There's Profit in Playing Out-of-Favor Fashion Retailers

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Value investors usually hunt for bargains in very unpopular areas. Out-of-favor fashion retailers, often some of the most disliked firms on Wall Street, can frequently be a lucrative hunting ground. When a clothier misses a trend, both customers and shareholders abandon it quickly. But it's then, when the company is most abhorred, that its stock can have significant profit potential. Here's why.

Why out of fashion can be attractive
History has shown that unpopular apparel retailers can turn themselves around, often quickly, for two main reasons. The first is that fashion changes rapidly. What's in vogue now can be swiftly on the outs and what's snubbed now may then become desirable. While it's impossible to predict when a hot trend will end, it's fairly easy to deduce that it eventually will and that profits will flow in much different circles than currently.

The second is that bad same-store sales numbers get easier to match or beat over time. Retail same-store sales, or sales for comparable stores open for more than a year, usually fall dramatically at a struggling retailer. However, these sales can typically be stabilized and, after a period of disappointing comparisons, a flat same-store sales result is achieved and usually taken as a sign of improvement. This increased optimism tends to boost the relevant shares.

Gap is one noteworthy example of an unpopular fashion retailer rebounding. After coming back from the 2008 financial crisis with its stock reaching around $25 in 2010, disappointing results forced the stock down to around $16 in mid-2011. At that time, most analysts and media pundits panned the company. After management undertook curative measures successfully, the shares ran up to near $30 within a year and recently topped $45.

What's currently out of fashion
The Gap's story is not unusual. Here are three apparel retailers that are currently out of favor. They are not only interesting from a value perspective, but have also shown an ability to recover from tough times.

American Eagle Outfitters is a specialty retailer with more than 1,000 stores in North America. The company disappointed in its latest quarter, reporting an earnings-per-share drop of over 50% with total revenue decreasing 2% and comparable sales falling 7%. Gross profits fell 11% due to higher markdowns and the negative comps.

Like Gap, American Eagle has demonstrated a recovery from prior disappointments. In May 2011, after reporting a 17% decline in earnings per share and comparable-store sales falling 8%, American Eagle's stock dropped from around $14 to $10 by mid-year. But the company steadied the business and by the fall of 2012, its share price breached $24. 

American Eagle's recent share price currently looks cheap but not yet a meaningful bargain. Using a cash earnings times a capitalization multiplier valuation, fair business value looks around $18 a share at a standard 14 times multiple. The calculation being based on revenue of around $3.6 billion, cash earnings of $256 million, and a cash profit margin of around 7.1%, compared to an 8.9% margin achieved in 2012.

Aeropostale  is a mall-based retailer principally targeting 14-to-17 year-old young women and men. Currently mired in a sales slump, Aeropostale has shown it can turn things around.

In early 2011, shares fell from around $18 to near $10 after earnings per share decreased 58% and same-store sales fell 7% in its first quarter. But in less than a year, and bolstered by beating lowered expectations, the company's shares rebounded to over $20.

In its latest quarter, results were horrendous. Sales decreased 6% from last year with same-store sales collapsing a staggering 15%. The company also reported an adjusted net loss of $26.9 million thanks to a challenging teen-retail environment with weak traffic trends and high levels of promotional activity. Management expects this tough teen-retail environment to continue.

Aeropostale's shares look appealingly discounted if the company can achieve normalized sales of $2.3 billion and cash earnings of $80 million at a profit margin around $3.5%, a margin similar to that made in 2012. Admittedly, recent results suggest that may be unlikely. Nonetheless, the company, with no meaningful debt, seems to have the time to try to reach a reasonable fair value of around $12 a share with normalized results at a reduced 12 times multiple.

Abercrombie & Fitch is a well-known specialty retailer that sells a broad array of casual apparel under the Abercrombie & Fitch and Hollister brands. The company recently posted weak quarterly results with net income falling 33% from 2012 and comparable sales for the quarter dropping a surprising 10%. The company's poor sales performance was due to weaker traffic and continued softness in women's goods.

In early 2012, Abercrombie faced a like setback when quarterly income came in at $3.0 million, compared to $25.1 million a year earlier, and comparable-store sales declined 5%. That disappointment was due to poor European sales and higher cotton costs hurting profit. The shares dropped from around $49 to $30 in response. Yet, thanks to a slight turnaround and reduced expectations, the stock topped $50 within a year.

Abercrombie shares currently look nearly bargain priced, given normalized sales of around $4.6 billion, cash earnings of $300 million, and a cash profit margin of around 6.5% compared to a 2012 margin of 7.6%. Its reasonable fair value is around $52 per share at an industry-standard 14 times multiple.

Fashion retailers occasionally miss a trend. In doing so, their shares are usually shunned. But these apparel vendors have shown a resilient ability to turn things around, often fairly quickly. So, the most opportune time to consider picking up some shares in these out-of-favor names may be when they are the most disdained.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

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Bob Chandler has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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