American Eagle Outfitters (AEO), Aeropostale, Inc. (ARO), Abercrombie & Fitch Co. (ANF): There’s Profit in Playing Out-of-Favor Fashion Retailers

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Value investors usually hunt for bargains in very unpopular areas. Out-of-favor fashion retailers, often some of the most disliked firms on Wall Street, can frequently be a lucrative hunting ground. When a clothier misses a trend, both customers and shareholders abandon it quickly. But it’s then, when the company is most abhorred, that its stock can have significant profit potential. Here’s why.

Why out of fashion can be attractive
History has shown that unpopular apparel retailers can turn themselves around, often quickly, for two main reasons. The first is that fashion changes rapidly. What’s in vogue now can be swiftly on the outs and what’s snubbed now may then become desirable. While it’s impossible to predict when a hot trend will end, it’s fairly easy to deduce that it eventually will and that profits will flow in much different circles than currently.

American Eagle Outfitters (AEO)

The second is that bad same-store sales numbers get easier to match or beat over time. Retail same-store sales, or sales for comparable stores open for more than a year, usually fall dramatically at a struggling retailer. However, these sales can typically be stabilized and, after a period of disappointing comparisons, a flat same-store sales result is achieved and usually taken as a sign of improvement. This increased optimism tends to boost the relevant shares.

Gap is one noteworthy example of an unpopular fashion retailer rebounding. After coming back from the 2008 financial crisis with its stock reaching around $25 in 2010, disappointing results forced the stock down to around $16 in mid-2011. At that time, most analysts and media pundits panned the company. After management undertook curative measures successfully, the shares ran up to near $30 within a year and recently topped $45.

What’s currently out of fashion
The Gap’s story is not unusual. Here are three apparel retailers that are currently out of favor. They are not only interesting from a value perspective, but have also shown an ability to recover from tough times.

American Eagle Outfitters (NYSE:AEO) is a specialty retailer with more than 1,000 stores in North America. The company disappointed in its latest quarter, reporting an earnings-per-share drop of over 50% with total revenue decreasing 2% and comparable sales falling 7%. Gross profits fell 11% due to higher markdowns and the negative comps.

Like Gap, American Eagle Outfitters (NYSE:AEO) has demonstrated a recovery from prior disappointments. In May 2011, after reporting a 17% decline in earnings per share and comparable-store sales falling 8%, American Eagle Outfitters (NYSE:AEO)’s stock dropped from around $14 to $10 by mid-year. But the company steadied the business and by the fall of 2012, its share price breached $24.

American Eagle Outfitters (NYSE:AEO)’s recent share price currently looks cheap but not yet a meaningful bargain. Using a cash earnings times a capitalization multiplier valuation, fair business value looks around $18 a share at a standard 14 times multiple. The calculation being based on revenue of around $3.6 billion, cash earnings of $256 million, and a cash profit margin of around 7.1%, compared to an 8.9% margin achieved in 2012.

Aeropostale, Inc. (NYSE:ARO) is a mall-based retailer principally targeting 14-to-17 year-old young women and men. Currently mired in a sales slump, Aeropostale, Inc. (NYSE:ARO) has shown it can turn things around.

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