Description

Aéropostale (ARO) – Buy

Opinion

This recommendation is to purchase shares in a broken company.  Aéropostale’s financial condition is far from robust.  The retail sector faces secular headwinds.  The company sells clothing to teenagers and pre-teens, a fickle and competitive market.

At its core, we see Aéropostale as an investment in Julian Geiger, the returning CEO.  In our opinion, his experience from the company’s glory days, common sense, and ability to move the organization will result in a change in investor attitude and valuation from “when does Aéropostale fail” to “how the company survives and prospers.”

Last year, former CEO Julian Geiger returned to the company.  Consistent with Geiger’s guidance, we expect the first changes from his administration to become apparent in this year’s back to school and holiday seasons.  Julian Geiger and his strategy is why we think investor perception will shift.  Over a longer term, we see management’s close alignment with shareholders as potentially providing better business results and higher valuation.

Key Points

• First significant changes are about  to surface

• International and web business are growing

• Shareholders and management seem well aligned

• Valuation vs peers and history is low

• Margins have improved modestly

• Financial condition

Catalyst Events

• On June 25, Aéropostale is previewing a portion of the Back to School line.

• On August 27, the company will report second (July) quarter earnings and updates investors on launch progress.

Business and Trends

Aéropostale sells clothing for teenagers and pre-teens in malls.  Its clothing is more mainstream and less expensive than competitors like Abercrombie and Fitch, Nantucket Vines, or American Eagle.  We see this as a very tough business.  Fashions are fickle.  Fads come and go.  Winners become losers fast.

Aéropostale has fallen on hard times.  It was a dominant company when logo merchandise was in high demand and the strategy was “stack it high and let it fly.”  More recently Aéropostale’s strategy has not worked.  Going forward, we expect the company’s history as a budget friendly clothing provider will complement new product, brand, and merchandising strategies.

During the last year or two, Aéropostale stores have been stocking a broad range of SKUs.  This means popular items sell out quickly and a considerable amount of less popular merchandise is marked down.  Now and as best we can tell, there are few reasons to enter an Aéropostale store beyond the deep discounts.

Teenage shopping (sidebar)

• Teens want their clothing to demonstrate individuality without straying too far from peers.

• Parents have input.

• Quality and value are increasing in importance.

• Brands and logos are decreasing in importance.

• Since the financial crisis, America’s teens have become more budget conscious.

• Food is taking a larger budget share and clothing is taking a smaller budget share than in the past.

• Teenage mall traffic appears to be declining.

Recent Results and Outlook

Consensus estimates appear to be generally below guidance.  For example consensus’ revenue estimate for the current quarter is a decline of 14% despite company guidance of a mid to low single digit same store sales decline.  Looking over a longer term, CapitalIQ’s consensus service anticipates sales declines to continue through FY 2017.

CFO Comments from the Transcript

“. . .  Total net sales for the (April) quarter declined 20% versus last year, driven by weighted average square footage decrease of 19%, resulting from closed stores and an 11% decrease in comparable sales, which includes our e-commerce channel . . ..  During the quarter for our Aéropostale brand, we opened one store and closed 12 stores, ending the quarter with 823 stores.  For our P.S. from Aéropostale brand, we ended the quarter with 26 stores. . . .  On an adjusted basis, excluding these charges, gross margin for the quarter was 19.2% versus 18.5% last year.  The 70 basis points improvement in adjusted gross margin was driven by 150 basis points of higher merchandise margins and 50 basis points of lower depreciation, partially offset by 120 basis points from the deleveraging of occupancy and distribution costs. . . .  On an adjusted basis, operating loss was $39.3 million versus $46 million last year.

. . .  Second quarter guidance.  On an adjusted basis, excluding the impact from asset impairment charges, accelerated store closing costs, lease buyout costs and anticipated real estate consulting fees, we are initiating guidance for the second quarter of 2015 and an operating loss range of $37 million to $43 million, which results in a loss of $0.52 to $0.60 per diluted share.

