Aeropostale: A Turnaround Play or a Sinking Ship?

While retailers in general have had a tough time of late, teen retailer Aeropostale (AROPQ) is unraveling. The stock has collapsed over the past year, falling nearly 80% from its 52-week high as revenue declined and profits turned to losses, and the first quarter of 2014 was downright abysmal. The company recently closed a deal for $150 million in loans, giving it some breathing room, but things appear to be deteriorating fast.

Some competitors, like American Eagle Outfitters (AEO -1.85%) and Abercrombie & Fitch (ANF 3.29%), also suffered from declines in both revenue and profit in 2013. While it may be tempting to bet on an Aeropostale turnaround, given that a return to the $30 per share level seen in 2010 would result in an enormous gain, Aeropostale is not just suffering from short-term retail weakness. The company's problems have been evident for years, and the long-term picture doesn't look pretty.

Warning signs aplenty
Between 2004 and 2012, Aeropostale averaged a gross margin of about 34%. But in 2011, this number collapsed, a trend that the company has yet to reverse. In fact, the decline in gross margin mirrors the decline in the stock price quite accurately:

Aeropostale gross profit margin (annual) data by YCharts

After peaking in 2009 at 38%, the gross margin fell by more than half to just 17.1% in 2013. People stopped wanting to buy Aeropostale products, and the company lost its ability to charge typical prices. As the gross margin declined, operating expenses continued to rise, increasing by 8.8% from 2010 to 2013.

This level of gross margin isn't sustainable, and it's far lower than any major competitor, even the ones not doing all that well:

Source: Morningstar

Abercrombie, American Eagle, and Aeropostale all suffered from dramatic declines in net income in 2013, but there are some important differences:

Source: Morningstar

Abercrombie suffered a significant revenue decline, but the company managed to grow its gross margin slightly. American Eagle suffered a smaller revenue decline, and its gross margin fell considerably. Aeropostale suffered the largest revenue decline and the largest gross margin decline, and of the three it was the only company to post a loss in 2013.

While revenue declines are never a good thing, the gross margin tells the real story. Abercrombie's gross margin in 2013 was very close to historical values, and while revenue declined significantly, the company wasn't forced to slash prices in order to move merchandise. American Eagle suffered a significant gross margin decline, and this suggests that the company needed to be more promotional than usual. But that's nothing compared to Aeropostale. A gross margin of 17.1% means that Aeropostale needed to drastically cut its prices, and that points toward a loss of interest in the brand altogether.

Two problems at once
Aeropostale is suffering from a brand crisis at a terrible time. Retailers in general have been posting lackluster results, and the combination of falling revenue and falling gross margin is leading to enormous losses. In the first quarter of 2013, Aeropostale reported a net loss of $76 million, a little more than half the total net loss in all of 2013. There were some restructuring charges, but the results were significantly worse than the same period last year no matter how you slice it.

An Aeropostale turnaround is difficult to imagine because the company is not just dealing with short-term problems. Abercrombie, and to a lesser extent American Eagle, are both struggling in a difficult retail environment, but most of both companies' problems seem to be external. Gross margin was at reasonable levels for both companies, and it's not hard to imagine profits rising once consumer spending begins to pick up. But Aeropostale's brand is its biggest problem, one that has been evident since 2011, and the company won't be able to simply wait out this period of weakness. The financing deal buys the company some time, but with losses piling up, it may not be enough.

The bottom line
Aeropostale is an extremely risky turnaround play. If successful, the reward for investors buying at current prices will be enormous, but there is just so much working against the company. With the gross margin falling by more than half over the course of three years, it's clear that Aeropostale's strategy has been a disaster. I don't have much faith that the ship can be righted, and while a buyout is possible, shares of Aeropostale are risky even at a little more than a tenth of sales.