see a value story emerging at Aeropostale. As evidence, investment firm Sycamore Partners announced in mid-March that it would infuse $150 million of capital into the company, potentially increasing its ownership stake to roughly 12%. So is Aeropostale a good bet at its depressed price?
What's the value?
Along with competitors American Eagle Outfitters (NYSE:AEO) and Abercrombie & Fitch, Aeropostale had been part of a triumvirate of players that had built strong franchises in the teen retail sector, thanks primarily to trendy, logo-displaying apparel assortments that caught on like wildfire with their core demographic. Unfortunately, the teen cohort anecdotally seems to have made sweeping changes to their shopping patterns lately, as they have preferred more value-priced offerings from so-called fast-fashion players like Forever 21 and H&M. The net result for Aeropostale has been a big headache, complete with steadily shrinking customer volumes and declining store sales.
As illustrated by Aeropostale's fourth-quarter bombshell, fiscal 2013 did not show a successful campaign for the company under any financial metric. Aeropostale posted a 12.4% top-line decrease but it felt even more pain on its operating profit line, which produced a significant amount of red ink during the period. The main culprit was the use of heavy promotions and discounts to move merchandise, as evidenced by a steep drop in the company's gross margin to a dangerously low mid-teens level.
Of course, Aeropostale isn't alone in its suffering, as other teen retailers have been witnessing similar, if less extreme, negative impacts to their operations from teens' apparent newfound frugality in their apparel-purchasing decisions. Like Aeropostale, American Eagle had a poor year in fiscal 2013 as it reported a 4.9% top-line decline that likewise resulted from lower customer volumes and negative comparable-store sales.
Fortunately for American Eagle's shareholders, the company has responded a little more quickly than Aeropostale has to operational challenges. This is highlighted by the elimination of its 77kids brand in 2012 and the ongoing pruning of its Aerie intimates store base. In addition, American Eagle's focus on a slightly wider demographic, young teens to mid-20-somethings, seems to have provided some stability to its gross margin that has allowed it to maintain its operating profitability even in the currently challenging selling environment.
Looking into the crystal ball
Despite its weak recent results, Aeropostale's brand clearly has value. It has the leading brand position among its teenage demographic, according to data provider NPD Group. The financing package from Sycamore Partners also gives the company breathing room to figure out a profitable merchandising strategy without having to resort to wholesale reductions of its national store footprint. Nevertheless, with its management forecasting further operating losses in fiscal 2014, investors who hope to gamble in the teen space should probably be looking for a better-positioned player like Urban Outfitters (NASDAQ:URBN).
Unlike Aeropostale and American Eagle, Urban Outfitters generated a top-line gain of 10.4% in fiscal 2013 thanks to double-digit growth at its Anthropologie and Free People units. More important, the company achieved these sales without resorting to large-scale promotional efforts, the main source of Aeropostale's problems, which allowed Urban Outfitters to post a slightly better merchandise margin during the period. The net result for Urban Outfitters was stronger cash flow and a further buildup of its sizable net cash position, which has allowed it to expand its primarily U.S.-centric operations into select international markets.
The bottom line
With a market valuation that is less than half of what it was a year ago, Aeropostale seems like an intriguing bet on the surface. However, that assumes that the company can turn things around before its coffers run dry, which isn't a high-probability event in a sector as tough as teen retailing. As such, prudent investors would be wise to stay clear of this story and focus on the best-of-breed in the sector, Urban Outfitters.
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Robert Hanley owns shares of Aeropostale and Urban Outfitters. The Motley Fool recommends Urban Outfitters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.