Can You Find Value in the Teen Retailers?

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Large institutional investors have been circling the teen retail sector in 2013 looking for value from retail chains with solid finances and national footprints. While teens’ fashion choices change as frequently as the weather, the teen cohort as a group has meaningful disposable income and the proclivity to spend rather than to save money.  In March, retail-focused investment firm Sycamore Partners agreed to buy teen retailer Hot Topic for roughly $600 million. More recently, fellow investment firm Apax Partners agreed to buy teen retailer Rue21 (NASDAQ: RUE) for roughly $1 billion, reacquiring the company that it floated to the public back in 2009.

What’s the value?

Taylor Swift might want to feel 22 in her new song, but Rue21 wants everyone to feel like they are 21, which was ostensibly the best time of their lives.  The company sells a broad range of apparel, accessories, and jewelry for the teen crowd, though their stores also have a following from people in their 20’s and 30’s.  As befits its core teen demographic, Rue21 does little traditional advertising, relying on viral social marketing via Internet-based communication channels.

In its latest fiscal year, Rue21 reported solid financial results, with increases in revenue and operating income of 18.6% and 8.9%, respectively, versus the prior year. The company’s sales growth benefited from adding 122 new stores to its network, as well as generating its fifth straight year of same store sales gains.  In addition, Rue21’s gross margin reached a five-year high due to reduced inventory markdowns and fewer promotions.  The company’s improved profitability has management thinking big for the future, with plans to almost double their store base to 1,700 over the long term.

Who else might be on the block?

With Rue21 leaving the public markets shortly, investors are likely wondering which other teen retailers are intriguing acquisition targets.  The first company that comes to mind is Pacific Sunwear of California (NASDAQ: PSUN), the California-inspired teen retailer with a presence in malls across the country and in Puerto Rico.  Despite still searching for operating profitability after over-expanding in the previous decade, Pacific Sunwear has a loyal customer following, with national brands that include Billabong, Hurley, and Vans.

In its latest fiscal year, Pacific Sunwear continued to show modest financial improvement, with a 3.3% increase in total sales and a smaller operating loss compared to the prior year.  While its sales growth was negatively impacted by the closure of 89 net stores, the company posted a rise in same-store sales due to better inventory pricing.  In addition, Pacific Sunwear has been improving its overall supply chain efficiency, as it continues to eliminate unprofitable mall locations from its network.  With rising sales per store and plans to close an additional 20 to 30 locations in 2013, the company looks primed for much better future performance.

Another interesting target is Aeropostale (NYSE: ARO), the trendy teen retailer that was originally formed by Macy’s during the 1980’s as an in-store concept.  Since opening its first specialty store in 1987, the company has grown to over 1,000 stores globally, including 100 P.S. from Aeropostale children’s stores.  However, recent results have been weak as Aeropostale’s classic casual apparel lines have struggled to find a winning formula against heavy competition from value-priced specialists like Rue21 and Forever 21.

In its latest fiscal year, Aeropostale reported poor financial results, with a 1.9% increase in revenues, but a steep 47.4% decline in operating income.  Its results were impacted by a second year of declining same-store sales, as well as a lower gross margin due to inventory markdowns.  Despite its operating performance, Aeropostale is forging ahead with plans to increase its store base, with a major expansion of its children’s unit and selected openings for its core Aeropostale unit in new international markets.  When the company finally finds the right merchandise mix for its value conscious customers, it has an opportunity to create substantial value, given its depressed stock valuation.

The bottom line

While the teen retail space can be a tough place to do business, there are profits to be had for aspiring companies with the right product mix.  Pacific Sunwear and Aeropostale are currently struggling through company-specific issues, but they both have strong leverage for stock price gains due to the economies of scale in their national store bases.  In addition, Sycamore Partners could eventually be back on the acquisition trail, once it finishes digesting its Hot Topic purchase.  As such, investors need to keep these two small retailers on their watchlist.

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