Retail Rally Clothed in Denim
Young America's love affair with denim is helping to drive the stellar sales results that have recently been the rule at teen-targeted specialty retailers.
Teen spending trends are brutally cyclical on Wall Street, but with this fashion cycle in full swing and discretionary spending on the mend, the blowout sales reported for February brought the winning streak for many chains to a year or more.
Last month's sales gains posted by the likes of
American Eagle Outfitters
(AEOS)
,
Aeropostale
(ARO)
and
Pacific Sunwear
(PSUN)
caught analysts off guard, sending prognosticators into a tizzy.
American Eagle proved that its preppy stylings are still in favor by more than doubling growth estimates, logging a 32.4% jump in same-store sales compared with last year. Aeropostale reported a 13.4% gain, more than six times its estimate, and Pacific Sunwear doubled its own target with a 10.5% increase.
The list goes on.
Abercrombie & Fitch
(ANF) - Get Report
posted a 19% gain in same-store sales, and
bebe stores
(BEBE)
posted a 25.3% gain. Even
Hot Topic
(HOTT)
, the alternative-style chain that has been said to be falling out of favor with youngsters, posted a small gain after analysts predicted a loss.
To be sure, February was a winning month for nearly all retailers. Only a handful of companies posted lower-than-expected sales, while the vast majority beat estimates. But these specialty teen apparel chains remain a clear standout, and analysts say they appear to be riding a strong denim trend that is showing unusual endurance.
"We are in a denim cycle that is much broader and deeper than any of us had imagined for both men and women," said Andy Graves, a retail analyst with Pacific Growth Equities. (He does not own any stocks mentioned herein, and his firm does not do any investment banking). "Furthermore, you can wear just about anything with denim, but jeans tend to be dark, so they call for brighter, more colorful tops. So, the strong denim cycle is drawing a lot of top business as well."
Along with fashion trends, Graves said that these teen apparel retailers are finding new strength in early spring due to mild weather in many parts of the U.S. He also believes rising interest rates are steering spending away from big-ticket items, like cars, furniture and large appliances that tend to be bought on credit, toward discretionary items.
"This is very typical of this point in the monetary cycle where you see rates start going up in a strong economy," Graves said. "What slows are those things that are bought on interest, because of the fear that you're going to get squeezed, or maybe people already have a lot of this stuff from the days of record-low rates. Now, people are out buying truly discretionary consumer items. Low and behold, these businesses look extremely strong right now."
On a valuation basis, specialty teen apparel stocks aren't cheap. Teen-agers have been migrating in droves from traditional department stores to these specialty stores for years now to find hip outfits, and the move has not been lost on Wall Street. Most of the stocks have long garnered heavy amounts of institutional ownership. For instance, financial institutions and hedge funds own 100% of American Eagle's float, and roughly that much of Aeropostale and Abercrombie.
Meanwhile, these stocks have proven worthy investments in recent years. After virtually all of them posted huge gains in the bull market of 2003, American Eagle added 188% in 2004, Aeropostale added 61%, Abercrombie gained 93%, Hot Topic rose 42% and Pacific Sunwear was up 5.5%.
At this point, the valuations might be strained, with an average price-to-earnings ratio of about 20.5 times earnings estimates through 2005. Traditionally, they have traded closer to 17 or 18 times earnings.
Part of their premium could be attributed to short-covering from the hedge fund crowd, whose short positions got mowed over following last week's sales reports. American Eagle gained almost 7% last week, Aeropostale added 7.4%, Pacific Sunwear rose 9.3%, Hot Topic jumped 5.5% and Abercrombie was up 4.7%. Meanwhile, the
S&P 500
added only 0.9%, and the S&P Retail Index gained 1.1%.
"Most hedge funds out there have rules that if a stock goes against you by 5% or 10%, you have to cover it," Graves said. "So there's almost institutionalized, or structural, short-covering as these stocks are going up based on the positive short-term news that we're seeing."
That said, he predicts the strength in the sector will continue throughout the spring and summer, into back-to-school season, when youth hordes overrun malls in search of new pairs of jeans.
Beyond that, the risks that are inherent to this industry mount. Morningstar analyst Brady Lemos does not recommend the sector as a long-term stock investment. He thinks the valuations are too high.
"Right now, American Eagle is trading at 20 times earnings, and I just think that's too high," Lemos said. "They're riding this current preppy trend that's been around for two or three years now, and my feeling is that this is just not going to last forever. If you go back far enough in this industry, you understand that it's cyclical and you don't want to assume that the outlook is always going to be this rosy."
Lemos said his favorite stock in the sector is Pacific Sunwear, which trades at about 17 times its 2005 earnings estimate. The company sells a plethora of national brands rather than just a single private label, like most of its peers. This flexibility reduces the fashion risk in the stock's valuation.
Still, Morningstar estimates there are about 800 desirable malls in the U.S. Between the company's two store concepts, PacSun stores and d.e.m.o. stores, its total store count is 1,100.
"They're approaching saturation," Lemos said. "So this kind of growth just can't last, but they've still got more room."
Wall Street analysts estimate that Pacific Sunwear's sales are set to slow to an average growth rate of 14% over the next three years from 21% for the last three, and its net income is set to slow to 17% growth from 25%.
Graves said he likes Aeropostale, which is trading at about 18 times its 2005 estimates. He estimates its sales are set to grow 20% to 25% this year, down from its average 32% growth over the last two years. Its earnings growth is set to slow to around 25% from the 64% rate it saw over the last two years. Meanwhile, a look at its monthly comparisons shows the difficulty it could have maintaining these growth levels in the future. Last February, the company posted a 26% same-store sales gain. This year, it delivered with a strong 13%, but comparisons will only get tougher.
Despite his concerns for the future, Lemos said the sector looks poised to have a strong year.
"In the short term, things look great," he said. "The stores have been packed, inventory looks clean, so I think they're going to have a good spring."