. . . This guidance assumes a low to mid-single-digit comparable sales decline and gross margins down year-over-year. SG&A dollars are expected to be down by low double-digit percentage versus last year due to our cost savings initiatives and tight expense controls.  We currently expect depreciation and amortization of approximately $10 million, a pro forma tax rate of approximately negative 2% and shares outstanding of 79.2 million.

. . . With the inventory overhang in certain categories, we are expecting to be driving that inventory to the right levels and optimizing inventory for our back-to-school season.  So we expect to see some pressures on gross margin. Medium and long-term, we obviously believe that the back half of the year is going to be better and we think there is opportunity both from a margin and sales performance opportunity in order to drive margins higher.”

Why things can get better

We expect the merchandise, marketing, and product attractiveness will begin to improve with the 2015 Back to School season.  Returning CEO Julian Geiger has been clear in setting expectations that merchandise lead times prevented substantive improvement until Back-to-School 2015.  We expect there will be two critical periods in BTS.  In august there will be “first day of school” buying of new clothing then in September we expect a second round to complete wardrobes.  If Aéropostale is successful, this second wave will skew toward tops.  Since its heyday, Aeropostale’s ratio of tops to bottoms has declined from 5:1 to about 3:1 today.  The company’s goal is to get the ratio to 4:1.  Aéropostale is hosting a preview of the new line on June 25 in New Jersey.

In the meantime, the company has reorganized, improved its web and social media presence.

Web and Social Media

It is hard for us to judge Aéropostale’s website.  First, we do not have a long history with the company.  Second, our clothing choices range from khakis and button downs to cargo shorts and polos.  Hence, we sought opinions of two experts.  One used to shop Aéropostale regularly and works in the fashion industry.  The other never regularly shopped at Aéropostale but their profession requires deep fashion knowledge and attire.

Both are very aware of style and fashion trends.  Both qualified themselves by explaining the conundrums of teenage clothing.  Both began with a negative opinion of the brand and stores.  Both found Aéropostale’s website more appealing than they expected, and found the new sub brands and lines, particularly Bethany Mota, impressive.

Leveraging social media, Aéropostale has built lines around Bethany Mota and United XXVI.  Mota is a teenage fashion blogger with more than 8.8 MM You Tube followers and 1.7MM likes on Facebook.  Her line targets at teenage girls.  United XXVI is two brothers and a friend who have developed a substantial following on video loop site Vine.co.  This line targets both boys and girls.  Aéropostale.com presents these two lines better than most of its better-established lines.  We see this as positive evidence of Aéropostale’s new direction

Key Investor Risks

Any equity investment carries risk.  Beyond the usual market, economy, and company risks, Aéropostale carries other risks.  We provide this non-exhaustive risk list to assist readers in determining what position, if any, is appropriate for their funds.

• Competitors could shift prices down to increase competition with Aéropostale.

• Teen and preteen customers could further separate themselves from the Aéropostale brand.

• Unappealing stores have created a larger barrier than we expect for returning customers.

• Being teenagers, the United XVI boys or Bethany Mota (less likely) could behave in a manner that tarnishes Aéropostale.

• Something could happen to Aéropostale or social media that causes the promising strategy to backfire.

• Julian Geiger is 69 years old.

• Recent trends favoring higher quality, non –logo merchandise could accelerate further causing fewer gains and/or wider losses from the new clothing lines.

A coarse earnings estimate

The one thing we know about earnings estimates is that most of the time they will be wrong.  The trick is figuring out where and why.  As might be expected, our outlook for revenue and earnings is more positive than consensus.  These graphs demonstrate the core differences between our “naïve” forecast and consensus.  The first documents the year-to-year change in trailing 12-month revenue growth.  Our naïve forecast anticipates revenue growth from the company’s new lines, web site, and international licenses.  The consensus forecast seems to think that revenue will shrink and margins will remain under pressure through the forecast period.  Aéropostale’s current guidance extends only through the July 2015 quarter.  The company has not commented on any of our forecasts or expectations.

Obviously, we think business will be better than consensus expects.  We do not know how much better it can be.  We recommend readers think of the forecast as providing rough directional and magnitude for business and not as a precise view.  

