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MagicDiligence (< 20)

MFI Stock Review: Aeropostale

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October 20, 2009 – Comments (0) | RELATED TICKERS: AEO , ARO , GPS

Aeropostale (ARO) is one of the numerous teen clothing retailers you see at pretty much every decent-sized mall in America. As of August, the company operated 888 Aeropostale stores in the U.S., 38 in Canada, and 9 "P.S. from Aeropostale" concept stores in 2 states. The target demographic is the 14 to 17 year old age group, and the company utilizes its own fashions and designs exclusively. Aeropostale differentiates through targeting lower price points and using more promotional pricing throughout the year than competitors like American Eagle (AEO) or Abercrombie & Fitch (ANF).

When examining a stock in an industry like teen apparel retail, we must first consider competitive positioning. If there is a poster child for a business with very few long-term competitive barriers, it is this one (a classic "no-moat" business). There are few barriers to entry for new players outside of the capital it takes for rent, fixtures, inventory, and marketing. New entrants pop up all the time. And the inherently high returns on capital earned by many teen retailers make it a particularly attractive business to enter. Not only that, but the industry is characterized by several large existing players, all of whom have established brand appeal, large retail and distribution networks, and very strong balance sheets. Furthermore, teen fashion is very fickle, changing dramatically from one year to the next and from one generation of teens to the next. Combine this with the fact that about 40% of sales are earned in one quarter (Q4), and missing the fashion boat for even a short amount of time can leave you dragging behind your competitors or, even worse, "un-cool" in the eyes of teens.

Considering all of this, MagicDiligence believes that analyzing no-moat companies often comes down to evaluating how good the management is. Fortunately for prospective buyers of Aeropostale stock, this company is probably the best-run business in the field. Through a historic recession, Aeropostale has been increasing same store sales at unbelievable 10-12% year-over-year rates, and that's on top of double digit increases in 2008! In the just completed quarter, the company grew sales by 20% and operating income by 83% - incredibly impressive considering the difficulties in retail. Operating margin is at an all-time high. Straight return on capital is over 55%, with a Magic Formula return on capital of about 98%. And, like most of its competitors, Aeropostale sports a debt-free balance sheet with nearly $250 million in cash, on top of a free cash flow run rate nearing $200 million a year. Financially, and momentum-wise, Aeropostale looks like the best pick in the sector right now.

The price is right too, at a 11.5% trailing and 13% forward earnings yield. But, while MagicDiligence has a positive opinion of the stock, it really doesn't come close to making the cut as a Top Buy recommendation. Why not?

For one, it will be difficult for Aeropostale to continue such torrid organic growth, in my opinion. Double-digit comp increases are impressive, but unlikely to be maintained moving forward. Part of the company's success has been their relatively low prices in a decidedly low-price friendly environment... this should mitigate going forward as the economy and employment improve. Also, competitors are likely to mimic the lower-price strategy if things do remain difficult, seeing as Aeropostale is eating their lunch on market share right now. These factors will conspire to bring operating margins down from current highs.

Longer term, the company has nearly saturated the United States with stores - most analysts estimate a potential for 1,000 U.S. stores and another 100 in Canada, so we're already 90% of the way there. They have a new children's concept, P.S., but this was just recently launched and will take some time to find traction, if it does at all. Combined with the difficulty of maintaining such high same-store growth, this makes Aeropostale's growth opportunities limited.

Also, Aeropostale does not pay a dividend. Its competitors do: American Eagle pays a 2.10% yield, Gap (GPS) a 1.50%, Abercrombie 1.9%, The Buckle (BKE) a 2.4%, etc. While the company has been an aggressive re-purchaser of shares (4.5% average annual buyback over the last 5 years), this is less reliable than a stated dividend, and makes the stock somewhat less attractive in comparison.

Last, and most importantly, long-time CEO Julian Geiger recently announced his retirement at the end of 2009. As I mentioned earlier, management is of paramount importance in no-moat, highly competitive industries, and there is little question that Geiger has been critical to this company's past success. His departure worries me, as comparable investments like PacSun (PSUN) tanked when long-standing leadership left the company. Worse yet, the succession plan calls for a co-CEO setup of chief merchandiser Mindy Meads and chief operating officer Thomas Johnson. This just sounds like a big problem waiting to happen - the outcome of "co-CEO" setups in business is generally one of failure.

Aeropostale is hitting on all cylinders right now, and may be able to keep up momentum to make this a worthy MFI pick. However, a lot of serious questions loom, enough to avoid this as a consideration for Top Buy status.

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