One of the primary rules of investing is having a thorough knowledge of the business model of your planned investment. This is one of the major reasons why I like the retail sector. It is not abstract and is very intuitive. You can walk into a mall and see the retailers you own in operation, visualize the supply chain and the factors that would affect the business.
As an example, during this recession American Eagle (AEO) and Abercrombie & Fitch (ANF) employed two contrasting approaches in their day to day operations. With a view of controlling its inventory, American Eagle resorted to massive markdowns. Contrarily, Abercrombie & Fitch was more concerned about protecting its brand value and did not resort to promotional events and sales. By walking into a mall, one could see this strategy in operation. When the two firms reported their financial results, it was no surprise that margins at American Eagle fell by approximately 1,000 bps compared to the 400 bps fall in margins at Abercrombie and Fitch.
In this article, I will compare the valuations of three major apparel retailers, namely American Eagle, Abercrombie & Fitch, and Aeropostale (ARO). The table that follows summarizes the basic information for these companies:
Company Fundamentals
| AEO | ANF | ARO |
Market Cap (Millions) | $2,920 | $2,330 | $2,272 |
Sales (Millions) | $2,989 | $3,540 | $1,885 |
Income (Millions) | $179 | $272 | $149 |
Net Profit Margin | 6% | 8% | 8% |
Return on Equity | 13% | 16% | 54% |
P/E | 16 | 9 | 15 |
Projected 5 Year Growth Rate | 12% | 15% | 15% |
Forward PEG | 1.26 | 0.92 | 0.95 |
LT Debt to Cap | 0% | 5% | 0% |
% Price Change YTD* | 49% | 16% | 117% |
* - Through May 7, 2009
As shown in the table above, the three companies have a similar market capitalization and have little to no long term debt. Further, they are expected to grow at a similar rate. The major negative for these retailers is the fact the industry is highly competitive. Due to competition, these companies have faced margin erosion and this could weigh in on their long term growth.
The EPS estimates for the three companies are shown in the table that follows:
| AEO | ANF | ARO |
TTM EPS | $0.86 | $3.05 | $2.21 |
2011 Average EPS Estimate | $0.92 | $1.92 | $2.47 |
Valuation
Relative valuation was performed for the three retailers using the 2011 average analyst EPS estimates. The fair value was calculated using the average P/E, the ratio of average P/E to average P/E of the peer group, and the ratio of average P/E to the average P/E of the S&P 500 index. This is presented in the table that follows. It should be noted that the data from the last four financial years was taken in calculating the averages shown in the table.
| AEO | ANF | ARO | |||
Average | Estimate | Average | Estimate | Average | Estimate | |
P/E | 13 | $13 | 15 | $28 | 16 | $40 |
(P/E) / (P/E – Peers) | 0.80 | $11 | 0.80 | $23 | 0.92 | $35 |
(P/E) / (P/E – S&P 500) | 0.74 | $11 | 0.77 | $25 | 0.86 | $36 |
The Call:
American Eagle
I am initiating coverage of AEO with a SELL rating and a 12-month price target of $11. At these levels, AEO would be trading at a P/E of 12, which is modestly below its historical average. This reduction in P/E is warranted due to the stock's below average fundamentals.
Abercrombie & Fitch
I am initiating coverage of ANF with a HOLD rating and a 12-month price target of $29 derived by applying a multiple of 15 to the 2011 analyst average estimates.
Aeropostale
I am initiating coverage of ARO with a BUY rating and a 12-month price target of $40. At these levels, ARO would be trading at its historical average multiple.
Disclosure: The author was long AEO at the time of posting. He will sell his position in AEO three days after this blog is posted.
You can follow the performance of these stocks and all other stocks that I cover on the following page.