Source: Capital IQ and proprietary Naive Forecast

Similarly, we believe the new management’s merchandising and inventory plan will provide better results than consensus anticipates.  We do not think last quarter’s uptick in profitability was a fluke.  While management has been clear that it expects lower margins this quarter, last quarter was a small demonstration of new management’s more pragmatic approach.  

Source: Capital IQ

Financial Assets and liquidity

Aéropostale’s balance sheet has diminished in size because of weak fundamentals and share repurchases.  Historically, the company uses cash in the first half of the year and generates cash in the second half of the fiscal year.  Currently the company has about $65MM in net debt.  We expect borrowing will increase in the July quarter to fund losses and finance new inventory purchases.   This should then reverse.  We expect positive cash flow  in the October and January quarters

Source: Capital IQ

Management and stockholders alignment

Aéropostale’s compensation plans seem well aligned with shareholder interests.  For example, the 2014-2016 three year compensation cycle is 100% based on shareholder returns.  The 2015-2017 plan splits compensation between shareholder returns and EBITDA targets.  CEO Julian Geiger has received options on 3.5MM shares and, should the stock ever reach $15.93, he received 2% of the market cap improvement.

In 2014, Aéropostale received a low level of support for the executive compensation program.  As a result, named executives did not get any raises, cash bonuses and forfeited two tranches of performance based equity awards.  The board appears to be working in shareholder interests.

Aéropostale uses a three-year incentive cycle to keep management focused on long-term results.  The CEO does not have any annual performance incentives.  The company adopted claw back, anti-hedging, and anti-pledging policies.  It shifted incentive criteria to emphasize performance more than tenure.  Annual incentives for named executives shifted to EBITDA from Operating Income and added individual department criteria.

CEO Julian Geiger’s compensation is limited to base salary, stock option grants awarded in August 2014 and March 2015 and a three-year special incentive plan.  Mr. Geiger received 2.0 MM in $3.24 stock option when he rejoined the company in August 2014 and options for 1.5MM shares in March 2015.  Geiger will receive 2% of the difference between Aéropostale’s market cap at the time he joined (about $255MM) and the current market cap if Aéropostale’s average share price exceeds $15.93 for 90 days in 2017.

Source: Aéropostale Proxy

Recent Open Market Purchases – better than a sharp stick in the eye

Between May 29 and June 9, 2015 CEO Julian Geiger purchased 250,000 in the open market.  Non-executive Chairman Karin Hirtler-Garvey purchased 20,000 shares and director Jane Grove purchased 25,000.

Valuation  $1.83 on the down, $15.93 in the Sky

When measured on price to sales, Aéropostale seems remarkably cheaper than its peers.  Given its lack of profits and sustained sales downtrend, it should sell for a lower revenue multiple.  CapitalIQ assembled the peer group and we excluded Lululemon because of its high valuation.  

If Aéropostale can capture ½ the industry’s forward revenue multiple or 0.35, its stock would be 2.7 times higher than current trading.  Should management return Aéropostale to something near its former trajectory, the stock could appreciate further.

The CEO’s compensation plan rains money should the stock attain an average price of $15.93 or better for 90 days in 2017.  Should Aéropostale attain this target, it implies a market capitalization of $1.35B based on 85 MM shares outstanding (slightly above the current 79.3MM).  In turn this translates to a revenue multiple of 0.77 on current trailing 12 month revenue.  This is still below the group’s average.  When considering potential merger synergies it seems like it could prove accretive to an acquirer.

Seeking to define the downside, we apply

• consensus revenue estimates through April 2017

• assume the company’s revenue growth does not improve through the rest of FY 2018

• increase share outstanding to 85MM once revenue begins to grow (April 2017)

• the current 0.1 revenue multiple

to obtain a low risk value of $1.83, or about 6 % below the current stock price.

As such, we view the ARO risk/reward as highly attractive given relatively low expectations, attractive valuation relative to history and industry peers, solid alignment with management, and a capable management team.

Catalyst

New Merchandise and Merchandising strategy for Back To School 2015.

Investor BTS line preview June 25, 2015

July quarter earnings and first read on new merchandise during the earnings call August 27, 2015.