American Eagle Outfitters (NYSE:AEO) plunged recently after the teen apparel retailer reported a sour second-quarter forecast that fell woefully short of analyst expectations. American Eagle’s weak earnings are a dire warning for the rest of the teen apparel industry, since the company had fared slightly better than its troubled peers, such as Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO), over the past year. Should investors stick with these three companies, or are their stock prices set to melt together in the summer heat?
A sad second quarter ahead
For its second-quarter earnings, which will be fully reported on Aug. 21, American Eagle Outfitters (NYSE:AEO) warned that it would only earn $0.10 per share, less than half of the $0.21 per share that analysts had expected. Revenue fell 2% year-on-year, while same-store sales, including its direct-to-consumer channel, AEO direct, plunged 7%. Analysts had expected flat revenue from the prior year quarter.
What this means for the teen apparel industry
To understand why American Eagle Outfitters (NYSE:AEO)’s results dragged down Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO), which fell 4% and 2.3%, respectively, after its second-quarter warning, we should look back at last quarter’s top line growth.
| Revenue Growth (y-o-y) | Same-Store Sales Growth (y-o-y) | |
| American Eagle Outfitters | -4.1% | -5% |
| Abercrombie & Fitch | -8.9% | -15% |
| Aeropostale | -9.0% | -14% |
Source: Yahoo Finance, Aug. 7, 2013
During the first quarter, American Eagle Outfitters (NYSE:AEO) fared much better than Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO). A fundamental comparison of these three companies shows that although Abercrombie & Fitch can be considered the cheapest from a traditional PEG and P/S perspective, American Eagle looks the healthiest, thanks to its more robust margins.
| 5-year PEG | Price to Sales (ttm) | Operating Margin | Profit Margin | |
| American Eagle Outfitters | 1.19 | 1.12 | 12.49% | 6.39% |
| Abercrombie & Fitch | 0.98 | 0.91 | 8.73% | 5.67% |
| Aeropostale | 4.06 | 0.50 | 2.37% | 0.52% |
Source: Yahoo Finance, Aug. 7, 2013
Unfortunately, those margins will likely be much lower in the second quarter, considering the company’s comments about using increased promotions to drive sales. That’s the same slippery slope that Aeropostale, Inc. (NYSE:ARO) slid down over the past several years, and it’s a very tough decline to climb back from, as seen in the following chart.
The reason is simple — once a brand becomes cheaper, shoppers expect it to stay that way. In addition, a common consensus in the retail apparel industry is that “large logo” apparel, commonly associated with Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO), is no longer popular with teen shoppers, who have since moved on to the trendier fashions of Forever 21 and H&M.
Failing to mind the Gap
A lesson that American Eagle Outfitters (NYSE:AEO), Abercrombie & Fitch Co. (NYSE:ANF), and Aeropostale, Inc. (NYSE:ARO) constantly neglect is The Gap Inc. (NYSE:GPS)’s tiered pricing system. Gap is the parent company of its namesake brand, Old Navy, Banana Republic, Piperlime, and Athleta. Its three primary brands — Old Navy, Gap, and Banana Republic — are respectively aimed at lower-end, mid-range, and high-end shoppers.
American Eagle Outfitters (NYSE:AEO), on the other hand, only has two main brands: its namesake brand and Aerie, which sells intimate apparel and swimsuits for young women. Last quarter, same-store sales at American Eagle fell 4%, but they rose 6% at Aerie. While operating two distinctly different stores reaches a wider demographic, it doesn’t solve the problem of pricing. One of The Gap Inc. (NYSE:GPS)’s core strengths is its ability to maintain pricing power — if shoppers feel like an outfit at Banana Republic is too expensive, they can always go to Gap instead. As a result, Gap reported operating and profit margins of 13.1% and 7.8%, respectively — higher than American Eagle, Abercrombie & Fitch Co. (NYSE:ANF), or Aeropostale, Inc. (NYSE:ARO).
Abercrombie has a similar problem, since its three core brands — its namesake stores, Hollister, and Abercrombie Kids — appeal to different shoppers in different demographics rather than shoppers in different price tiers. Aeropostale, Inc. (NYSE:ARO) also followed Abercrombie & Fitch Co. (NYSE:ANF)’s example, by adding a children’s brand, P.S. from Aeropostale, in 2009.
Moreover, The Gap Inc. (NYSE:GPS)’s same-store sales rose 7% in June, a clear indication of improvement from the first quarter, when the retailer’s same-store sales rose 2%. Investors have also noticed this divergence, as seen in Gap’s share price growth compared to its industry peers over the past five years.
A Foolish final thought
American Eagle Outfitters (NYSE:AEO)’s second-quarter forecast is a bleak sign of things to come for the teen apparel industry. Teen shoppers are a notoriously fickle demographic, and if American Eagle is going down, then Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO) are sure to follow, so it would be prudent to avoid the teen apparel sector completely.
However, The Gap Inc. (NYSE:GPS) could continue rising throughout the rest of the year, based on its positive monthly same-store sales growth. Investors should watch Gap’s July same-store sales release on Aug. 8 for further confirmation of that uptrend.
In closing, American Eagle Outfitters (NYSE:AEO) needs to distance itself from Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO) to revive its top and bottom line growth. If American Eagle can tap into some strategies used by The Gap Inc. (NYSE:GPS) (tiered pricing) and H&M (lower prices, faster rotation), it could still turn things around, since it hasn’t fallen as far as Abercrombie and Aeropostale yet. However, investors should avoid American Eagle for now, since the stock’s downtrend could continue for several more quarters.
Leo Sun has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Should You Stick With This Teen Apparel Retailer? originally appeared on Fool.com.
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