Be Greedy, Buy This Teen Retailer

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

Prolonged high unemployment among teenagers in the United States has crushed teenage clothing retailers. However, where there is fear there is often opportunity. Aeropostale (NYSE: ARO) looks particularly compelling despite a bleak backdrop.

Market Full of Fear

Investors are finding it difficult to have conviction in Aeropostale due to the unpredictable nature of the industry. Fast-growing retailers like H&M and Forever 21, which sell similar products, are stealing market share from Aeropostale. In addition, success in teen retailing is dependent on offering low-priced clothing that fits current trends; there is little evidence of brand loyalty in the space. This means that a company that is on top of the trends today can easily be left behind tomorrow. There is also high volatility in commodity and labor prices, which affects the company's margins. The inherent unpredictability makes it difficult to determine what the business will be earning even five years from now.

Tailwinds

However, the company is in much better shape than the market gives it credit for. Aeropostale is the Wal-Mart of teen clothing retailers. When the economy gets tough, teenagers put a lot more emphasis on price. Aeropostale has some of the lowest price points in the industry; only American Eagle (NYSE: AEO) competes effectively with Aeropostale on price. However, a prolonged recession in teenage spending will ultimately hurt the company.

The company is also working to improve its supply chain and lower its inventory levels. Aeropostale competes on price, so margins are low which means it must turn over its inventory faster than its higher-priced competitors. Therefore, it is critically important that the company makes the necessary changes to its supply chain.

Finally, the P.S. concept should be a growth driver in the coming years as it attempts to grab an adjacent customer base. When combined with the firm's plans for international expansion, it looks like there is plenty of growth ahead for the company.

Competitive Landscape

Since Aeropostale competes on price, its gross margins are expected to be lower than higher-priced competitors like Abercrombie & Fitch (NYSE: ANF).

<img src="/media/images/user_13490/aro-gross-margin_large.png" />

So the company must make up for the lower margins with higher inventory turnover. Fortunately, the company turns over its inventory more than two times Abercrombie & Fitch.

<img src="/media/images/user_13490/aro-inventory-turn_large.png" />

Even better, Aeropostale consistently posts higher inventory turnover than American Eagle and Pacific Sunwear (NASDAQ: PSUN). This shows that Aeropostale is competing effectively in this fiercely competitive industry.

Valuation

Since 2002, Aeropostale has turned 7.3% of sales into free cash flow. If you assume a similar free cash flow margin going forward, then normalized free cash flow should come out to about $174 million (after tax). At 10x free cash flow, the company is worth $21.40 per share before accounting for growth.

The company is even more attractive on a return on tangible assets basis. Aeropostale produces cash flow at a rate of 33 cents per dollar of tangible invested assets. If you assume this rate to hold, then normalized free cash flow is about $202 million. At 10x this figure, you get a no-growth value of close to $25 per share.

At a recent price of $13.58 per share, a lot can go wrong before investors lose money. However, investors should first be comfortable with the inherent unpredictability of the industry before investing.


titans8904 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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