Aeropostale (NYSE:ARO) has been among the worst-performing retail stocks of the year, down about 35% the last 52 weeks as of this writing. This may provide an opportunity for contrarian, patient investors to acquire a stock that is relatively cheaper than its peers and among the leaders in market share among young adults aged 14-17.
I will show that shares have gotten to a point where the risk/reward tradeoff is skewed to the upside, and if the company can turn things around or the teen retail environment picks up, or if Aeropostale can adapt to the changing market environment by expanding their target audience, ARO shares will recover quite nicely. ARO's debt-free balance sheet and large cash balance also give us a margin of safety.
As investors, we ask ourselves: "Is this decline due to a permanent impairment in the company's prospects for profitability, or is it a temporary one which can be reversed when the retail market picks back up again or the company adapts to changing tastes?" I will argue for the latter argument in this article.
If you've been reading the news headlines, you'll see plenty of articles talking about how fashion retailers expect weak holiday sales this year, especially the three major teen retailers: Abercrombie & Fitch (NYSE:ANF), Aeropostale, and American Eagle (NYSE:AEO). There's been a lot of bearish talk about the three "Big As" as they are called as you can see from the news article snapshot below.
Declining sales have forced analysts to all but write off any kind of investment in teen retailers at this point. Teens have "new tastes," "the three As are no longer in vogue," and "teens are spending more on electronics than clothing" are just some of the things you'll read. While to a certain extent this might be true, I believe analysts are underestimating these retailers' ability to quickly adapt to changing tastes and the fact that the retail industry goes through cyclical highs and lows. I also believe that a good deal of the pessimism is already built into the stock price of ARO. This creates a situation where any sort of good news can result in a quick turnaround of the stock price. Now let's look at ARO as compared to some of its peers.
Aeropostale Vs. Peer Comparable Companies
- Right away, we can see that ARO has been the worst performer over the past 52 weeks with a negative 34.73% return.
- Aeropostale's EV/LTM Revenue of 0.24 is cheapest among its peers, 67% less than American Eagle's, which is next best.
- Also notable, is ARO's price to median free cash flow multiple (P/FCF) of 7.44, where free cash flow is taken as the median of the past seven years. This is also the best value among its peers.
- Finally, the price investors pay per dollar of sales is only $0.28 for Aeropostale, much less than any of its competitors. (This is measured as market cap/LTM sales.) So, with the stock price at $8.25, we are only paying 28 cents and are getting a dollar of revenue.
In terms of value, ARO seems to be a steal at this price, at least when measured against its peers. Now, let's attempt to value the common stock of Aeropostale based on three models.
Aeropostale Intrinsic Value Estimates
Valuation Based on Tangible Book Value
- Industry Price to Book Ratio: 2.55 (Source: Zacks.com, Industry: Retail)
- ARO Tangible Book Value per Share: $4.32
- Industry-Implied Fair Value of ARO: 2.55 * 4.32 = $11.01 (33.45% upside to current price of $8.25)
- Assumed Conservative ARO Price to Book Ratio: 1.60
- Conservative Estimate for Fair Value of ARO: 1.60 * $4.32 = $6.91 (-16.24% downside to current price of $8.25)
Valuation Based on Median Free Cash Flow of the Past Seven Years
- Industry P/FCF Multiple: 11.13 (source: Zacks.com, Industry: Retail)
- ARO Median FCF per Share Over Last Seven years: $1.11
- Industry-Implied Fair Value of ARO stock: $1.11 * 11.13 = $12.34 (49.52% upside to current price of $8.25)
- Assumed Conservative ARO P/FCF Multiple: 9.0
- Conservative Estimate for Fair Value of ARO stock: 9.0 * $1.11 = $9.98 (20.91% upside to current price of $8.25)
Valuation Based on LTM Revenue and Median EBIT Margin Over Past 7 years
- LTM Revenue ($M): $2309.93
- Median EBIT Margin Over Past 7 Years for ARO: 13.2%
- Discounted EBIT Margin to be Conservative and Comparable to Peers over Last 7 Years: 10%
- Normalized EBIT ($M) = $2309.93 * 10% = $230.99
- Median EV / EBIT Multiple for ARO Over Past 5 Years: 5.22
- Total Implied Enterprise Value for ARO ($M) = 5.22 * $230.99 = $1204.91
- Plus Cash & Short-Term Investments ($M): $100
- Minus Long-Term Debt: $0
- Divided by Number of Shares (M): 78.49
- Equals Fair Intrinsic Value for ARO Common Stock: ($1204.91+$100-$0)/78.49 = $16.63 (101.52% upside to current price of $8.25)
Our three valuation measures provide estimates ranging from $6.91 to $16.63 for the intrinsic value of Aeropostale's common stock, which is definitely skewed to the upside.
- The retail sales environment may not disappoint as badly as some analysts may be predicting.
- Aeropostale may be able to adapt to "fickle" teenager's tastes and new fads quickly.
- Aeropostale's stores aimed at 12- to 14-year-old kids, called P.S. from Aeropostale are a growing chain, and over time will gain more share of that segment of the market.
- GoJane.com, owned by Aeropostale, is an online women's footwear & apparel website that is growing sales. Despite ARO's overall net sales decreasing by 6% in the second quarter of 2013, net sales from the e-commerce business of ARO including GoJane.com, increased by 22% to $39 million. ARO's e-commerce business may continue to become a bigger piece of the sales pie, which may stimulate an increase in ARO's share price.
- Sophisticated activist investors are on the scene. Sycamore Partners has taken a nearly 8% stake in Aeropostale, calling ARO "an attractive investment." This makes it the third largest holder of the stock. Communication with the company's management and board about Aeropostale's business and strategy may force the company to take steps that enhance shareholder value more quickly.
- Competition from lower-cost retailers such as Forever 21, H&M, Zara, and others may continue to erode market share from Aeropostale, causing them to lower prices in order to compete, resulting in lower margins.
- The retail environment may continue to suffer from low demand as young adults choose to spend the bulk of their money on things such as electronics.
- High teen unemployment will result in less disposable income to spend on apparel.
- Despite the stock reaching new lows, the lack of insider buying of Aeropostale stock is a concern.
Overall, I think Aeropostale's stock is a good value at this level. A good amount of the fear may already be priced into this stock, and the concerns about a weak retail environment lasting for a long time may be overblown. The presence of activist investors taking an 8% stake in the company gives us additional confidence. ARO's low valuation statistics as compared to its peers, and its debt-free balance sheet and cash position also make this stock worth considering as a contrarian play.