When it comes to spotting a potentially distressed retailer, there are several factors that one should consider. The first factor is the cash/liquidity situation for the company. Naturally, retailers with low levels of cash in comparison to immediate financing needs pose a significant risk of bankruptcy. Retailers with fundamental issues to their business models, on the other hand, may sometimes emerge victoriously from their troubles and reinvent themselves to reach previous glory. This holds especially true if such retailers are able to maintain high enough cash levels to allow for a proper turnaround strategy to be executed. I believe that Aeropostale (NYSE:ARO) could be one such future successful turnaround story-provided that the company is able to properly execute on its turnaround initiative.
The First Stage of a Successful Retail Turnaround:
When a distressed retailer begins to show diminishing signs of profitability and sales, the first step to any successful turnaround is the implementation of a cost-reduction strategy combined with rapid action and strategic redirection. During its recent earnings announcement, ARO had announced a 15% drop in fourth quarter same-store sales along with a reported net loss of $70 million. This is a clear indication of a struggling business, and a sign that action must be taken if Aeropostale hopes to turn around its business.
Given Aeropostale's current situation, rapid cost-reduction is one of the most critical first steps as it allows for management to conserve its cash levels while identifying the root causes behind the decline in business. Right now, I believe that Aeropostale is beginning to initiate this stage of the turnaround process. Aeropostale has already announced its plans to implement a notable cost-reduction strategy by closing roughly fifty of its underperforming stores nationwide (representing a closure of roughly 4.5% of its current total store count). This is a great first step, but apart from simply reducing the overall store count, ARO must also work to ensure that further cost-reduction measures are implemented as well as identify what has driven the decline in business in the first place.
The Second Stage of a Successful Retail Turnaround:
Once a distressed retailer has taken measures to reduce its operational overhead and improved the efficiency of operations, it is necessary for the root issues to be identified and strategically rectified through quick and decisive action. This is one of the most difficult stages of any turnaround process.
Finding the root cause behind a business decline is often much harder than it seems. For this reason, turnarounds may only be able to pass through this stage and onto the final stage if the initiative is led by an executive with great change management skills and/or ability to radically reinvent the operating model. Without great change management there is sure to be a loss of morale within the employee workforce as cost reductions often require significant corporate downsizing and layoffs. For this reason, I believe that it would be a great idea for Aeropostale to appoint a temporary CRO (Chief Restructuring Officer) to assist the CEO with the turnaround initiative. This would help to reduce the physical burden on executive management during the transformational process.
With Aeropostale's financial transaction with private equity firm Sycamore Partners, I believe that Aeropostale may be able to tap into the retail expertise it needs to execute a successful turnaround. In fact, an officer from Sycamore could make a great potential temporary CRO. Sycamore Partners has extensive history within the retail industry and has acquired stakes in various retailers including its acquisitions of Hot Topic & Talbots, and deals with Express (NYSE:EXPR) and Zale (NYSE:ZLC). With the support of the private equity firm's extensive experience, I believe that Aeropostale will be able to obtain the guidance and consultation required to facilitate the turnaround process. Additionally, the private equity firm is incentivized to act in the best interests of shareholders as Sycamore Partners holds a 12.3% total stake in the apparel retailer (this number assumes that Sycamore will eventually convert the issued convertible preferred stock into common stock).
The Final Stage of a Successful Retail Turnaround:
Once the root problem has been identified and a process put in place to correct the issue, the stage is set for the final portion of a turnaround initiative. At this stage of any turnaround, the focus should be all about controlling the newly implemented process and monitoring results. Although Aeropostale has not yet reached this stage of the three-stage process, it has, however, initiated a social media experiment involving Bethany Mota. This initiative is what could potentially help to address ARO's decline in business as Mota has been successful at drawing a large audience amongst ARO's target market-something which Aeropostale has struggled with in recent years.
What's really notable about Mota's following isn't its size, but the level of user activity. In fact, a single one of Mota's Instagram posts often leads to more than 300,000 likes in only a few days time. This level of user engagement is definitely impressive. If Aeropostale is able to utilize Mota's influence and newly released product line to drive customer traffic into its stores, it is possible that the retailer may find itself on the path to future profitability.
How to Monitor a Turnaround:
During the entire three-stage turnaround process, it is important to continually monitor key performance metrics to understand if the business economics are improving. As a general rule of thumb, if a distressed retailer is able to operate profitable stores at a lower cost, then this is a great sign of an improving business. Some great metrics to look at would include increasing revenue per square foot, increasing same store sales, improving customer satisfaction ratings, and/or increasing customer retention percentages. An improvement in any of these metrics would generally indicate a recovering business, so these are some great key metrics to pay close attention to.
One of the interesting parts about investing in turnarounds is that distressed retailers need not return to peak profitability to allow for tremendous potential upside. In the case of Aeropostale (currently trading at an Enterprise Value of 0.24 times consensus 2014 FY revenue), a return to prior year profitability alone would mean a substantial rise in ARO's share price. In fact, a return to prior year earnings could mean potential upside north of 100% (assuming a price target of $11).
Given the nature of the retail industry, turnarounds in the industry can often prove to be very difficult to execute. However, this does not mean that they are impossible. With Aeropostale's highly shorted shares (30%+ short float) and current positioning in the marketplace, I believe that the company is well poised to stage a potential turnaround. This, combined with the company's strategic alliance with Sycamore Partners, leads me to conclude that shares of Aeropostale are currently trading at a great buying range for long-term investors.
Disclosure: I am long ARO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.