Aeropostale Hits the Value Bull's-Eye

Posted: February 3, 2012 at 4:57 pm


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The teen fashion market is not generally an investing niche geared toward value-focused opportunities.  The industry contains very little, if any, barriers to entry, and is thus highly fragmented with many players all targeting the same customer base.  Likewise, as with most fashion sectors, teen apparel is subject to large swings in popularity.  Most brands are therefore largely fad-fueled, and the door for new entrants and those leaving the industry is ever-revolving. 

Aeropostale (NYSE: ARO), which targets the market with highly sellable active wear geared towards the so-called “universal teen,” represents a potentially lucrative value investment at its recent market price of $16.80. 

Why So Cheap?

At $16.80, ARO trades inexpensively on both an absolute and relative basis.

Largely due to a generally weak retail sector over the past several quarters and the new breed of value-conscious buyers, as well as rising commodity costs, nearly all players in the consumer apparel industry have been subject to “perfect storm” like conditions. 

ARO, which markets products at a lower price point than other premium-priced competitors like Abercrombie & Fitch (NYSE: ANF), American Eagle Outfitters (NYSE: AEO), and Urban Outfitters (NASDAQ: URBN), has maintained modest sales growth but largely at the expense of slowly dipping margins. 

Average 10-year gross and operating margins – 32.4% and 11.2%, respectively – have decreased nearly 5.5 and 6.6 percentage points, respectively, over the past three quarters.  ARO’s stock price fell over 65% within the first nine months of 2011 as a result, and prices have recently stabilized nearly 37% off their early 2010 highs. 

ARO Past Performance

An investment in ARO more or less follows a return to normalcy hypothesis.  By no means is the recent slump deeply ingrained in the corporation’s operations, as some sort of gross inefficiency.  In looking at the past performance of the company, quite the opposite is actually true. 

SSS = Same Store Sales

ARO’s past five year performance is much more consistent than that of the competition, despite the unfavorable economic climate.  Likewise, its strong performance over the past decade hints that ARO contains a degree of lasting value and is by no means a passing fad – sales have grown at a 20.2% CAGR between 2003 and 2011, gross and operating margins both increased nearly 700 basis points over the same time period, and the growth was largely organic:

Between 2003 and 2011:

Number of stores increased 275% Average SSS growth was 5.7% Sales/square foot increased 33%

Although the retailer’s past three quarters performance has disappointed the market, a normalization scenario under which ARO shares revert back to their early 2010 highs in the mid $20s is not farfetched. 

First, the sector will not continue to operate with depressed margins indefinitely.  ARO has historically been priced on a lower tier than premium priced brands – ANF’s five year gross margins averaged 66% -- and margins have recently been squeezed from both ends as higher-level brands utilized uncharacteristically prolonged periods of promotion and input prices skyrocketed. 

In order for brands like ANF to retain their premium images and their premium pricing powers, prices will need to return to normalized levels.  As the general state of the retail sector improves and consumers’ willingness (and ability) to spend increases, prices will follow suit.  Cotton prices, although still elevated, have fallen from their mid-2011 peaks.  With margins at near all-time lows, even a slight improvement will tend to revamp the market’s confidence in the brand and the stock. 

Next, the retailer has been accused of missing recent changes in fashion.  Inventory levels, in relation to the seasonal nature of the corporation’s sales, have returned to very manageable levels.  Management’s stated plans of heavy product focus and slight store redesigns to better highlight products should help to strengthen margins as inventory would be better tailored to consumer tastes.  Likewise, seeing that there is no longer a gross overabundance of inventory, and taking into account the slowly strengthening retail market, chances of another fire sale-like operating environment are low. 

Sales figures on four quarter run, and DSI on four quarter averages, to adjust for seasonality

Lastly, from a long-term perspective, ARO’s largely-organic growth strategy has been efficient, and more importantly, safe.  Unlike the past five year operating history of competitors like ANF, AEO, and GPS, ARO’s system of stores has not appeared to be affected by severe cannibalization.  New store openings per year have slowed to a conservative level, and per-store metrics have continued to improve despite the opposite effect most competitors have experienced.  Likewise, as previously mentioned, ARO is hardly a passing fad.  Its “universal teen” product focus is once again effective yet safe, and its performance shows that the style resonates with a large portion of the younger generation despite their tendency to frequently change tastes. 

Valuation

What does the market’s current price imply about the growth prospects of the brand, and what would it take for the stock to appreciate 40+ % to its early-2010 high in the mid $20s?

*Look at footnote for additional information

Aside from the sales, margin expansion, and same-store metrics that ARO has improved over the past several years, the corporation has created superior shareholder value through the growth of residual earnings – above and beyond its cost of capital requirements – on its core operating assets.  Residual operating income over the last twelve month period, $90.1 million, is severely dampened by the market conditions already discussed.

Residual operating income grew at a 24.4% CAGR between 2004 and 2011, and at a 10.2% CAGR between 2004 and the last twelve months.  What is the market assuming?

_________________________________________________________________________

Market Price Per Share = Net Operating Assets Per Share – Net Financial Obligations Per Share + [Residual Earnings Per Share / ((1 + Cost of Capital) * (Cost of Capital – Growth Rate))]

$16.80 = $3.75 - (-$0.99) + [($1.12) / ((1.15)*(.15 - G))]

G = 6.9%

_________________________________________________________________________

The current market price, which assumes a very pessimistic 6.9% future growth rate for ARO’s residual operating income, offers one of the best entry points for the stock over the past several years.  Even with the recent cyclical downturn, which can be assumed to occur once every decade, the corporation’s residual growth rate has averaged 10.2% per year.  Assuming that ARO continues at this average trajectory – although its growth rate prior to the recent downturn averaged near 25% per year – a market price of $24/share is very realistic (plug 10% growth rate into equation above).

Considering that margins are at near all-time lows and the retailer’s residual operating earnings are at trough levels, even a slight improvement in performance should yield residual earnings growth in excess of the market’s assumptions.  The recent ARO sell off, from a long-term, value-focused perspective, is well overdone. 

 

* Footnote

NOA, net operating assets = (total assets – financial assets) – (total liabilities – financial liabilities).  NFO, net financial assets = (total liabilities – operating liabilities) – (total assets – operating assets) CSE, common shareholders’ equity = NOA - NFO 5% of each year’s sales is assumed to be needed for operations, and the remaining cash/equivalents balance is considered excess financial assets. Financial assets, because the firm has never taken on any debt, is zero for each year.  The firm is essentially a net creditor, as its financial assets outweigh its financial obligations. Post-Tax is post tax operating income.  RNOA = return on net operating assets = (post tax operating income / average net operating assets) Residual operating income = (RNOA – 15% cost of capital) * average net operating assets

The Motley Fool owns shares of Aeropostale and has the following options: long JAN 2014 $10.00 calls on Aeropostale, long JAN 2014 $15.00 calls on Aeropostale and long JAN 2014 $20.00 calls on Aeropostale. gibbstom13 has no positions in the stocks mentioned above. 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.

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Tom Gibbs

Tom Gibbs is a member of The Motley Fool Blog Network.

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February 3rd, 2012 at 4:57 pm