Aeropostale is a mall based retailer of casual apparel and accessories. Its target demographic is 14-17 year olds. It also has a new concept called “P.S. from Aeropostale (“PS”), launched in 2009, targeted at 7-12 year old kids. The company operates 973 Aeropostale stores and 54 PS stores. In addition there are 10 ARO stores in the UAE, operated by a licensee.

Summary: -

Aeropostale, at $11.50, is trading at an EV/EBITDA of 2.52, a P/E of 6.2 for a business that has i) No debt, ii) consistently returned 20-40% on capital (defined as after tax EBIT/(net working capital + fixed assets), iii) Increased sales every year from FY2002 to FY2010 from $284 million to $2.4 billion) @ 30.6% compounded, iii) Increased EBIT during the same period from $48.8 million to $386.8 million ie @ 30% compounded and iv) Increased Net Income during the same period from $30.3 million to $231 million ie  @ 29% compounded. Since its May 2002 IPO, the stock has compounded at approximately 9% versus 1.8% for the S&P 500 (about 13% before the big gap down).

The stock has come down recently because of i) a Fashion miss late in 2H 2010 and ii) worries about inflation, which are causing margin pressures. Buying the stock at this level is a bet that i) Management will be able to right the fashion miss and ii) They will be able to pass on some of the cost increases to their customers.

Industry: -

Aeropostale competes with other retailers like Abercrombie and Fitch, The Gap, American Eagle, etc. Its price points are generally lower, which enabled it to grow sales during 2008-2009 as compared to the above retailers who saw sales declines.

Concept management is key in this sector, and management spends a lot of time in promoting the brand. However, it is hard to get fashion tastes right every time, and every now and then, a fashion miss can lead to promotions and markdowns. However, there are basically three seasons – back to school, spring and holiday. So if management gets one season wrong, there is always an opportunity in upcoming seasons. Moreover, there is always a supply of teenagers wanting to look cool.

Secondly, I believe that ARO does have a core customer. Walking into the stores, their customers seem to be more the suburban (mom) type. On the other hand, if I walk into an ANF, their whole concept is built around a club atmosphere – cool hip music, everything looks like one of those lounges in Sex and the City. Plus the people inside are extremely well groomed. So if the economy recovers, I don’t think ARO is really going to lose its core customer to ANF (or AEO for that matter).

Current situation:  -

The concept does not seem to be broken. I did some store visits and talked to a few people, so not too extensive. At least one person told me that she has been shopping here for 6 years and plans to continue to do so. I took her word for it.

After positive SSS for 12 consecutive quarters, ARO started comping down. Most recently, comping -14% in Q2 2011.

Notice the positive sss during 2008-2009 – which were terrible years for the economy in general and retailers in particular. Also, going forward, comps should be easier.

Management’s explanation for the negative comps was a fashion miss. Judging by their history, I am willing to take the bet that management will be able to right this ship in the next year or so. Also, ARO (according to management), is not really a fashion leader. So that makes “getting the fashion right” a much more easier job.

Inflation is the word of the day. There is a lot of QE2/3 rhetoric making its way in the media. But specifically, with respect to Aeropostale, here is what the margins have looked like over the years ..

However, in Q1 2011, their GM went down to 29%. Cotton prices affect a significant part of their COGS. And they were up more than a 100% in 2010 and had surged by another 100% by March 2011.

http://www.indexmundi.com/commodities/?commodity=cotton&months=120

As can be seen, they have come down. A surge of this magnitude can’t be all inflation. I am not a commodities expert, and I don’t want to unnecessarily pontificate, but my reading of the media points to huge demand from China and floods both in Pakistan and China that have caused supply disruptions. Cotton is a commodity, and a price rise like this will surely bring on more supply.

ARO has also stated in recent conference calls that it  (and other apparel retailers) are also contemplating ticket increases of 5-10% on items to combat the rise in their COGS. This seems to be an industry wide phenomenon, and they should be able to pass on these increases. Again, this needs to be watched – as I am just going by what management has said in recent conference calls. Obviously, ticket increases lag inflation, so we will have to see.

