Is It Time to Go Fishing for Gains at Aeropostale?

Shareholders in teen retailer Aeropostale (NYSE: ARO  ) haven't had much to celebrate in 2014, with the company's share price down sharply. Aeropostale's once highly profitable business model has been turned completely on its head, due to an anecdotal shift toward more price-conscious buying habits on the part of its teen demographic, a trend that has also hit the fortunes of competitors like American Eagle Outfitters (NYSE: AEO  ) .

Case in point was the company's performance in its latest fiscal quarter, which included a double-digit top-line decline and an operating loss. On a bright note, though, retail-focused investment firm Sycamore Partners found enough promise in Aeropostale's books to lend the company roughly $150 million recently, giving management time to effect a turnaround. So, is Aeropostale a good bet at its discounted price?

What's the value?
Aeropostale took advantage of wide popularity for its fashionable, logoed apparel offerings to become a major player in the teen sector, currently operating a network of more than 1,000 stores under its Aeropostale and P.S. by Aeropostale brands. While the company remains a strong brand, as evidenced by roughly $2 billion in sales in its latest fiscal year, it has been slow to adapt to its customers' general desire for lower price points in their apparel purchases, which has stuck Aeropostale with uncompetitively priced inventory and required it to use heavy promotions in its operations. The net result for Aeropostale has been a contracting gross margin and sharply lower operating profitability over the past few years.

In its latest fiscal year, it was a continuation of the same story for Aeropostale, highlighted by a double-digit drop in comparable-store sales and a contraction of its gross margin to the mid-teens level. Not surprisingly, that level of gross margin was incapable of supporting the company's corporate overhead, leading to a sizable operating loss. More important, the loss severely weakened Aeropostale's once-solid balance sheet, making its current restructuring initiative a foregone conclusion.

The more the merrier
Of course, Aeropostale's performance, while bad, is not exactly an outlier given the struggles that competitors are having in the current selling environment. American Eagle's business has similarly come under increasing pressure lately, highlighted by a 6% decline in comparable-store sales in its latest fiscal year, its first negative comp performance since FY 2010.

While American Eagle remained profitable during the period, unlike Aeropostale, it recorded its lowest operating margin of the past five years, mostly due to a contraction in its gross margin. More important, the company's cash flow also registered a substantial decline, a trend that led management into its own restructuring activities, including the elimination of its stand-alone Aerie intimates store base.

Even sector standout Urban Outfitters (NASDAQ: URBN  ) has come under profit pressure recently, reporting a double-digit decrease in operating income in its latest fiscal quarter, due in part to weakening sales at its Urban Outfitters unit. The company remains solidly profitable, thanks to strong sales and profit growth for its Free People brand, but Urban Outfitters' lower-than-expected profitability during the period undoubtedly has management rethinking the pace of new store expansion.

The bottom line
Times are tough for the teen retailers, a fact that is reflected in their generally declining stock prices, including that of Aeropostale. However, after a more than 70% stock price decline over the past 12 months, Aeropostale is an intriguing bet, more so given the potential ability of Sycamore Partners to effect profit-maximizing decisions due to its presence on Aeropostale's board of directors. While Aeropostale has more work to do, it appears to have the time and resources to get back on the profit track, making it a good buy at current prices.

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