Aeropostale Is Worth a Look, Not a Touch

Note that defensive profits are a fraction of enterprising and accrual profits. That's because Aeropostale's capital spending is three times its annual depreciation charge. In the defensive income statement, investment in fixed capital (i.e., capital spending minus depreciation) is immediately expensed because it's a use of cash. (I don't treat increases in operating leases as investments in fixed capital, but I know others that do. It's an intriguing idea.)

While Aeropostale is situated in the Earnings Power Box (see chart), we don't have enough financial information to know whether it's a Staircase because the company recently changed its fiscal year. (I tried jury-rigging the financials to compensate for the date change, but wasn't satisfied with the results.)

While you can make big bucks by owning growth companies like the ones featured on the Business Week list, don't forget these three risks: First, valuation. Companies with rapid sales and earnings growth tend to be expensive. Second, competitive advantage. Profitable companies attract competition, which can reduce margins and slow capital turn rates. Third, earnings quality. Just because a business is profitable in the accrual (i.e., GAAP) sense of the word doesn't mean it possesses authentic earnings power. (Enron (ENRNQ - commentary - Cramer's Take) is a case in point.)

Responding to these risks in reverse, our charts show last year's financial performance was bona fide. That's a positive signal in my book.

As for competition, the teen market is a crowded space. In addition to Aeropostale and Gap, the 11-to-20 age crowd can also spend their parents' money at Abercrombie & Fitch (ANF - commentary - Cramer's Take), American Eagle Outfitters (AEOS - commentary - Cramer's Take), Gadzooks (GADZ - commentary - Cramer's Take), Hot Topic (HOTT - commentary - Cramer's Take), Wet Seal (WTSLA - commentary - Cramer's Take), and Urban Outfitters (URBN - commentary - Cramer's Take). I'm sure others could be added to this list. All these competitors make me nervous.

Last, valuation. At $21, Aeropostale sells for 25 times accrual earnings (net income) and almost 6 times book. This is not a cheap stock.

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].