ARO is a specialty retailer targeting 14-17 year-olds and owns ~1,070 stores mainly in the US and Canada and has been researched in previous posts. After missing its earnings call during Q2, stock dropped from ~$20/s level and is currently trading at $13/s. Recent stock underperformance was as a result of a few industry and company specific issues:

1) Starting in the fall of 2011 and continuing to early 2012, a significant inventory glut had built up in the specialty retail channel (i.e. inventory per square foot across the industry was up ~30%-40% in Q1/Q2 of 2012). Given soft consumer demand and increase in inventory, competitors became aggressively promotional and started slashing prices to clear this excess inventory. Given competitive landscape, ARO was forced to also reduce prices, which significantly impacted same store sales. Between 2000 and 2010, average sales/sqft grew at a CAGR of 4% from ~$415 in 2000 to $625 in 2010. In 2011, sales/sqft dropped by ~10% to ~$560 as the company posted its first negative annual comp in 15 years of positive comps.

2) A second issue affecting sales was company induced. ARO failed to refresh its product line and allowed its “basic” product line to become stale along with a low penetration across its fashion line of products. Given its high reliance on basic products which resulted in little differentiation against competitors’ products, ARO had price as the only differentiating factor to compete in consumers’ eyes.

3) Another headwind has been high commodity prices, especially the rise in cotton prices in 2011. Gross margins have fallen from around 38% in 2009 to 26% in 2011. This again is due to higher raw material costs as well as higher markdowns to clear inventory.

At $13/s, the stock offers a compelling opportunity given the following factors:

1) Attractive valuations. At $13/s, company has a $1.1bn market cap, $170MM of cash on hand, and is trading at 10x FCF.

2) Share buybacks. ARO has demonstrated a shareholder friendly management with total shares outstanding decreasing from 110MM in 2008 to current levels of ~80MM. Management has stated that it would like ~$200-250MM of cash on hand to work through their working capital cycle. Thus assuming FCF generation of ~$100MM per year and given their current cash on hand, I would expect management to increase its current buyback program in mid 2013/early 2014.

3) Restructuring in product lines will lead to increase in SSS. Management has acknowledged that it dropped the ball in terms of their product line refresh, with its fashion penetration estimated at ~30%, which is too low in their mind. As such, they have started taking corrective actions to increase the penetration of their fashion lines and decrease reliance of basic lines. The fashion category tends to have less pricing pressure and tends to lead to higher AURs and higher inventory turnover, which should be beneficial to the topline and margins as they implement the strategy.

4) Another positive is that inventories in the channel have become leaner in Q3, thus reducing the markdown pressure across the industry. As stated in ANF’s Q3 call, inventories at cost declined by 21% YoY, which is significantly higher than what management had projected.

5) Cotton prices presents a tailwind for the industry as current cotton prices are at a 2-yr low which will translate into lower average unit cost pressures. During Q2, gross margins increased by ~260bps, driven primarily by higher merchandise margin and management has indicated that they expect to achieve similar gross margin expansion for the second half of the year. 

Despite the recent headwinds in the company and industry, ARO still represents a compelling opportunity given its business fundamentals. While I don’t believe company will reach its historical high levels of sales/sqft or margins, I do believe the current levels represent the bottoming out and expect to see some margin recapture opportunity. My expectation is that they can grow sales/sqft back to $630 and increase margins to 29% + share buyback benefit, upside potential is 30%+.