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By Zoe Tan

Faced with plummeting top lines at the end of 2008 amid a severe drop-off in consumer spending, most specialty apparel retailers responded aggressively by cutting capital expenditures, slashing operating expenses, running on ultralean inventories, and suspending share repurchase programs. These efforts, coupled with modest top-line growth in late 2009, allowed many retailers to generate substantial amounts of free cash flow over the past year. On average, we estimate that these specialty apparel retailers will end fiscal 2009 with free cash flow around 8% of revenue, which is double the 4% posted in the previous year.

Despite improvements in consumer spending trends, a slow revival of the job market and elevated household debt levels are likely to lead to a muted recovery, leaving specialty apparel retailers cautious. In our view, these companies will continue to take a defensive approach this year, maintaining a sizeable cash reserve, with only modest increases in capital expenditures. Store growth is not likely to return to the levels we saw from 2005 to 2007 anytime soon, and specialty retail chains will probably take a more measured approach to expansion plans in the longer term. Many of these retail chains are now focused on improving productivity in existing stores and growing through less capital-intensive channels such as e-commerce. Should these efforts pay off, we would expect returns on invested capital to improve. Only a handful of companies have reinstated share repurchase programs or increased their dividend payments over the past six months; however, we expect more news on this front in the coming year as retailers gain a stronger footing amid a more stable stock market and economic climate.

Domestic Expansion Is Out, Improving Productivity of Existing Stores Is In
As the U.S. economy slumped into a recession in late 2007, specialty apparel retailers were plagued with overexpansion woes and a glut of inventory. After undergoing a series of store closures and honing their core concepts over the past two years, we don't expect these companies to go on another expansion spree in the near term. Even younger chains like Lululemon (LULU) as well as firms that are growing new concepts such as Urban Outfitters (URBN) and Aeropostale (ARO) are taking a more measured approach to expansion and will likely account for most of the near-term store growth domestically.

The notion that bigger is better is a thing of the past, and specialty retail chains are fixated on improving productivity at existing stores by pouring money into developing new products and hiring new talent to revamp merchandise designs. This has been especially true in the women's apparel market, where an overhaul was long overdue given the lack of newness on the shelves. With fresh merchandise and better assortments in stores, companies like J. Crew (JCG) and Chico's (CHS) benefited from improving trends in consumer spending among women in late 2009, delivering impressive results. Both chains posted revenue growth in the low teens, as well as operating margin improvements north of 850 basis points. Many specialty apparel retailers such as American Eagle (AEO) and Limited (LTD) have also been investing in supply chain and product allocation systems in an effort to improve products' speed to market. This has not only allowed the companies to bring the latest fashion trends into their stores at a quicker pace, it enables them to tweak product orders within a shorter time frame based on prevailing sales trends, avoiding costly seasonal markdowns. We anticipate that retailers will realize significant benefits from these initiatives, which should boost returns over the next few years.

Additionally, specialty retail companies have become more opportunistic in adapting their product offering in response to the changing consumer environment. For example, American Eagle is allocating additional floor space to the accessories category based on positive trends in this segment as consumers try to update their wardrobe for less. Similarly, J. Crew is adding concepts for kids and men within existing stores. In our view, these are strategic moves to improve productivity with minimal incremental costs.

Retail Expansion Will Likely Be Measured
Specialty apparel companies have also taken a more conservative approach in launching new concepts to avoid possible flops like Abercrombie's (ANF) Ruehl and Gap's (GPS) Forth & Towne concepts. In our view, companies are doing a better job at gauging interest of new concepts and getting more efficient at assessing prospects in different markets before marking costly investments in new retail concepts. Over the past year, retailers such as Aeropostale and American Eagle tested their new preteens concepts online before launching physical stores. Retail websites not only act as a cheaper alternative for introducing new concepts, they also provide the firm with invaluable information on market demand by geographic region and demographics.

Additionally, Limited has taken a creative approach to generating brand awareness and testing market demand overseas by opening small format travel and tourism shops at major international airports. And if Limited decides to roll out more stores in these markets, it plans to do it primarily through franchise stores, instead of corporate-owned ones, where franchisees will bear most of the up-front investment and expenses tied to the new stores. We believe this helps limit the firm's downside risk in new markets, which is a prudent move, given the uncertain macroeconomic environment.

Dividends and Share Buybacks Should Increase
Based on our estimates of improved earnings and only a modest rise in capital expenditures for specialty apparel retailers this year, free cash flow should continue to increase. Furthermore, these companies tend to have a lighter debt load, which gives them the financial flexibility to buy back shares and pay dividends. As shown in the table below, American Eagle, Abercrombie, and Limited, which we believe are moderately undervalued, are paying investors a decent dividend yield. In fact, Guess (GES) and Ross Stores (ROST) have recently increased their dividend payments, and we believe companies like Gap could follow suit, given its cash balance and history of dividend increases.

Similarly, we expect to see more specialty apparel retailers initiating or reinstating share repurchase initiatives in 2010. Over the past quarter, Ross Stores and Gymboree (GYMB) authorized new share repurchase programs. Given excess cash available, companies like American Eagle, Aeropostale, Gap, and Urban Outfitters will probably give a positive update on their share repurchase programs in the near term, barring any acquisitions on the horizon. In contrast, we think Lululemon and J. Crew will continue to reinvest cash in their businesses, given their smaller store bases. However, we wouldn't be surprised to see either firm initiate a share buyback program at some point down the road as their cash balances build. Assuming they take place at reasonable prices, we think share repurchases are a prudent way to return value to investors, especially for relatively mature retailers. (Click to enlarge)


Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Will Retailers Spend Their Newfound Cash Wisely?