Raw Materials Are Squeezing Aeropostale

Aeropostale ( ARO ) is a specialty retailer that sells casual apparel and accessories targeted toward teens and young adults. Aeropostale's primary competitors include American Eagle ( AEO ), Abercrombie & Fitch ( ANF ), Gap ( GPS ) and Urban Outfitters ( URBN ). Aeropostale designs, markets and sells its own brand of merchandise through its retail stores as well as through the Internet and catalogs sales channel, which accounts for 16% of our price estimate.

Internet & Catalog Carrying Sales Growth

Aeropostale reported mixed fourth quarter and full year results last week. Though net sales for the fourth quarter increased by 5% as compared to the same period last year, comparable store sales for the period decreased by 3%. The increase in sales was largely driven by increase in Internet & catalog orders sales, which was up 21%.

For the full fiscal year 2011, the net sales increased 8% to $2.4 billion with comparable store sales increasing 1% and internet & catalog orders sales increasing 24%.

Increasing cotton prices towards the end of last year had an impact on the company's profitability as full year operating margin dropped by 110 basis points. The impact was more visible in the fourth quarter, where a significant fall in merchandise margins brought down the operating margin by nearly 300 basis points.

Raw Materials Inflation Taking its Bite

The increase in cost of key raw materials like cotton, fuel and overseas labor had an impact on the whole supply chain as clothing retailers were not able to offset cost increases. In addition, consumer spending has been slow to pick up, and Morgan Stanley estimates that apparel sales volumes could fall 2.2% this year if prices rise 4%.

Last year, Aeropostale also lost market share as a result of price cuts by some of its more up market rivals in the aftermath of the recession. To offset this, the company resorted to deep discounting that further impacted its merchandise margins. However, with further increases in raw material costs expected this year, the company is planning to increase prices on some of its products. But, to increase its competitiveness, it plans to improve its assortment as compared to last year, when some of its assortment missed prevailing fashion trends.

Aeropostale's revenue per square foot has been increasing since 2005 and we expect this trend to continue. Specifically, the company added significant market share and brand value during the recent economic crisis, and we expect the company to build on this. See the chart above for our estimates.

We estimate that the EBITDA margin for Aeropostale Stores increased from around 10% in 2005 to 19% in 2009. In 2010, we estimate ticked down slightly to just under 18% largely a consequence of increasing raw material costs and increasing competition limiting the ability of Aeropostale to increase prices, especially as it relies on a promotional strategy. However, we expect margins to recover slightly and stabilize around 19% by the end of our forecast period.

However, there can be a downside to our forecasts, if there is an extended period of increasing raw material prices and weak consumer spending. These events would further intensify competition among clothing retailers leading to more discounting to offload inventory.

If the EBITDA margin falls to 16% by the end of our forecast period, it would mean a downside of around 10% to our current price estimate for Aeropostale's stock.

See our estimates for Aeropostale

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

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

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