As a value-oriented apparel retailer catering to the teen market, Aeropostale (NYSE:ARO) did pretty well during the 2009-2010 period when many other youth retailers like American Eagle Outfitters (NYSE:AEO) and Abercrombie & Fitch (NYSE:ANF) saw serious sales pressures. Since then, though, it hasn't been exactly clear that Aeropostale has a workable strategy outside of pricing - and shrinking price differentials have whittled away the company's momentum, cash flow and market cap. The real question for investors, then, would seem to be whether this company can develop a strong enough merchandising identity that price is no longer its primary weapon.
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Third Quarter Results Iffy
Although Aeropostale did OK relative to sell-side expectations in the third quarter, those analysts weren't expecting a lot. In absolute terms, the performance presented in its earnings report was not so impressive.
Revenue rose a bit less than 2%, as comps declined 1% for the quarter. Comps were pressured by a 5% decline in unit prices that was mostly (but not wholly) offset by improved volume components (more transactions and more units per transaction). Keep in mind, though, that Aeropostale had a -7% comp in the year-ago quarter, so it wasn't as though this was a challenging quarter.
Margins contained good and bad news. Gross margin did improve 80 basis points from last year, but several analysts were looking for more, and it seems as though Aeropostale had to pass on a lot of margin leverage to customers. Operating income did rise 7%, though, as the company did well on core operating expenses.
It's Still Tough out There
It sounds like the third quarter saw some pretty fierce competition and promotions in the teen sector, particularly in the "basics" categories like graphic tees and fleece where Aeropostale generates a lot of business.
All in all, though, it doesn't look like Aeropostale fared especially well. American Eagle posted a 10% comp for its recent Q3, Urban Outfitters (Nasdaq:URBN) saw 8% comp growth, while Buckle's (NYSE:BKE) comp was up more than 2%. Abercrombie & Fitch was on balance worse than Aeropostale (down 3%), but its Hollister brand showed a similar -1% comp.
These results are why I'm concerned about Aeropostale's merchandising. If gross margins didn't improve as much as hoped because pricing and promotion drew off some leverage, but the comp store performance still wasn't all that strong, where is Aeropostale's edge?
It's Never Over Until It's Over
Some of my pessimism is tempered by the fact that apparel retailing (especially youth-oriented retailing) seems to be surprisingly cyclical. A long list of companies (including American Eagle, Abercrombie, Urban Outfitters and Hot Topic (Nasdaq:HOTT)) have had stretches of fantastic performance, only to see traffic and comps plunge for a while. And in many cases, at least among the better-run retailers, the trend reverses back up in time.
So, it's not over for Aeropostale. Maybe Emilia Fabricant, hired by the company as executive vice president of the Aeropostale brand in August and responsible for design and merchandising, can put the company back on track. Although I think "brand identity" is somewhat overrated in retailing, Aeropostale definitely needs to get better at figuring out what teens want to buy and put the company in a position to compete on more than just low prices.
The Bottom Line
Wall Street definitely did not like what it heard from management in regards to guidance, as it sounds like the retail environment is significantly limiting the company's gross margin. Again, that goes to the heart of Aeropostale's merchandise lineup and having products for sale that people will buy without aggressive pricing or promotion.
Expectations are pretty low for this company right now. Free cash flow in 2011 was just 20% of what it was in 2009, but even if the company grows just 8% off that low base (and doesn't regain that 2009 level of free cash flow for more than 20 years), the stock is about fairly priced today. If Aeropostale can pull its free cash flow margin back into the mid-single digits, though, and grow revenue at even a low-to-mid single digit rate, these shares could be priced to perform. That performance is not a given, though, and investors need to have confidence that Aeropostale can drive sales through more than just low prices for this stock to work.
At the time of writing, Stephen D. Simpson did not own shares in any company mentioned in this article.