What to do About the Headwinds for Apparel Stocks

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

If you are looking to buy retail and/or apparel stocks, you're almost surely keeping an eye on Black Friday and holiday sales. Bear in mind, however, that companies follow a long-term future outlook and are not merely reflections of isolated events. The media has been playing up Hurricane Sandy and so have CEOs at top retailers. I encourage looking at the fundamentals, such as ROIC, sales trajectory, and expansionary plans. Below, I review three apparel / retail stocks with this in mind.

American Eagle (NYSE: AEO) Vs. Abercrombie & Fitch (NYSE: ANF)

American Eagle and A&F have been on quite a roll over the last few months - up 83% and 61.7%, respectively, from their 52-week lows. But are they overvalued at this point? American Eagle has a 11% return on invested capital, which is well below the 13.6% sector average. A&F is even worse at 6.9%. Sharp EPS declines over the next half decade are expected for both apparel companies, but particularly for A&F. With the stocks trading at around 13.4x forward earnings, the upside does not look great.

There are several other factors to look at. Retailers have been missing expectations, and many are blaming Sandy. Holiday sales are expected to decelerate to 4.1% (generating $586.1 billion in economic activity) from 6.1% a year ago. In the first day of trading, the market gave mixed signals to several retailers, with A&F rising by 0.4%. A&F's recovery in the third quarter has already been more than reflected in the shareholder returns--much of which is owed by shorts covering their positions. In fact, the stock jumped 32.1% on the third quarter earnings call when management actually announced planned store closings and guided for same-store sales falling to the mid-single digits.

In regards to American Eagle, the trajectory looks better. EPS has declined by 14.6% annually over the past 5 years, but operations are turning around. $423.5 million in FCF was generated over the TTM ending 3Q12--a terrific 10.6% yield against the market cap. In the third quarter, management yielded double-digit same-store sales growth--excellence that has caused the market to get bullish on several mall retailers. And unlike A&F, American Eagle is also getting aggressive on the future and looking to expand. Management has guided for greater marketing costs, with the intent of adding up to 175 new domestic factories.

Why You Should Avoid Gap (NYSE: GPS)

Gap has roughly doubled from its 52-week low. It now trades at 17.6x and 14.1x past and forward earnings, and is forecasted for 9.9% annual EPS growth over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $3.37. At a multiple of 15x, this translates to a future stock value of $50.55. Discounting backwards by 10% yields a present value of $31.39 - slightly below the current market assessment. With such a small dividend yield and an uncertain consumer market, I recommend avoiding the stock.

In the most recent sales report, all four geographies saw gains but were short of analyst forecasts. November same-store sales grew only 3%. It also doesn't hep that free cash flow has gone absolutely nowhere after the last decade--going up and down but always hovering around $1.2 billion, which yields a disappointing 8% today. Though the company may have expanded margins, long-term input pressures and competition will cut into the bottom-line. With return on invested capital lagging this competition, the stock is to be avoided.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend American Eagle Outfitters and Gap. 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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