Sector Spotlight: Abercrombie, American Eagle Flying High

Many of the nation's specialty clothing retailers have been swimming upstream against a tide of bad news, including unfavorable fashion trends, poor weather that soaked up March sales and a slowing economy.

Still, stock prices for many of the companies have done well, mainly on the hopes that interest rate cuts would jump-start consumers and expectations that the second half of the year would deliver strong gains in comparable-store sales. Same-store sales gauge activity in stores open at least a year and are a key metric for judging the health of retailers. But with that second half beckoning and no clear signs of a strong rebound in consumer spending, investors would be wise to pick and choose in the sector carefully.

After all, overall same-store sales in the sector posted their largest decrease in five-and-a-half years in March, off some 5.1% from the same month last year, according to the Lazard Freres Comparable-Store Sales Index. And the Gap (GPS Quote), once the benchmark for the sector, continues to disappoint investors with dismal sales figures, the latest being a fall of 8% in March that had analysts once again slashing earnings estimates.

A Few Good Men's Shops

Among analysts that follow the sector, two names pop up on virtually everyone's recommended list: teen-oriented retailers Abercrombie & Fitch (ANF Quote), which has quickly rebounded from its own Gap-like problems to once again become an investor favorite, and American Eagle Outfitters (AEOS Quote), which analysts say has made wise fashion decisions that have driven strong gains in same-store sales in recent months.

Jefferies analyst Eliot Laurence says Abercrombie is replacing Gap as the marquee name in the sector. "We remain convinced that this is a winning story," he wrote in a recent report. "The company is simultaneously fixing core businesses and managing [earnings]. ... With Gap remaining an iffy investment, we believe some investors will begin using Abercrombie as the apparel retailing proxy." Laurence rates Abercrombie a buy and has an accumulate on American Eagle, which, he notes in the same report, posted the strongest March same-store sales gains of any junior and young men's apparel retailers with a 5.3% gain. (Jefferies does not have a banking relationship with either company.)

Abercrombie's resurgence has attracted the attention of David Brady, a former retail analyst and manager of the $1.2 billion Stein Rowe Young Investor fund. "I think from a longer-term perspective they might have pushed their franchise too much and gotten stale about a year ago," he says. Although he doesn't own shares, he says, "Abercrombie is a name that does interest me."

Two Tracks

While American Eagle has enjoyed an almost steady ascent in its share prices since 1997, Abercrombie's attractiveness has ebbed and flowed. As recently as the past holiday season, it saw its sales fall far short of estimates, which forced the company to warn of a shortfall in quarterly earnings. However, in recent months, analysts have come to believe that Abercrombie is quickly moving past its problems, which stemmed from fashion missteps and bloated inventories.

Both companies stand a good chance of exceeding Wall Street earnings estimates in the coming quarters, analysts say, and despite a strong run in their share prices valuations, are still attractive.

Abercrombie shares are up an impressive 58% on the year, while American Eagle has risen 22%. Still, both are trading at multiples below their projected growth rates. Abercrombie trades at about 17.5 times forward earnings, with an expected five-year annual earnings growth rate of 20%, according to consensus estimates compiled by Thomson Financial/First Call. Meanwhile, American Eagle trades at about 21 times forward earnings, with a projected five-year growth rate of 25% annually.