Aeropostale Drops: Restrained Outlook Scares Investors, Creates Opportunity

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 |  Includes: ARO, BAL
by: NakedValue

Teen clothing retailer Aeropostale (NYSE:ARO) reported earnings yesterday that were above estimates but offered future guidance that fell short of expectations. This led to a sharp drop in the stock price after hours, making an inexpensive stock even cheaper. Based on the company's cheap valuation metrics, continued stock price weakness should give investors a margin of safety while they wait for benefits from potential positive opportunities.

Earnings

During the forth quarter of fiscal 2010, diluted earnings per share were $0.95 or $0.98 before a higher-than-expected tax rate. Diluted net income for the fiscal year 2010 was $2.49 per share. For the year, same-store sales growth slowed from 10% in 2009 to 1% in 2010.

The company expects 2011 earnings between $2.20 to $2.40 per diluted share. The CEO blamed the lackluster outlook on inflationary pressures (cotton). Capital expenditures were expected to be $70 million vs. $100.8 million in 2010 and $53.9 million in 2009. Aeropostale expects to open 30 stores, 20 P.S. From Aeropostale stores, and to remodel about 50 stores.

Investment Outlook

With the stock trading at $22.75 after hours, the forward P/E is about 9.89. Excluding cash, the forward P/E drops to around 8.75. In addition to this cheap valuation, management's dedication to shareholder value through stock buybacks gives potential shareholders some margin of safety to pursue the below listed upside.

Opportunities

Aeropostale's sales growth means store construction will slow as ARO reaches its self-described saturation point of around 1,000 stores, but the P.S From Aeropostale brand has grown quickly to 47 stores in 13 states since its launch in 2009. Based on the cheap valuations, the company doesn't need to grow -- but growth at P.S From Aeropostale would be a bonus.

Aeropostale's cheap valuation makes it a takeover target in an industry ripe for consolidation and private equity participation. The company is well aware of this; as such, it hired Barclay's (NYSE:BCS) to advise against a takeover defense. While this may signal management's reluctance to sell, it may also simply signal a reluctant to sell anywhere near current levels.

Embedded in the Aeropostale stock price is exposure to cotton prices. While this has been a bad thing since September 2010, the cheap stock valuation gives investors a low-risk way to gamble on reversion in rising cotton prices and other inflationary pressures. Cotton and other commodity prices rose sharply starting in September 2010, shortly after U.S. Federal Reserve Chairman Bernanke made his famous Jackson Hole speech signaling QE2. It may make sense for investors to take advantage of weakness in this stock as a cheap way to bet on a reduction of inflationary pressures once QE2 ends in June.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.