Aeropostale (ARO) certainly doesn’t seem quite aerodynamic in facing current short-term headwinds. Perhaps that’s why many investors are valuing the company like it is set to crash and burn in the foreseeable future. While Aeropostale faces some challenges to be sure, there are definitely some things to get excited about.
Aeropostale can be seen more or less as a discount version of other teen specialty retail shops such as Abercrombie and Fitch or American Eagle. As such, Aeropostale’s growth actually exploded in the wake of the recession as cash strapped teens and parents looked for ways to cut back on spending. Such growth was bound to be unsustainable in a super competitive retail market; and as other specialty stores started slashing prices, Aeropostale started to see some of its newly attained market share slipping away. Additionally, Aeropostale also faces the same challenges as other clothing retailers such as the skyrocketing input costs of cotton. In the short run, these rising prices have squeezed margins across the industry.
To some, the words squeezed margin and diminishing growth rate sound like the death knoll of a once popular teen retail store. To be sure, it is certainly a concern, and wouldn’t be the first time a retailer has fallen as quickly as it rose (yes, I’m talking about you, Pac Sun and Hot Topic)! However, Aeropostale’s price is looking extremely undervalued for a company with a strong brand and balance sheet. It’s almost as if the worst-case scenario has already been priced in.
Aeropostale shows very high returns on capital and no debt. Of course, this is deceptive because one must account for all the off balance sheet financing done through leases, particularly when dealing with retailers, in order to make them comparable to other businesses. The fact is, without their leases, there’s not much value in their equity. But even after adjusting for their inherent leverage by capitalizing their leases, Aeropostale still shows decent returns for a retailer, and still looks cheap. In addition, management has recognized this low valuation and has engaged in an aggressive share repurchase program, which can make an enormous difference when you reinvest your high cash flow in your extremely undervalued stock.
It’s no surprise to our readers that we remain concerned about the economy and as such have favored more recession resistant businesses. We don’t claim that to be the case for Aeropostale, but they have certainly proven to be much more so than many other companies – as we mentioned, they actually grew during this past recession. Their target demographic is the pre-teen years (10-13), and the fact is, teens continue to grow and need clothes on their backs. Studies have shown parents are more likely to curb their expenses than to cut back on their children’s clothing. So, if they are grappling with tighter finances and dealing with a sorry employment situation, when shopping for kids clothes, a fashionable discount retailer is one place they’ll search. One drawback, though, is we recognize teen demographics recently gave this age group some tailwinds, and they are likely to grow at a slower rate these next few years.
As long as Aeropostale isn’t another fickle fad that’s on the down and out as the new generation of teens refreshes, this company’s stock will be “en vogue” again. And if it is a fad, the blessing and the curse of clothing retailers is they will have the opportunity to reinvent themselves and rebrand for the next batch of teens. They may not be the only basket I’d want to put my eggs in, but it’s definitely worth a look.
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