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L Brands Inc (LTD), The Gap Inc. (GPS), Abercrombie & Fitch Co. (ANF): Three Attractive Stocks in the Apparel Business

Limited Brands calls look for near-term rallyThe apparel retail arena is highly contested. Three major worldwide players, L Brands Inc (NYSE:LTD), The Gap Inc. (NYSE:GPS) and Abercrombie & Fitch Co. (NYSE:ANF), offer interesting investment opportunities and are trading at reasonable price-to-earnings ratios while offering substantial dividend yields. Let’s take a closer look at these firms and try and decide whether they are worth our trust or not.

A catching brand

This retail giant is known worldwide for its The Gap Inc. (NYSE:GPS), Banana Republic and Old Navy clothing and accessories brands. Despite its financial strength, profitability, and growth history, I, like Zacks, would recommend holding The Gap Inc. (NYSE:GPS)’s stock. This view is principally on account of the intense competition from newer specialty retailers and some merchandising errors that have led to five years of revenue declines and flat or negative comps (except for 2010’s 1% upsurge).

However, these mistakes are being rectified by a new merchandising strategy that has garnered encouraging early results over the last 12-to-18 months. As stated by Morningstar analysts:

If management continues to improve merchandise and inventory turns while growing the operating margin through supply chain improvements and increasing higher-margin international and e-commerce sales, Gap may be able to compete better with fast-fashion retailers like H&M, which may help it regain its core consumer and attract a new audience, while remaining loyal to its traditional Western fashion focus.

So, keeping an eye on this stock for a future buy is not a bad idea.

Additional concerns about The Gap Inc. (NYSE:GPS)’s risk package lead me to believe that holding is the best thing to do at the moment. Namely, these worries are:

1.) A high exposure to the volatility in commodity prices, especially cotton and labor

2.) Rising inventory levels that will most likely impact on the firm´s margins

3.) Exposure to weak markets, like Europe, where customers’ spending capabilities are highly limited by austerity measures

4.) Susceptibility to oscillations in foreign currencies, as it operates in multiple locations outside the U.S.

5.) Limited spending capacity for discretionary items (like apparel) in the U.S. bolstered by a high unemployment rate

Notwithstanding, as consumer spending capabilities increase, the industry is starting to recover. Gap will probably lead the sector due to its strong brand recognition and revenue growth. For now, I would hold Gap while still keeping it on my stock shortlist, especially as an operating margin of 12.4% and return on equity of 39.2% rank considerably above the industry median.

A stock to keep an eye on

Just like Topeka Capital analyst Dorothy S. Lakner said, although Abercrombie & Fitch Co. (NYSE:ANF) seems to be headed in the right direction, I would hold this stock, at least until expense initiatives for the 2013 fiscal first quarter are revealed.

The opinions regarding this company are pretty divided among equity analysts. While Morningstar and Barron’s recommend overweight positions in this stock, Zacks advises holding. I will incline for this last opinion because comps have been declining over the past two years and have been attaining negative results for four consecutive quarters now. This trend is expected to continue as company projections for the 2013 Q1 call for high single-digit comp drops.

Similarly to The Gap Inc. (NYSE:GPS)´s case, macroeconomic headwinds, like the aforementioned unemployment issue in the U.S., could strongly affect Abercrombie & Fitch Co. (NYSE:ANF)´s earnings. In particular, the unemployment rate for 16-to 19-year olds, which has persistently been in the mid-20% range, considerably constrains spending among the company´s main demographic

The firm is highly exposed to political, social and economic fluctuations as it operates (both manufactures and sells) in several overseas markets.

However, a wise investor should also keep an eye on Abercrombie & Fitch Co. (NYSE:ANF)‘s stock as growth prospects begin to ameliorate. Its last reported quarter produced diluted earnings of $1.82 per share, up 727% year-over-year, and 109% from the previous quarter. FY 2013 EPS growth is projected at more than 17% too.

This improvement is most likely to continue for several reasons. Most importantly, like Morningstar´s Jaime M. Katz assures, a  “..certain allure remains around the company’s namesake brand, which will likely make it more resilient through fashion cycles as long as strict inventory management prevails.

Despite improving gross margins that reached 63% in Q4, beating The Gap Inc. (NYSE:GPS)´s 39%, I would recommend holding on this stock, at least until 2013 Q1 results are revealed by mid-May.

A market leader

I once heard that “there´s nothing limited about L Brands Inc (NYSE:LTD),” especially not its growth prospects. Although I am not sure this company’s stock is a definite buy, I would advise an overweight position, inline with Barron’s and Morningstar’s recommendations, especially for those interested in long-term returns.

Morningstar specialists expect another 5-to-10 years of L Brands Inc (NYSE:LTD)’ leadership in the segments in which it operates. This positive outlook is generated by both strong financial results and the company’s efforts to downsize and refocus on its higher-margin specialty-retail business.

As owner of Victoria’s Secret and Bath & Body Works, both sector-leading brands, among other smaller businesses, this $10 billion company targets the high-end market segment with its quality products while still offering reasonable prices to the public. Consequently, its stores have retrieved considerably good results even through a sluggish economy, with sales volumes that more than double the U.S. average.

Also central in keeping the company profitable are management initiatives for cost containment and inventory administration. Furthermore, the careful, strategic approach to expansion has certainly reduced the company’s risks in its overseas operations, providing consistent and sustainable growth.

Moreover, new product offerings helped to boost Victoria’s Secret and BBW’s comps by 3% and 7%, respectively, in 2012. Additional efforts to overhaul its La Senza brand worldwide have retrieved positive results, as comps for January grew 15%.

As a result of all these factors, the company retrieved better-than-expected results for Q4 2012. Earnings of $1.76 per share beat the Zacks’ consensus estimate of $1.74 for the 10th consecutive quarter, offering an increase of 17.3% year-over- year.

While offering the highest operating margin (15%) and return on capital (92.7%) in its history, L Brands Inc (NYSE:LTD) trades at a 19.9 x P/E. Although slightly above the 18.9x industry average, you should consider paying a premium for this stock, as forward P/E is projected at 15.6x (Morningstar), implying a 27.5% growth in EPS during FY 2013.

Bottom line

Limited discretionary spending power is certainly a matter of concern when considering investing in apparel retailers. Although all of the above analyzed companies offer relatively positive outlooks, I would recommend holding these stocks until the market shows further signs of normalization. I would say wait, but if you need to put your money down somewhere, I believe I would go for L Brands Inc (NYSE:LTD).

The article 3 Attractive Stocks in the Apparel Business originally appeared on Fool.com and is written by Victor Selva.

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