Highlighting the Large Upside Potential for Aeropostale

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Aeropostale ( ARO ) is a specialty retailer that sells casual apparel and accessories targeted toward teens and young adults. Aeropostale's stock has fallen from highs of around $30 during the middle of 2010 to about $18 in July 2011.  The stocks of many of Aerospostale's competitors, like American Eagle ( AEO ), Abercrombie & Fitch ( ANF ), Gap ( GPS ) and Urban Outfitters ( URBN ), have also declined in large part due to rapid increases in cotton prices that have compressed margins.

Our price estimate of $36.55 for Aeropostale is about double the market price.  We believe that two key drivers of Aeropostale's stock and our views on those drivers explain why our price estimate is so much higher than the market price.  Below we highlight these drivers in detail.

1.  Aeropostale's Revenue per Square Foot Expected to Increase

Revenue per square foot is an important metric to judge the performance of an apparel company.  As you can see from the chart below, Aeropostale's revenue per square foot has increased significantly during the recessionary period, even while the revenue per square foot of some competitors declined.

Aerospostale's pricing and marketing during the recession helped the company outperform competition and grow revenue per square foot.  We expect Aeropostale's revenue per square foot to continue to increase as the company continues to benefit from the brand awareness built during the recession.

If, however, Aeropostale's revenue per square foot were to decline back to pre-recession levels of about $545 per square foot, then that would translate to a $4-5 negative impact to the current Trefis price estimate for the stock.

2.  Aeropostale's EBITDA Margins Expected to Recover from High Cotton Prices

Rising cotton prices have have been one of the most significant reasons for the downward slide in the stocks of many apparel companies.  The impact has been particularly pronounced among those apparel retailers that serve customers at lower price points where the companies may be more reluctant to pass on the cost increases to customers.

Cotton Prices. Source: Index Muni

Cotton was at $0.77 per pound at the start of 2010 and peaked at $2.30 per pound in March 2011.  A prime driver for the cotton price increase was the drought in the Hubei province of China, a major cotton producing area, followed by government restrictions on exporting cotton out of India to safeguard domestic supplies and a devastating flood in Pakistan.

Cotton is a key input material for apparel retailers like Aeropostale and its sudden increase has led to margin compression.  Aeropostale's EBITDA margin for 2010 was about 18% in 2010 and it is expected that the profits will be lower in 2011, leading to a further fall in the margins to around 12%.

Cotton prices have already started to fall and we believe this trend will continue throughout most of 2011 as the normal supply of the crop from China resumes. Moreover, even if cotton prices were to remain high, this is an industry wide input cost that would eventually lead to Aeropostale as well as its competitors passing on costs to consumers.  In either case, the margin compression that is expected for 2011 and part of 2012 would be transitory.  Longer term, we believe margins will recover due to a combination of falling cotton prices and some costs being passed on to consumers.

Since our valuation for Aeropostale is based on cash flows expected over a long term horizon, our valuation is positively impacted by a forecast margin recovery.  Investors that are valuing the company by applying a valuation multiple to 2011 or 2012 EBITDA forecasts, figures that will  be temporarily depressed due to higher input costs, will end up with lower valuations for the company than us.

However, if we're wrong and Aeropostale's EBITDA margins continue to slide, there could be $8-9 of downside to our price estimate for the stock if margins were to reach 10% over our forecast period.

Summary of Downside Scenarios

Based on the downside possibilities we've highlighted above for both Aeropostale's revenue per square foot and EBITDA margins, the Trefis price estimate would be $22-25 if these scenarios were to materialize.  This still suggests meaningful upside to the current market price for Aeropostale.

See our complete analysis for Aeropostale's stock here



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: AEO , ANF , ARO , GPS , URBN

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