2 Teen Apparel Retailers With Very Different Risk/Reward Outlooks

Includes: HOTT, PSUN
by: Clumsy Rick, CFA

Apparel retail stocks have seen some upheaval the last few weeks as concerns about consumer spending are causing investors to re-evaluate second half 2011 earnings expectations. I believe the market is beginning to create some nice opportunities, but there could also be casualties if we spiral into a recession. Companies with little to no earnings and in the midst of turnarounds seem most vulnerable. I looked at two in particular that I think have very different risk/reward profiles: Hot Topic (NASDAQ:HOTT) and Pacific Sunwear (NASDAQ:PSUN). As the market presses down on both, Hot Topic seems the stronger, safer bet.

Hot Topic and PacSun are both teen apparel retailers, but also have significant overlap in core customers -- more so than either has with, for example, Abercrombie (NYSE:ANF). Both retailers have struggled over the last few years, have fairly new management and have recently stabilized sales. Both are mature chains, not growth companies, and both currently are losing money, with negative operating margins. Despite some similarities, Hot Topic has maintained positive free cash flow and has the stronger balance sheet.

Looking at PacSun first, same store sales were down 9% last year, including a 7% decline in 4Q. This 9% decline was on top of a 20% decline in 2009. While sales have stabilized so far this year (up 1% in 1Q11, expected flat for 2Q11), margins continued to deteriorate. Gross margins were down 310 bps last year to 22.1%, down 320 bps to 19.1% in 1Q11 and guidance is for 320 bps decline in 2Q11.

I can see a bullish case for PacSun very easily. It goes something like this: The outcome of recent landlord negotiations leads to modest rent reductions; recent merchandising improvements finally get traction on the girls side of the business, which leads to stronger sales growth even in spite of a weakening industry; and inventory management improves dramatically, leading to significantly lower markdowns. While the rent reductions seem most likely, the latter two are less certain, especially given rising expectations that were never realized last year.

If the economy holds up, PacSun could continue to struggle along even without strong improvements in its business. However, the company's precarious financial position means trouble if we enter a recession. Last year, PacSun's earnings before interest and taxes was a loss of $20 million and free cash flow was a negative $58 million. The run rate this year so far is slightly worse on a FCF basis. The company had $25 million in cash on its balance sheet at the end of 1Q11 and $29 million in debt. Availability of its revolver at the end of 1Q11 was $50 million. While the company did not expect to be in its revolver at the end of 2Q11, I suspect its cash balance will be near zero due to seasonal capital needs and continued cash flow burn.

Based on my forecast of 3% same store sales growth this year (essentially assuming the company gets it together for the holidays and sees mid-single-digit same store sales growth) and modestly positive gross margins (22.5%, up 40 bps), free cash flow burn should fall to $20 million this year and the company should end with about $40 million in cash. However, if the economy slows, the picture could be dramatically worse. Even assuming same store sales and gross margins remain flat-ish in the back half of 2011, FCF burn would be about $45 million and cash to under $20 million. If the sales decline was more in line with 2010's decline, cash would be depleted. Either way, the company would have to go deep into its credit line in 2012 for seasonal capital needs, which would be scary for investors and suppliers.

Hot Topic is in a much better position. Same store sales were down 5% last year, but up 3% in 2Q11, including a 7% increase in July. Excluding restructuring charges, gross margins were up 90 bps in 1Q11 and will likely show twice that level in 2Q11. FCF was only modestly positive last year and is on track for a similar result in 2011. Cash and short term investments stood at $74 million at the end of 1Q11 ($1.65/share) and no debt.

The bullish case for Hot Topic is refocusing the business. Non-core divisions (music site) are being jettisoned while old inventory is being cleaned out. A new focus is being placed on reviving the fashion side of the business after the company let it shrink over the last several years. While this will not be easy and I suspect it will take more than one season to get this right, the company's financial position leaves it in much better condition to survive a downturn.

Even assuming sales decline in the 2H11 at the same rate they did in 2010 (down 5%) and gross margins stabilize (as we assumed for PacSun), earnings would only be slightly negative for the year and FCF would be a burn of $6 million. The company would still end the year with over $60 million in cash ($1.40/share). While obviously the results could be worse, just as they could be for PacSun, its seems unlikely Hot Topic will be in a precarious financial position if the economy turns down again.

Obviously both companies would suffer in a recession. You don't have to buy or sell either. However, if you are looking to take advantage of the market downturn and place a bet on the future with a retail turnaround story, the stronger balance sheet and business momentum make Hot Topic a good be.

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

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