3 Apparel Retailers to Watch

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Although apparel sales have outperformed many other retailing segments over the past year, the sluggish economic recovery and the rise on the payroll tax in the U.S. have hurt consumers’ discretionary spending power and, therefore, the industry’s profits. Below, you will find three companies, Guess? (NYSE: GES), Aeropostale (NYSE: ARO), and Urban Outfitters (NASDAQ: URBN), that a worth a look even in such an economic environment.

A company with a renewed outlook 

Urban Outfitters had undergone a rough period after 2009. However, its latest results and renewed management make me believe that a recovery is feasible and make the firm worth a closer look. Years of experience in the specialty retail segment have provided the company not only with a strong brand name, but also with the necessary knowledge to create unique shopping environments that induce customers to remain longer inside the shops looking for deals, bargains, and value.

Urban Outfitters has fewer than 500 stores. This provides plenty of expansion opportunities, in the U.S. as well as in overseas markets, for years to come. As management has proven prudent in its expansion plans -- seeking to multiply in under-penetrated markets in order to attain higher revenue per square foot -- its less than 100 openings between 2013 and 2014 carry plenty of upside potential. Looking forward, new store openings should drive growth.

Furthermore, profit should be driven in the long-term by other initiatives apart from the store base expansion, including productivity and merchandising improvements, technological advances, and growing wholesale revenue. As a result, Urban Outfitters is expected to deliver a 15.4% average annual consensus growth rate for the next five years. Meanwhile, a renewed product offering and its multiple brands, which create opportunities for flexible merchandising strategies, should boost revenue in the near-term.

Just like every other apparel business, the company faces the risk of not getting the fashion right. However, offering:

  • better growth prospects and wider net (8.5%) and operating (13.4%) margins than most of its peers
  • substantial pricing power and a loyal customer base
  • a debt free and cash filled balance sheet

I'd recommend buying this stock before it gets more expensive.

Not only a teenage brand

Aeropostale operates both a popular retail segment for young people and a wholesale apparel business. However, its retail section contributes roughly 95% of the firm’s total revenue, so my focus will be on it. Although many believe that Aeropostale is a brand targeted at teens, the company also holds the P.S. brand, which is aimed at mature audiences and has created some kind of brand loyalty over time.

Nevertheless, switching is always a risk factor one should take into account when investing in the apparel industry. Volatility in input expenses, especially in cotton prices and Chinese labor costs, is another important concern among stockholders. Furthermore, recent missteps in the merchandising area have strongly hit margins and comps and getting the fashion right remains a sizable challenge. Given this situation, the company’s lack of a moat and its above average valuation at 34.4 times its earnings, versus the 20.2x industry average, I’d recommend a hold on this stock for now.

Further, its previous quarterly results were not promising as it posted a loss of $0.16 per share, compared to the $0.13 it earned in the comparable year-ago quarter. Net sales and comps also dropped, portraying an outlook that does not seem so bright for the near future. Even after plummeting following this announcement, its stock price is still high, not concurrent with the outcome and below average growth prospects.

Despite the discouraging signs, the firm has been working hard to amend its mistakes. Its inventory turns of 11 times are considerably higher than those of its closest competitors. This allows the firm to rapidly respond to fashion and trend changes, placing it in an advantaged position to benefit from an increase in demand. While the turnaround seems likely, I remain on the sidelines for now.

A worldwide name 

Guess? is one of the leading casual apparel designers, manufacturers, and distributors in the world. It holds a strong and varied brand portfolio and strong international presence. However, its target demographic is young and concerned about fashion, thus, not faithful to one brand but rather attracted by trends. With fierce competition to face, Guess? relies on its ability to maintain innovation and trendiness.

Although its lack of a moat concerns me and I would, therefore, recommend holding on this stock for now, I advocate on taking a closer look at it, getting to know it, and being attentive to its performance as it might deliver bigger growth than the 9% expected average annual rate. Nevertheless, its strong focus on the slowly recouping European market is still a major concern -- although it also provides plenty of store expansion opportunities.

One of the main reasons to believe this is the broad franchise model that the firm has developed, which counts about 20 licenses. Having contributed with over one-fourth of the total operating income (while representing only 5% of the total revenue) in FY 2012, this strategy provides plenty of growth opportunities as the economy recuperates and the brand continues to strategically acquire new licenses (Morningstar).

Other markets, apart from Europe, like Asia, provide plenty of space for store base expansion and results have been encouraging over the past few quarters. Furthermore, the company targets new, fast developing markets such as China, Brazil, Germany, Russia, Japan, and India. Its e-commerce segment also provides various avenues for growth; already strong, it is still a priority for management.

Some analysts are more optimistic and project a 12% annual growth rate going forward (Zacks). If this comes true, Guess? would be a pretty good investment, trading at 14.4 times its earnings, a 33% discount to the industry average. Although some risks keep me on the fence about this firm, its history and prospects make it worthy of attention, especially as the firm’s focus on revamping its brand image in order to attract new customers exhibits plenty of upside potential and a takeover is not to be discarded.

Bottom line

In a business as risky and non-moated like the apparel retail industry, a few companies offer a better leverage/risk ratio that the median firm. In particular, Urban Outfitters presents above average consensus estimated growth rates for the upcoming years and, although it trades slightly above the mean valuation for the industry, it's worth the premium.

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.

Damian Illia has no position in any stocks mentioned. The Motley Fool recommends Guess?. The Motley Fool owns shares of Guess?. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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