Not all of the GM compression is due to cotton though. Markdown driven inventory liquidation also caused GM to go down to 24% in Q2 2011. However, if we look at their Q2 2011 numbers, their Balance sheet looks really ugly:

i)              Cash down 75% Q-Q. Management wants to keep this at around 10-12% of sales. The current numbers are 3.6% of net sales. This number has ranged between 3.9% to 18%. Again, remember that this is a fashion retailer. Such companies build inventory during the year. 35%+ of ARO’s sales come in during the important holiday season (ie Q4). So these are depressed numbers and expect this number to creep up at the end of Q4 2011. Also, management has stated that they will stop buybacks until cash is at a 10-12% level.

ii)             Inventory up 15% Q-Q versus sales down -5.4%.  However, Accounts Payable was also up 13.4% so looks like they are being able to work with their suppliers during this tough period. Note that their DPO has ranged between 15-28. I like to see a number below 30, as closer to that number it means that they might be squeezing their suppliers too much. Currently the ratio is around 27 so definitely the higher end of the range.

Current operating margins at 1.2 and 3.2 % (Q1 and 1H 2011) are also too low for this retailer.

If they get their act together, they should be able to generate 16%. But suppose they can get to the 12-13% margins they achieved in 2008/2009, which were bad years. Suppose they do this in 2 years – with no stock repurchases. In 2008/2009, they made about a $100 million in cash per year (off of a smaller store base).. So say in 2 years, they make $100 million, to be conservative. So ending cash = $173 million. EV = $690 million. Or in 2 years,  they could be trading at an EV/EBITDA of 2.3. Versus ANF which trades at 8.67 and AEOS which trades at 3.67. If it trades to 4x, that translates into a stock price that is about 49% higher than today’s. Obviously, if things go right sooner, or it trades higher, the IRR can be much better.

Note that ARO has improved store productivity (Sales/psf) every year from 2002 to 2010 from $456 to $626 (or 4% compounded). Some of this is probably due to inflation, but some is definitely because of more productive stores. They also have an opportunity to increase this number because currently 170 of their stores are making over $800 psf. Obviously, the current issues are important, but there are additional levers management can pull after these are resolved.

Capital Allocation: -

ARO was established by Macy’s in the 1980’s as a department store private label enterprise. The first mall-based store was opened in 1987 and expanded to over a 100 stores before selling it to Bear Stearns Merchant Banking and Aeropostale management.  In 2002, the company IPOed and has grown to its current size with no acquisitions or having to access capital markets.

Management has instituted a buyback program and consistently bought back shares. Weighted average diluted shares have decreased from 116 million in FY2003 to 91.7 million in FY2010. Obviously, hindsight is 20/20 and one wishes that management had the cash now and had not bought back shares $15 ago. As previously noted, ROC has been around 20-40%.

Management has said that its traditional Aeropostale stores can grow to a maximum of 1000 to 1100 stores. The ARO stores at 973, ie around saturation, and the PS concept is just getting rolled out. But PS breakeven level is a 100 stores (currently they are at 64 stores). According to the latest conference call, PS had a “solid quarter”.

Management does not break out the numbers, but if we look at FY 2008, when there was no PS and management was winding down the JimmyZ stores, total stores were 914 of which 903 were ARO. During this (again a depressed) year, ARO did $1.89 billion in sales, $248 million in EBIT and $294 million in EBITDA. Since JimmyZ was being shut, and loss making, lets assume that all these numbers belong to ARO only. The current store base is 973. So standalone, ARO should be able to make $264 million in EBIT and $312 million in EBITDA. A 4x multiple on that EBITDA yields a $1.2 bn EV or a stock price 30% higher, today – based on depressed numbers and multiples. And we get the growth of the PS segment for free.

Management: -

Obviously management is important here. Upper management has incentive compensation and bonus thresholds starting at $371 million of operating income and $2.32 eps. So they are incentivized to turn this ship around.

Risks :-

Fashion risk is obviously the main thing here. Also, if the economy were to slip into a recession, then management will have two things to fix instead of one.