8/24/2010
By Brian Sozzi, Research Analyst

We are smack in the middle of back to school shopping.  Sales tax free events are en vogue, and so are the discounts.  The reasons for the discounts at apparel chains are straightforward.  First, consumers have retrenched, having satisfied their pent up thirst for frivolous goods earlier in the year.  The savings rate nearing 6.5% is evidence of the "pause" we are hearing mentioned by many retailers on their second quarter earnings conference calls.  Second, retailers simply got too amped up by the positive reads in their business that resulted in the first quarter, ordering inventory to support sales growth.  Since inventory has to be ordered 6-8 months in advance for an apparel retailer, retail management teams sized up the demand environment as one that would continue to improve in health.  My oh my, how wrong they were.

Specific to teen retailers, it will be a trying back to school season.  While I believe a Target (TGT) will do well this season as a result of a strong merchandise selection in food and back to school essentials, and even Macy's (M) is likely to stick out as a winner as private label offerings gain share, leading mall-based names such as American Eagle (AEO), Aeropostale (ARO), and Pacific Sunwear (PSUN) are in store for an interesting remaining weeks in August and transition into September.  I would summarize the sales environment as littered with irrational competitors, companies essentially reducing prices to bring in traffic and work down inventory prior to holiday flows.  For example, Abercrombie & Fitch (ANF) is running a 40% off all jeans sale; this is indeed telling of demand trends as the company is positioned as an accessible luxury destination for teen apparel and accessories.  The company's surfwear inspired Hollister division is peddling t-shirts for under $10.00 and jeans at $20.00, seriously encroaching on the promotional turf held by Aeropostale.  Price wars, you bet.

The teen unemployment rate also does not help the cause for these retailers, nor does what I see as a seismic shift in how teens spend their discretionary dollars.  Teen unemployment is now a shade below 18.6% after peaking at 19.6% in April 2010; I would expect this to head higher as summer jobs wind down.  The current rate of unemployment is at a level comparable to ones seen in 1982-1983.  As perspective, the teen unemployment rate was in a range of 8.9% to 12.5% from 2000 to 2007, supporting sales, earnings, and returns for teen retailers (and valuation multiples that may have to be thrown aside when developing investment theses as the pace of spending was artificially propped up).  Other factors worth pointing out include:

1. Older workers hit by the Great Recession are picking up the jobs once given to teens.
2. Teens are being enticed by many different areas like never before; apps from iTunes, iPods, iPads, text message plans, and bills forced to be assumed because parents are no longer employed.  Without question, apparel is not the sole back to school item on the list of teens.

Gun to my head, I would recommend dropping a deuces sign (as in "see you later") to the teen apparel sector.  In Merriam-Webster English, avoid investment as the macro trends, coupled with excess inventories at the major players in the mall, suggests compressed valuation multiples (earnings revisions to the downside fueled).  The stocks in the sector, despite an average sell-off of 25% from 52-week highs in mid-April, continue to trade on premium multiples relative to the broad market in an expectation that even the slightest reentry of the consumer will be conveyed into above market growth due to favorable two-year sales comparisons and lean operating expense budgets.  A modest degree of optimism continues to be reflected in the share prices, optimism I fancy will be wrung dry once the August and September same-store sales data is received.
In an effort to not be entirely doom and gloom, as well as trying to satisfy the desires of investment risk takers, I have devised a "picks" and "pans" list.  The "picks" are stocks of companies that fit all, or some, of the following criteria:

* Inventory lean on comparable store basis.
* Growing international businesses.
* Clear momentum this back to school.
* Opportunities for strong earnings growth in 2011, even under more adverse scenarios than currently modeled for by Wall Street analysts (including us, as we are part of the Thomson Reuters consensus estimates).

"Picks"

Abercrombie & Fitch (ANF)
* Bought inventory in expectation for a mid-single digit percentage same-store sales increase for back to school.  Abercrombie & Fitch will cycle 15% plus declines in monthly sales in the third quarter, making the investment appropriate in my estimation.
* International on a path to 20% of sales.
* Store closures by 2011 end will number 110, which bring down the leverage point of the business in a new normal spending climate.
* Has gained share for two consecutive months from direct competitors (American Eagle and Aeropostale).

Urban Outfitters (URBN)
* Success in holding prices, counter to industry trends.
* Same-store sales inventory only increased 3% in the second quarter.
* Valued at a P/E multiple that is 50% below historic average.
* Growing internationally.
* Product differentiation.

As for the "pans", they represent shares of companies that are not executing or have had a recent stumble that hints at below consensus financials in the near future.

"Pans"

Pacific Sunwear (PSUN)
* No return to profitability seen anytime soon.
* 10 straight quarters of same-store sales declines.
* Very promotional for back to school.
* Consistent net losses may require outside investment or debt financing, which would be shareholder unfriendly.

Aeropostale (ARO)
* Though valued at 8.0x estimated earnings for 2011, the lowest in the sector, increased promotions on top of difficult margin comparisons is not a recipe for success.
* Seeing strong merchandise being offered by direct competitors and discounters.

Brian Sozzi
Wall Street Strategies