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Of all the sectors that I follow, the retail sector is one of my favorite sectors for investment as the business model is fairly simple to understand. The operations of the firm can be seen by just visiting the nearest mall where the store is located. Apparel retailers fall under this category. In this article, I will perform a fundamentals-based valuation analysis on five predominantly teen-oriented apparel retailers to determine if it makes sense to open a position at current levels. The companies selected for analysis are American Eagle (NYSE:AEO), Abercrombie & Fitch (NYSE:ANF), Aeropostale (NYSE:ARO), The Buckle (NYSE:BKE) and Urban Outfitters (NASDAQ:URBN). The table that follows presents the basic information of these companies.

Company Basics

AEO

ANF

ARO

BKE

URBN

Market Cap (Billion)

3.7

3.81

1.08

2.61

6

Debt to Equity Ratio

0%

11%

0%

0%

0%

Stock Performance 5 Yr

15%

-30%

-36%

68%

21%

Stock Performance 1 Yr

8%

54%

-19%

17%

47%

Dividend Yield

2.6%

1.6%

0.0%

1.5%

0.0%

The five companies selected are relatively small in size with URBN being the largest company with a market capitalization of approximately $6 billion. ARO is at the other end of the spectrum with a market capitalization of $1.08 billion. Barring ANF, which has modest levels of debt, none of the companies has long-term debt on the books.

The stock performance over the past 1 year has been a mixed bag with BKE appreciating in value by 68% and strong gains from AEO and URBN. ARO and ANF have both declined significantly falling by 36% and 30% respectively. AEO, ANF and BKE are dividend payers with AEO leading the way with a respectable yield of 2.6%.

Growth Rates

Next, I evaluated the historical growth rates of revenue, income, EPS, book value and the projected growth rates. These are summarized in the table shown below:

Growth Rates

AEO

ANF

ARO

BKE

URBN

Revenue

10 Year

9%

10%

12%

10%

18%

5 Year

3%

4%

8%

13%

13%

1 Year

10%

8%

2%

6%

13%

Income

10 Year

14%

1%

-4%

17%

17%

5 Year

-10%

-13%

-23%

17%

8%

1 Year

53%

85%

-50%

9%

28%

EPS

10 Year

15%

3%

0%

17%

18%

5 Year

-9%

-11%

-18%

16%

12%

1 Year

51%

99%

-49%

8%

36%

Book Value

10 Year

-1%

-2%

-5%

0%

-1%

5 Year

-2%

-2%

-7%

1%

-3%

1 Year

3%

-8%

-2%

2%

-6%

Growth Projections

Next Year

14%

21%

76%

4%

17%

Next 5 Year

11%

16%

10%

6%

15%

AEO and URBN have reported strong revenue growth rates last year in the 10% to 13% range. URBN grew its revenues at the fastest rate on an annualized basis during the past 10 years. ARO which also reported robust revenue growth over the past decade has experienced a difficult time recently with sales growth declining to 2%. Its EPS fell by 49% last year. ANF's growth in net income, EPS and book value is abysmal in my opinion. Going forward, ANF and URBN are projected to grow their earnings in the range of 15% to 16% while BKE is expected to lag behind with a 6% long-term growth rate. ARO and AEO are expected to deliver similar growth rates of 10%-11%.

Margins

After analyzing the growth rates, the next step was the evaluation of gross and operating margins of the five firms. The results are presented in the table below.

Margins

Averages

AEO

ANF

ARO

BKE

URBN

Gross Margins

10 Year

42%

60%

32%

41%

39%

5 Year

39%

64%

32%

44%

38%

Last Year

40%

62%

25%

44%

37%

TTM

40%

64%

24%

44%

37%

Operating Margins

10 Year

13%

13%

12%

18%

16%

5 Year

10%

7%

11%

22%

15%

Last Year

11%

8%

3%

23%

13%

TTM

11%

9%

1%

23%

14%

With the exception of ARO, the firms on this list have done a decent job of maintaining their operating margins, which declined by 400 bps from an average of 13% during the past decade to last year's operating margins of 9%. BKE reported the strongest margins of 23%, up from its10-year average of 18%.

Profitability

To evaluate the profitability of the five companies, ROIC and ROA were selected as the desired metrics. BKE is the clear leader based on these metrics with extremely strong ROIC and ROA ratios of 46% and 32% during the trailing 12-month period. URBN has also consistently generated returns on its invested capital in the 20% range. ARO is the obvious laggard falling from 10-year average of 38% to TTM ROIC of 3%. ANF has also experienced a sharp decline in its profitability measures, although the decline is not as drastic as in the case of ARO.

Operations

Averages

AEO

ANF

ARO

BKE

URBN

ROIC

10 Year

18%

20%

38%

28%

21%

5 Year

12%

8%

37%

40%

19%

Last Year

18%

12%

9%

50%

20%

TTM

16%

13%

3%

46%

20%

ROA

10 Year

13%

13%

21%

21%

16%

5 Year

9%

5%

20%

28%

15%

Last Year

13%

8%

5%

33%

14%

TTM

12%

9%

2%

32%

15%

Valuation

Having developed a good idea about the fundamentals of the five companies, the next step was to perform relative valuation. The multiples used in the analysis were based on historical analysis of individual companies and industry multiples. The table below presents the valuation analysis results.

Valuation

AEO

ANF

ARO

BKE

URBN

Next Yr Est

$1.64

$3.95

$0.65

$3.68

$2.24

EPS Growth Rate

11%

16%

10%

6%

15%

Future EPS (5 Yr)

$2.38

$6.70

$0.92

$4.56

$3.70

Expected P/E

15

16

16

18

20

Price 5 Yrs Out

$35.70

$107.28

$14.80

$82.11

$73.94

Unlevered Beta

0.93

0.93

0.93

0.93

0.93

D/E Ratio

0%

5%

0%

0%

0%

Current Tax Rate

35%

35%

35%

35%

35%

Levered Beta

0.93

0.96

0.93

0.93

0.93

Risk Free Rate

2.2%

2.2%

2.2%

2.2%

2.2%

Risk Premium

8.00%

8.00%

8.00%

8.00%

8.00%

Size Premium

0.97%

0.97%

1.63%

1.63%

0.74%

Cost of Equity

10.6%

10.8%

11.2%

11.2%

10.3%

Fair Value

$21.61

$64.17

$8.69

$48.25

$45.23

Current Price

$19.05

$48.76

$13.78

$53.92

$40.88

% Overvalued

-13%

-32%

37%

11%

-11%

As shown in the table above, AEO, ANF and URBN are undervalued while BKE and ARO are overvalued at current levels. ANF and ARO are the obvious outliers with ANF being grossly undervalued and ARO being wildly overvalued. Based on my analysis, I would look to initiate a long position in AEO, ANF and URBN and close any existing position in ARO and BKE. Although ANF is the cheaper stock, URBN and AEO are my preferred investment candidates in this sector. Based on valuation, I would look to initiate a short position in ARO.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision.)

Source: Apparel Retailers: 3 To Buy, 2 To Sell