With cotton prices having declined 18% over the last two months, margins of value-focused apparel retailers such as Aeropostale (NYSE:ARO) and Gap Inc. (NYSE:GPS) are expected to increase. Cotton is a key input for apparel retailers and a sudden spike in cotton prices in 2011 resulted in the Average Unit Cost (AUC) increasing significantly for apparel retailers across the board. This resulted in lower margins for both Aeropostale and Gap.
Chart: Cotton prices over time
Cotton prices expected to decline further
The price of cotton was at $0.84 per pound in July 2010 and peaked at $2.30 per pound in March 2011.  The major driver behind the increase in cotton prices was the drought in the Hubei province of China, a major cotton producing area. Additionally, government restrictions on exporting cotton out of India to safeguard domestic supplies and a devastating flood in Pakistan also drove up prices.
Value-focused apparel retailers such as Aeropostale and Gap were impacted significantly because they were unable to pass the costs onto consumers unlike premium retailers such as Abercrombie & Fitch and Ralph Lauren.
As seen in the cotton price chart above, prices as of June 2012 have fallen back to 2010 levels. Prices are expected to decline even further as production from China and Pakistan are expected to be high going forward. 
We believe that both Aeropostale and Gap should realize the benefit of declining cotton prices in the coming quarters and thus should improve their margins. Additionally, improving consumer confidence and fewer promotions should also contribute to higher margins.Notes: