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Aeropostale Inc.


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Stock Review

Aeropostale (ARO) is one of the numerous teen clothing retailers you see at pretty much every decent-sized mall in America. As of July, the company operated 979 Aeropostale stores in the U.S. and Canada, and 64 "P.S. from Aeropostale" children's stores. The target demographic for the flagship stores are the 14 to 17 year old age group. 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. 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. A few years ago, this was a major strength for Aeropostale, with long-time CEO Julian Geiger at the helm, the company delivering 12-18% revenue growth, and margins steadily marching upwards from 11% to over 17%. The stock soared to over $30.

Today, however, the company has cooled off considerably. Geiger retired at the end of 2009, originally replaced by an ill-advised co-CEO arrangement of COO Thomas Johnson and chief merchandiser Mindy Meads. Meads left the company last year, leaving Johnson as the CEO. Under his watch, things have not gone too swimmingly. Same-store sales have come in negative for the past 4 consecutive quarters, including dramatic declines in the last 3. The firm's cash balance has been gutted by aggressive share buybacks at much higher prices than today. The stock price dropped to under $10 before rebounding recently on a pre-announcement of better margins for Q3.

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 almost all of the way there. They have a children's concept, P.S., but teen retailers have a relatively poor history of successfully launching alternative concepts. Growth opportunities look limited.

Comparing this prospective investment against its peers, Aeropostale has one major disadvantage - it does not pay a dividend. Many of its competitors do: American Eagle pays a 3.1% yield, Gap (GPS) a 2.3%, Abercrombie 1.2%, The Buckle (BKE) a 1.8%, etc. While the company has been an aggressive re-purchaser of shares (7.5% 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.

The stock is unquestionably cheap at a 21.7% earnings yield. And I also believe it is likely that the firm will eventually find its footing on operating margins, which already are showing signs of a rebound. But the lack of growth opportunities and poor recent performance, combined with a recent spike in the stock price, worries me about considering it for a new Magic Formula position.

Steve does not own ARO.

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