Can Aeropostale’s Margins Revive?

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ARO: Aeropostale logo
ARO
Aeropostale

With only basic products such as logo t-shirts, jeans and hoodies in its portfolio, teen apparel retailer Aeropostale (NYSE:ARO) has had a difficult time in attracting customers. As the U.S. economy started recovering, the retailer found it extremely hard to keep customers interested in the brand due to the absence of a compelling fashion range. In order to drive store traffic and clear-off unsold inventory, Aeropostale has been relying heavily on promotional discounts, that have driven its margins into the ground.

The retailer’s EBITDA (earnings before interest tax depreciation and amortization) margins stumbled from 25.7% in 2010 to 15.5% in 2011, primarily due to a sudden rise in cotton prices owing to floods in major cotton producing areas, that troubled the entire apparel industry. While many players recovered from the impact of cotton price rise in 2012, Aeropostale’s margins further declined to 13.9%, as it continued to offer heavy discounts across its product range. In 2013, low brand loyalty and sluggish consumer spending forced the retailer to usher heavier markdowns in order to sustain an adequate amount of store traffic. As a result, Aeropostale’s margins crashed to 6.3%.

While we do not expect Aeropostale to relive its glory days, we do expect marginal recovery in its EBITDA margins going forward. The retailer has been closing a number of its under-performing stores, which will help it reduce operating expenses as percentage of revenues. This will ultimately have a positive impact on its EBITDA margins. Also, the company has launched a few fashion collections lately, that have driven its average prices (also known as average unit retail) slightly upwards. If Aeropostale is able to attract sufficient amount of customers with its slightly expensive products, its gross margins can improve. However, the company cannot go too high on product prices because U.S. buyers associate Aeropostale with affordability rather than design.

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Our price estimate for Aeroposatle is at $8.32, implying a premium of over 150% to the current market price.

See our complete analysis for Aeropostale

Reducing Mainline Store Count can Improve Profitability

Aeropostale stores are mainly located in shopping malls, where foot traffic has been weak over the past several quarters on account of weak consumer confidence. Moreover, shoppers have eluded the brand’s basic logo products in search of more fashionable merchandise offered by other retailers such as Gap Inc (NYSE:GPS) and Urban Outfitters (NASDAQ:URBN). Since the company hasn’t been able to drive sufficient store traffic, it is shutting down stores that do not generate significant revenues in order to cut operating expenses.

The company has accelerated the closure of its under-performing namesake brand stores to improve its overall store productivity. At the start of 2013, the company had planned to close about 15-20 stores by the year-end, but it increased this figure to 30-40 half way through the year. In Q4 alone, Aeropostale shut down 29 stores and it closed another 18 in the first quarter of 2014. Over the next several years, the retailer plans to close a total of 175 stores in the U.S., which will bring the store count down to around 750.

Closing stores that do not generate significant traffic can help Aeropostale eliminate operating expenses associated with them. Since these stores generate fewer revenues than other Aeropostale stores, but account for similar store operating expenses, their closure will help the company reduce SG&A expenses as a percentage of net revenues. This will have a positive impact on its operating margins.

Higher AUR (Average Unit Retail) can Result in Better Gross Margins

During its Q1 2014 earnings call, Aeropostale stated that its new fashion collections such as Bethany MotaLive Love DreamTokyo Darling, and Free State have been performing very well. Due to the strength of these product lines, the retailer’s average unit retail registered its first growth in the last seven quarters despite a highly promotional environment. If the company is able to sustain its prices at this level, we can expect slight recovery in gross margins going forward. However, Aeropostale needs to be extremely careful with its pricing strategy as expensive products can easily drive customers away. 

Buyers usually shop at Aeropostale for inexpensive t-shirts and jeans, while they go to retailers such as Urban Outfitters and Gap Inc for more trendy and eclectic products. Aeropostale’s customers do welcome fresh fashion but not if it comes with a premium price tag. This is the reason why the retailer’s fashion launches have failed in the past. Hence, the company cannot go too high on its average prices as it runs the risk of losing customers. Therefore, its gross margin recovery will only be marginal, but it will still be positive.

What’s the Significance of this Metric?

Our price estimate for Aeropostale is highly sensitive to its EBITDA margins. We currently forecast Aeropostale’s EBITDA margins to improve gradually from 6.3% in 2013 to 11% over the next five-six years. However, if the company’s aggressive promotional strategy continues to weigh on its operating profits, limiting the EBITDA margin recovery to 10%, there can be 10%-15% downside to our price estimate. On the flip side, if aforementioned factors yield better than anticipated results, pushing the figure to 12% towards the end of our forecast horizon, there can be about 10% upside to our price estimate for Aeropostale.

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