Is It Time to Buy Some Out-of-Favor Teen Retailers?

While economic uncertainties continue to cast dark clouds over the American consumer, the teen retail sector has been holding up better, on average, than some of the more discretionary retailers we cover. In this article, we review August sales results and discuss our outlook for teen retailers for the remainder of the year. We also highlight three stocks in the industry that are currently undervalued, in our view, and why we still like them despite these uncertain times.

Back-to-School Results
Teen retailers reported mixed but generally weak August same-store sales, or revenue at stores open for at least 12 months. August is a particularly important month for teen retailers because it includes the bulk of the back-to-school selling season. The decline in existing store productivity is worth monitoring, but it was not unexpected considering the overall slowdown in consumer spending and its negative effect on industrywide apparel sales.

Teens are facing a number of challenges in this anemic retail environment. In addition to higher gas and food prices, they're competing for jobs in a weak part-time employment market. Northeastern University's Center for Labor Market Studies estimates that roughly 34% of teens had jobs this summer, down from about 45% in 2000. They're also making due with smaller contributions from parents, who provide a sizable portion of teen spending money. These circumstances have forced teens to make decisions on how they use their limited budgets. Apparel must now compete with cell phones, gaming devices, and music downloads.

At Morningstar, we follow five of the largest specialty teen retailers:  Abercrombie & Fitch (ANF),  Aeropostale ,  American Eagle Outfitters (AEO),  Pacific Sunwear , and  Zumiez (ZUMZ). Each of these retailers has a national presence, and together they provide a good proxy for teen apparel spending trends, in our view. We estimate that these five retailers account for roughly 38% of the fragmented retail apparel market for 13-17 year olds. This demographic has significant spending power worth about $27 billion per year, or roughly 14% of the total apparel market, according to NPD.

August results highlighted the volatile and unpredictable nature of this industry. The top performer, Aeropostale, posted an impressive 13% jump in same-store sales, while Abercrombie & Fitch posted an 11% decline. Interestingly, Abercrombie & Fitch handily outperformed Aeropostale during August in each of the previous three years. Such is the life of a teen retailer.

August Same-Store Sales
	2005	2006	2007	2008
Abercrombie & Fitch (ANF)	24%	6%	6%	-11%
Aeropostale	1%	3%	2%	13%
American Eagle (AEO)	12%	11%	9%	-5%
Pacific Sunwear	3%	-9%	10%	-6%
Zumiez (ZUMZ)	9%	5%	17%	0%

This year, we believe Aeropostale is benefiting from consumers "trading down" to less-expensive merchandise. Aeropostale is one of the most promotional teen retailers, and its prices are typically 20%-40% lower than many of its competitors. Alternatively, Abercrombie & Fitch focuses on a premium-pricing strategy that gives its merchandise aspirational appeal. We think both pricing strategies can be effective over the long term if properly executed. In our opinion, the recent sales slowdown at Abercrombie & Fitch is mostly due to the challenging macro environment, rather than merchandising missteps.

Our Outlook for Teen Retailers
The retail environment isn't showing any signs of a quick recovery, and we anticipate most teen retailers will be more promotional this holiday season. Given its value pricing strategy, Aeropostale should continue to post industry-leading sales results over the next few quarters. In our opinion, the market has already priced this into Aeropostale's shares.

However, Aeropostale's future popularity is uncertain at best. Last year's coolest trend can be this year's fashion faux pas, and cashing in on rapidly changing consumer tastes could prove to be difficult. Brands can quickly gain and lose popularity, and teens may eventually decide to trade up to pricier labels. We anticipate that financial results for Aeropostale, as well as its competitors, will continue to be volatile going forward.

What We Like about Teen Retailers
For starters, teen retailers typically require little capital investment. They rarely own their own real estate or operate costly manufacturing facilities. Merchandise is almost entirely sourced from cost-efficient suppliers overseas. And because teen retailers generate plenty of cash, there is little need for outside financing, so most don't carry any long-term debt.

When merchandising is on trend and sales are growing, this business model yields high lease-adjusted returns on invested capital, often exceeding 20% according to our estimates. When merchandising is off the mark, it can usually be adjusted in time for the next major selling season. Plus, impressionable youngsters with money to spend enter the prime demographic each year, so retailers have the opportunity to reinvent themselves for each new batch of consumers. Customer switching costs are low, but a popular brand (often prominently displayed on the merchandise) can grow exponentially thanks to the herd mentality of many teenage shoppers. In a sense, this phenomenon acts like a short-term, but powerful, network effect.

Although teen retailers are not recession-proof, we think they tend to be more resilient in tough economic times given that youth apparel is less discretionary. We think that helps explain why August same-store sales in the teen retailing sector fell just 2.6%, according to Thomson Reuters, compared to a 6.3% drop on average for department stores, which cater to a broader demographic. History has shown that teens will buy trend-right clothes in almost any environment. Furthermore, parents are more likely to curb personal expenses in difficult times, rather than cut back on their children's wardrobe allowances. According to NPD and our estimates, spending on teen apparel has increased faster than spending on total apparel for at least the last two years. We think demographic trends (driven by echo-boomers) have benefited teen retailers over the last several years. According to the U.S. Census Bureau, the teenage population is estimated to grow at a slightly slower rate over the next few years.   

Valuing Teen Retailer Stocks
Positive same-store sales suggest a retailer is healthy and able to boost revenue without having to rely on new store expansion. Negative same-store sales, on the other hand, can imply that a retailer is struggling to match past performance. When sales are growing, profit growth tends to follow, often at a quicker rate because fixed costs (like salaries and rent) are spread out over a larger revenue base. When sales are falling, profit margins can evaporate quickly. The market understands this relationship and is often quick to punish retailers that miss sales expectations.

Same-store sales can be impacted by a number of factors--including merchandising, fashion trends, calendar shifts, promotional activity, competitor actions, and even the weather. With so many moving parts, it's not surprising that store productivity tends to be quite volatile from month to month--and consequently, so do share prices. Given this uncertainty, we require a larger margin of safety for teen retailers than we do for some of our more diversified clothing retailers, and we give each teen retailer a high uncertainty rating.

But we think this volatility can also provide investors with attractive buying opportunities when otherwise solid retailers have an off month or quarter. At Morningstar, we take a long-term approach to valuation. Our fair value estimates are based on a discounted cash-flow model that projects future cash flows over the estimated life of a business. Given our long-term focus, our fair value estimates are less influenced by short-term performance measures like monthly same-store sales results.

Below we've highlighted three top-quality teen retailers that we think are trading at deep discounts to our fair value estimates. In our opinion, the market's near-term concern over the consumer spending environment has overshadowed the fundamental strength of these companies. We believe these retailers are well-positioned to succeed over the long term.

Top of the Class

 Abercrombie & Fitch
We think Abercrombie & Fitch has separated itself from its teen retail peers through its highly sought after brand and unmatched ability to capitalize on ever-changing youth fashion. Furthermore, Abercrombie has demonstrated a knack for creating successful and relevant new retail concepts (like Hollister). For these reasons, we think Abercrombie is the only teen retailer with a narrow economic moat.

We're particularly excited about the growth potential of Abercrombie's newest retail concept, Gilly Hicks, which specializes in lingerie and accessories. In addition, Abercrombie's popularity in the United Kingdom and Canada gives us confidence that the concept will be successful in other international markets, such as Japan and Denmark, where stores are expected to open in 2009.

 American Eagle Outfitters
While American Eagle has struggled with merchandising lately, we think it is taking the right steps to cut down on fashion missteps that have led to costly markdowns. We like that the retailer is leveraging its size and reinvesting its ample free cash flow to conduct extensive market research, remodel stores, upgrade inventory-management systems, and form marketing partnerships with media outlets like Teen Vogue and  Viacom's  MTV. These strategic moves should help keep American Eagle a fashionable yet affordable alternative to retailers like Abercrombie & Fitch.

We're also optimistic about the growth prospects of aerie, a lingerie and casual apparel line, and we estimate the company will open about 80 of these stand-alone stores in 2008. We think aerie has the potential to expand into a 500-store chain during the next several years.

 Zumiez
Zumiez has quickly emerged as a leading teen apparel retailer. Although the chain has been around since 1978, it only recently began to expand beyond its home turf on the West Coast. Zumiez has added about 200 stores during the last five years, bringing its total to more than 300 stores in about 26 states. We believe Zumiez is entering the sweet spot of its growth cycle and has the potential to become an 800-store chain within the next decade.

As Zumiez has grown, it has remained quite popular among young consumers, as evidenced by impressive trends in store productivity; same-store sales have been positive in all but two years of operation (including a slight estimated decline in 2008). Zumiez has differentiated itself from other teen retailers by replicating the store environment of an independent action sports retailer and offering a wide selection of hardgoods, including skateboards and snowboards. We think this strategy has helped Zumiez gain credibility with its customers and take market share from rival Pacific Sunwear.