Markdown Mania Arrives in Teen Apparel Land

by: Wall Street Strategies

By Brian Sozzi

Throughout the bevy of first quarter earnings calls from teen apparel staples, two words stood out like a kid wearing an electric blue suit to senior prom: "Promotional environment." In the face of a 20%-plus teen unemployment rate all but set to extend beyond the summer hiring season, and the renewed crackdown by parents on the household budget as inflation hits from many angles, teen apparel retailers have kicked their promotional stances up a few notches to enter the back to school season showcasing fresh wares.

For some, such as American Eagle Outfitters (NYSE:AEO) and Aeropostale (NYSE:ARO), there is a greater sense of urgency to clear through slow-moving inventory in order to convey to the consumer new messages. American Eagle Outfitters will be returning to a more authentic prep look in men and women following over a year of trying to inject fashion into the assortment (namely boho chic in women's), which has been met with mixed responses.

Aeropostale became too trendy (for example, deeper necklines and too much sophistication in girls) in its assortments beginning late last year, confusing customers who have long viewed the chain as a destination for basics sporting a touch of trend. (In my dialogue with Aeropostale's management yesterday, it was indicated that all malls experienced soft sales in 1Q as a result of misguided product. The lack of any strength signals that Aeropostale has a tall order on its hands to regain enough market share for back to school that would spark a return of the bulls on the stock leading up to the holidays.)

Understanding why the inventory bulge has arisen across the space is important to strategizing as we enter back to school. Receipts currently in stores were planned in the latter portion of 2010 when the consumer was recovering, meaning an openness to engage in discretionary purchases. Management at teen retailers, usually an optimistic bunch, bought inventory to the upbeat comparable store sales expectations that were badly needed to overcome initial signs of costs of goods sold inflation and a ramp in operating expenses and capex related costs.

Additionally, I think many in the sector were experiencing positive demand trends in certain categories earlier in the year and decided to chase such demand. Unfortunately, those companies not named Abercrombie & Fitch (NYSE:ANF) and Zumiez (NASDAQ:ZUMZ) were hit by a slowdown in demand in the middle of 1Q commensurate with the spike in gasoline and food prices, spurring consumers to seek value online, shop where the most value was being offered at brick and mortar stores, or exit the market altogether to save up for back to school.

Since the May 12 peak in the S&P Retail Index, shares of Abercrombie & Fitch, American Eagle Outfitters, Zumiez, and Pacific Sunwear (NASDAQ:PSUN) have underperformed the index's move by a factor of two times, owing to a very subdued outlook for profit margins. Abercrombie & Fitch has been the relative outperformer, falling 6.5% from May 12 against the 7.6% pullback in the index; international exposure and a share gain domestic story explain why the bulls have remained their relative exposure.

I continue to recommend being near-term underweight teen apparel names at least until the early part of July (and considering the selling of cyclicals amidst the market's recent summer swoon). By then, I will have a clearer indication of who has successfully moved excess inventories and is properly showing their first back to school flows. In the meantime, sentiment is likely to remain negative due to the attack underway on profit margins, hence there is no pressing need to try and pick bottoms.