Buy These Apparel Stocks Despite Overvaluation, Competitive Issues

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

As a result of operating in markets with fickle consumers, apparel producers like Aeropostale, American Eagle, and Nike can be very difficult to predict. With that said, investors should look at corporate momentum and see whether the market has reasonably factored in the upside. If not, consider investing to profit off of the value gap being closed. If so, consider whether the company is on a consistent course to maintain its elevated trading premium. Below, I review the three companies mentioned above with this optimism in mind.

Reasons to Be Optimistic About Aeropostale (NYSE: ARO)

Aeropostale is a shopping-mall specialty apparel retailer largely targeting the preteen and teen markets. It has been able to outperform peers through successfully differentiating products. In the last fiscal quarter, Aeropostale saw a 27% growth in online sales while the company’s capital expenditures dropped, reflecting strong progress by management. Success was also reflected in same-store profits, which increased 10% and outperformed the market. Recent news that December retail sales have come out better than expected has also boosted spirits. This somewhat allayed concerns that management poorly executed during the holidays.

Negativity, however, continues to unreasonably surround the company. The stock has cratered more than 40% from the 52-week high. It now trades at 13.2x forward earnings, which appears too low for a company that is forecast 11.5% annual EPS growth over the next five years. There is no long-term debt on the balance sheet, and free cash flow is tremendous with a yield of 10.6%. Plus, Aeropostale is now trying to increase profits even more by expanding the number of factories nationwide by 175 locations, and it is increasing the marketing of all products.

I also encourage buying shares of American Eagle (NYSE: AEO), which trades at roughly the same multiples for the same expected growth. The only difference is that the Street is more optimistic about it outperforming, and it offers a 2.1% dividend yield. It provides a strong 11% return on invested capital and has a cash flow yield of 9.4% versus 7.5% for the sector average.

Buy Nike (NYSE: NKE) Despite Overvaluation

Nike is a solid company at an expensive price. It exceeded expectations by 14% for the most recent quarter, which carried forward sequential momentum. The company managed to show a strong performance in America to offset weak Chinese and European market sales.

In other news, Nike sold Cole Haan brand to Apex Partners for more than $570 million and Umbro to Brand Group for $225 million. Nike’s dividends increased by 17% in the last quarter of FY 2012, beating all expectations and keeping up with its historic double-digit increases. The only drawback Nike saw recently is in the Chinese market (6% fall), where the country is changing its consumer styles and facing a minor economic crisis. But the combination of a shareholder-friendly capital allocation policy and excellent strategy should keep investors glued on the upside.

At 17.8x forward earnings, Nike is expensive but not incredibly so. In fact, the stock's average PE multiple over the past five years is 19.3x. So, there's not a tremendous amount of downside. By contrast, growth continues and is forecast around a 10% rate over the next five years. Assuming expectations are met, 2016 EPS will come out to nearly $4. So, at a 18x multiple, the stock would be worth $72. Discounting backwards by 10% yields a present value of $44.71. While that is 17% less than the current market valuation, I do not see this premium being closed any time soon in light of the company's continued execution.

TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool recommends Nike. The Motley Fool owns shares of Aeropostale and Nike. 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. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

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