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by Brian Sozzi

The time has arrived to issue bold calls on select retailers in front of the holiday season. Detailed below are three of my revisions from the specialty apparel sector following September same-store sales.

American Eagle Outfitters Inc. (NYSE:AEO)
Sector: Specialty Retail
Rating Change: Buy from Hold
Price Target Change: $18.00 from $15.00

We are issuing our second consecutive upgrade in rating on American Eagle Outfitters (AEO). What was once a downtrodden story earlier in the year, amid fashion miscues and bloated inventories, has quietly become a story with considerable interest (fundamentals turning/takeover chatter swirling). For a second straight month, American Eagle produced results that suggested inventory execution (new planning tools helping) has tightened up and that product is finally winning with an ever discerning teen customer. We need not look any further than American Eagle's average unit retail prices (AUR) in September, which advanced 4% against double-digit percentage declines at Abercrombie & Fitch (NYSE:ANF) and Aeropostale (NYSE:ARO), as evidence of improved internal management of the business. Both men's and women's comps have strengthened since June, another positive sign, especially as it's happening on lower inventory levels.

Our EPS estimate for 3Q10 has been moved upward to account for management's guidance raise yesterday ($0.27 to $0.28 from $0.23 to $0.26)). As for 4Q10 and FY11, our increased EPS forecasts seem logical in light of American Eagle turning over inventory quicker, and that inventory being somewhat in accordance with teen preferences.

Aeropostale Inc. (ARO)
Sector: Specialty Retail
Rating Change: Sell from Hold
Price Target Change: $20.00 from $23.00

We are downgrading our rating on Aeropostale (ARO) to Sell from Hold. Our EPS estimates for 3Q10 and 4Q10 have also been marked down. The basic premise for our call on the stock is Aeropostale's increasing comp underperformance relative to its direct competitors in the mall, namely Hollister (division of Abercrombie & Fitch), Abercrombie & Fitch (ANF), and American Eagle Outfitters (AEO). Note this relative softness is in spite of Aeropostale becoming more aggressive on pricing to attract consumers. A discount apparel model where management is having to ratchet up promos further to compete is not one that is able to drive margin expansion, by and large.

Aeropostale stated its merchandise margins were down year over year in September as AUR fell a worrisome 10%. We think there is increased risk to management's 3Q10 guidance, and have set our assumption appropriately below the low-end of the range ($0.64) and current consensus ($0.66). Valuation, though on the surface at enticing levels relative to peers, is only attractive if an investor is unknowing of the unfavorable trends in the business that are developing.

Gap Inc. (NYSE:GPS)
Sector: Specialty Retail
Rating Change: Sell from Hold
Price Target Change: $15.00 from $18.00

"Issues persist" is what we penned on Gap (GPS) in the last week of September. Right now, the statement is worth revising to "issues may be spreading." Gap printed a -2.0% comp (consensus: -0.2%), and was one of the few in specialty apparel to miss consensus comp forecasts. While the success we observed in black pants (they were heavily promoted in stores and in malls) at Gap division did in fact ring true, it appears that not much else moved at a brisk pace, and what did sell through required promos. The sales softness may explain the aggressive, yet inviting, promo Gap division is currently running for October. The overall comp miss, however, was fueled by Old Navy, which rang in with a -5.0% comp. Old Navy's comp trend is not its friend at the moment. Increased promotional activity from Aeropostale (ARO) and Abercrombie & Fitch (ANF), as well as more style being offered at fast fashion destinations Forever 21 and H&M (OTCPK:HNNMY), may be hurting Old Navy. As for Banana Republic, we were disappointed given the quality, on trend product we noticed throughout September and prior month positive trends.

We are downgrading our rating on Gap shares to Sell from Hold and revising estimates. It's becoming apparent that Gap's desire to grow total sales is increasingly coming at the expense of merchandise margin; this is likely to hold consistent for the holidays in order to enter 2011 clean on inventory.

Other Notes
* Gap brand's logo change is a bold move by management, no doubt about it. But, it's something that is necessary to align management's vision (to promote a cooler brand) with store presentation (signage, marketing, merchandise).

Source: Some Bold Retail Calls Ahead of the Holiday Season