After a Bad Start to 2014, Should Tilly's Shareholders Hold ... or Fold?

Shareholders in teen retailer Tilly's (NYSE: TLYS  ) have been waiting awhile for some upside, with the company's shares down more than 35% since its initial public offering back in 2012.  Despite a solid store concept complete with visual effects and friendly salespeople, Tilly's has been a victim of a generally difficult sales environment, a trend that has also hit competitors like Zumiez (NASDAQ: ZUMZ  ) .

That being said, Tilly's does have a solid, debt-free balance sheet and has posted slightly better-than-expected profitability in its last few fiscal quarters.  So at its current discounted price, is the company a good bet for investors?

What's the value?
Tilly's has built a sizable operating footprint, with nearly 200 stores in 32 states at last count, by focusing on a diverse assortment of action sports-oriented brands that include Billabong, Converse, and Vans of VF Corp; this strategy has allowed it to attract a strong following among its core teenage demographic.  The company has also successfully supplemented its branded product portfolio with private-label offerings, which make up 28% of its sales; this has served as a point of differentiation for its customer base and has provided greater flexibility in merchandise mix and pricing decisions.  The net result for Tilly's has been consistent operating profitability over the past few years.

In its latest fiscal year, Tilly's consistency showed once again with a limited 5.4% drop in its operating income; this performance far outpaced those of rivals like Aeropostale (NYSE: ARO  ) and American Eagle Outfitters, which endured double-digit declines in operating income.  On the downside, though, the company's merchandise margin was significantly affected by the heavier promotions needed to move sales, which led to its lowest gross margin in the past five years.  Not surprisingly, this also negatively affected Tilly's operating cash flow to a degree, bringing into question the company's ability to grow its store base at a double-digit rate.

Of course, Tilly's isn't alone in its current struggle, as competitor Zumiez seems to be in the same boat. Like Tilly's, Zumiez caters to the action-sports oriented crowd with a product portfolio of popular brands that include Vans and Burton, to which it adds its own cadre of private-label offerings.  While the company reported an operating income increase in its latest fiscal year, it also generated its first comparable-store sales decline since fiscal 2009 as it's having difficulty in attracting a higher volume of customers to its stores.

Beware of false bottoms
On the surface, Tilly's doesn't seem like a high-risk bet, given its history of profitable operations, its debt-free balance sheet, and a P/E multiple that is line with the market averages.  Then again, things can go downhill fast in the teenage retail sector, as investors in Aeropostale have found out the hard way.

One of the major players in the teenage retail sector, Aeropostale has fallen on hard times recently due to a stylish, logo-oriented apparel mix that seems to be increasingly out of favor with its core demographic; this is evidenced by three consecutive years of comparable-store sales declines, including a double-digit drop in its latest fiscal year.  More importantly, the company has needed to resort to drastic promotional activity in order to drive sales, which has pushed operating profit into the red, a stark contrast from a few years ago.  The net result for Aeropostale has been a dwindling cash balance, which ultimately caused management to seek a financing lifeline recently in order to buy it time to restructure.

The bottom line
Tilly's shares seem like an intriguing bet; shares have been sliding since the start of the year and badly underperformed the market averages.  However, that performance likely indicates little faith from investors, a reasonable view given Tilly's inability to register annual operating profit growth since fiscal 2011.  While taking the opposite view could possibly be profitable, it seems unlikely given current sales volume trends; therefore, investors should avoid the shares.

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