I may not know much about fashion (cut to a shot of my co-workers nodding vigorously), but I know a cheap stock when I see one. And at current prices, Aeropostale (ARO) is sitting in the stock market's bargain bin.
Aeropostale operates 906 stores in the United States and 59 in Canada, selling cheap-but-stylish clothing to young teens. You don't need to be a mall rat to notice that the company's graphic T-shirts, polos, and hoodies look awfully similar to the clothes sold by competitors like American Eagle (AEO) and Abercrombie & Fitch's (ANF) Hollister. This is no coincidence: Rather than trying to set fashion trends, Aeropostale is content to copy what's already working for other companies. But although its merchandise may look similar to its competitors', Aeropostale's prices are much lower.
Aeropostale thrived during the Great Recession, posting record-high margins as cash-strapped customers loaded up on its cheap-but-stylish tops and pants. However, discounts from teen retail competitors, rising commodity costs, and a few fashion missteps have weighed on the company's profits lately. After two consecutive disappointing quarters, Wall Street has soured on this former highflier, and Aeropostale now trades at a steep discount to its peers, even though it operates the most productive and profitable stores:
Sales per Square Foot
Return on Capital
Enterprise Value-to-EBITDA Multiple*
Abercrombie & Fitch
*Data as of July 21, 2011. Data from Capital IQ, a division of Standard & Poor's.
That pricing discrepancy might make sense if Aeropostale's brand was permanently tarnished, the company was expanding recklessly, or it was run by a bunch of retail rookies. However, none of those conditions applies.
Aeropostale's balance sheet is rock solid, with $139 million in cash and no debt. The management team, led by Chairman Julian Geiger and CEO Tom Johnson, is experienced and shareholder-friendly. Rather than aggressively expand its retail empire, Aeropostale elects to return its ample free cash flow to shareholders.
Over the past eight years, the company has opportunistically repurchased $905 million of common stock, accelerating the pace when the stock drops and backing off as it recovers.
Plus-Sized Margin Potential
After hitting all-time highs during the Great Recession, Aeropostale's operating margins have slipped recently, as competitors have slashed prices, and the company's girls' clothing failed to resonate with its customer base. A short-term improvement here is unlikely, as Aeropostale must deal with rising commodity costs, while marking down its slow-selling merchandise to clear shelf space for the back-to-school season.
However, I believe the company has three opportunities to meaningfully boost its operating margins for the long haul:
The new children's clothing concept, P.S. From Aeropostale, is gaining traction with consumers. These stores are a drain on earnings now, but management believes P.S. will begin boosting the bottom line once the chain clears 100 locations.
Aeropostale's website contributes just 7% of total sales, compared with about 12% for its competitors. Because online sales are high-margin, any improvement here will have a big impact.
The company has only 10 licensed locations, all in the United Arab Emirates. These stores require no capital investment from Aeropostale and generate recurring royalties based on a percentage of sales. I expect additional licensing deals -- and high-margin revenue -- as the company expands its international presence.
The Bottom Line
Fashion retail is a risky business, but Aeropostale has a strong balance sheet, an experienced management team, and a brand that should benefit from a prolonged economic downturn. The next quarter or two may not be pretty, but I think this stock is a great fit for long-term-minded investors.
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Motley Fool senior analyst Rich Greifner and The Motley Fool own shares of Aeropostale.