Teen apparel retailer Aeropostale’s (NYSE:ARO) stock has declined significantly over the past few months, falling by roughly 33% since July, 2012. The decline started after the company issued lower than expected Q3 2012 guidance in its Q2 earnings call. 
We, however, believe that the steep decline is an overreaction and that the company is undervalued at its current price. Here are two reasons why we believe that Aeropostale is worth at least 50% more than its stock price suggests. Our price estimate is near $24.
While Aeropostale’s comparable sales growth were flat during Q2 fiscal ’12, the company seems to be working hard on improving its product mix. One of the primary reasons we believe that Aeropostale’s Q2 comps were disappointing was due to aggressive promotions by competitors such as American Eagle Oufitters and Gap Inc rather than Aeropostale’s faltering product mix as had been the driver behind its decline in mid-2011.
Aeropostale’s core customer continues to respond positively to the newness in silhouettes, fabrics and details. In Q2, the company experienced strong sell-throughs in key categories such as fashion tops, colored and printed denim, wovens and accessories. We expect Aeropostale’s revenues per square foot to improve, particularly for the upcoming all-important holiday season.
Additionally, the company is also implementing new processes and investing in new technologies that will enable it to chase bestsellers and increase its speed to the market. We believe these steps should help the company better capture current fashion trends and decrease the lead time in bringing new products to its store shelves.
Long-term recovery in margins
Although we expect Aeropostale’s margins to remain depressed for the near future due to the existing promotional environment in the teen apparel market, we believe, the market seems to have taken a short-term view on margins. We are less bearish on Aeropostale than the market as we expect the company’s margins to improve on a long-term basis.
Cotton prices have already declined to $0.84 per pound in August 2012, and the trend is expected to continue going forward. As cotton is a key input for apparel retailers, we expect Aeropostale’s margins to benefit from declining cotton prices. Aeropostale’s tight control on its inventory levels should also be an added factor in the long-term improvement of its margins. Additionally, an increase in Aeropostale’s direct revenues is also expected to provide further tailwinds to its margins as direct sales carry higher margins compared to retail sales.Notes:
- Aeropostale declines after lower than expected Q3 guidance, Source: Nasdaq [↩]