1 Fashion Stock to Avoid, 2 to Buy

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

While I’m generally am weary of stocks that target unpredictable demand, I also believe that the market feels the same way. For example, fashion designers often lament about how trends come and go with little or no explanation. This, however, has become common knowledge and is mostly factored into the price of many fashion stocks. Accordingly, there exists some opportunities where one can profit from strong growth brands.

American Eagle: Not Worth The Price Tag

As a leading premium brand, American Eagle (NYSE: AEO) will have strong appeal during a full recovery. The stock now trades at a high multiple above 24x past earnings, which limits much of the upside. During the last six months, the stock has been on a tremendous ascent. Analysts forecast EPS rising by 10.8% on an annual basis over the next 5 years, which is not enough, in my view, to justify the current price tag.

Although the balance sheet is attractive given no debt and a current ratio of 3.5x, there is very little that the company can do with the cash from an investment perspective. On the other hand, the firm did drive excellent second quarter results and boosted 2012 guidance. Top-line momentum was complemented with a decline in input and operational expenses. EPS grew more than 60% from the same quarter a year ago, and a special cash dividend of $1.50 displays management's confidence in the company’s fundamentals. Expansion into Japan and the Middle East has been followed by plans for the Philippines, but the brand is still, after all, American Eagle and likely will not have the same appeal abroad as it does here in the US.

Gap & Aeropostale Look More Undervalued

While cheaper is not always better (in shopping or investing), in this case it is. Aeropostale (NYSE: ARO) trades at a more attractive 11x forward earnings and is forecasted for around 1% more annual EPS growth over the next 5 years than American Eagle is. With free cash flow at a substantial 8.7% yield against market capitalization, Aeropostale is a worthy investment.

Like American Eagle, Aeropostale also has an attractive balance sheet. It has no debt and a current ratio of 2.1x. Assuming forecasts are met, the company will generate 2016 EPS of $1.72 over the next 5 years. At a 17x multiple, this translates to a future stock value of $29.24. Discounting backwards by 10% yields a present value of $18.16, which is at a substantial premium to the current market value. It also compares quite favorably to the $17.53 price target.

Gap (NYSE: GPS) similarly has strong fundamentals against American Eagle. The stock has been generally upgraded on better-than-anticipated second quarter performance. EPS of $0.49 was 40% greater than the same quarter last year. Strong performance was driven by higher margins and a 4% growth in same-store sales. Like American Eagle, management raised guidance from $1.78 on the lower-end to $1.95 and from $1.83 in the higher-end to $2. At a respective 20x and 15x past and forward earnings, however, Gap is cheaper than American Eagle. I thus recommend buying the former over the latter.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Aeropostale. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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