Why Aeropostale’s EBITDA Margins Can Rebound Going Forward

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ARO: Aeropostale logo
ARO
Aeropostale

Aeropostale‘s (NYSE:ARO) persistent struggle with its product portfolio is very well known across the industry. The once popular brand has seen customers rapidly shift to other basic and fashionable brands over the last couple of years. The retailer’s own fashion launches have been undermined by its long standing “cheap, basic” brand image. Heavy discounting and weak store and web traffic have not only weighed on Aeropostale’s revenue growth, but have also pummeled its EBITDA margins. Suppressed by weak gross margins arising from heavy discounting and higher SG&A rate (thanks to weak topline growth), the company’s EBITDA margins have come down from 25.7% in 2010 to just 2.1% four years later. Although a sudden rise in cotton prices owing to floods in major cotton producing areas was the main reason for Aeropostale’s margin decline in 2011, the company never recovered from this setback, even when cotton prices eased. Post 2012, U.S. consumers scaled back their spending on discretionary products and the entire apparel industry felt its impact. Aeropostale was the worst affected by this change in spending patterns. When buyers did increase their spending on apparel products, they preferred merchandise from fast-fashion players rather than basic apparel from specialty retailers. Aeropostale was again standing on the vanguard of these headwinds, taking the heaviest damage.

However, we believe that the worst is behind Aeropostale now and its margins may have bottomed out. A bottomline recovery is imminent because even a slightest improvement from here on will be reflected as increase in margins. At the end of 2014, Aeropostale had closed almost all stores of its promising P.S. from Aeropostale brand as part of its restructuring strategy, which clearly implies that the company did not earn enough revenues from this format in 2014. This had played a significant part in margin decline for the company, since these stores were contributing a higher margin than Aeropostale’s mainline stores. Going forward, as the company expands this brand elsewhere, where conditions are more lucrative for topline growth, it will easily see a positive impact on margins. Also, Aeropostale is closing stores that do not generate sufficient revenues but contribute disproportionally to SG&A expenses. This will help it reduce operating expenses relative to revenues, which will ultimately push margins up. In addition, we expect to see a reduction in the level of promotional activities as the company gradually integrates more fashion in its portfolio, which should help its gross margins. In fact, in 2014, Aeropostale witnessed its average unit price increase for the first time in the last five years.

While there will be a margin recovery, it is almost certain that Aeropostale will not be able to relive its glory days given that the industry is shifting to the online platform where margins are typically low and competition is increasing every day. Hence, we forecast that the company’s margins will only rebound to 14%-15% over the next five-six years, provided that its P.S. brand continues to perform well and it addresses its merchandise issues effectively.

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Our price estimate for Aeroposatle is at $6.18, implying a premium of over 90% to the current market price.

See our complete analysis for Aeropostale

Improving Average Unit Retail

Due to its limited fashion variety, Aeropostale usually relies on deep discounts to attract customers, which weighs heavily on its average unit retail. Between 2010 and 2013, the retailer’s average unit retail declined at an average annual rate of more than 6%. However, the company has seen a turnaround in this metric in recent quarters.  With better response to its fashion launches, Aeropostale saw its average unit retail go up 5% during 2014. The retailer’s collection’s such as Pretty Little Liars, Bethany Mota and Tokyo Darling are finally beginning to see some decent response, allowing Aeropostale to usher a slightly higher proportion of full-priced sales for its fashion products. Although store traffic at Aeropostale continues to decline at an alarming rate, a turnaround in average prices should provide some respite, both for revenue per square feet and gross margins. It is often said that Aeropostale needs to be more fashionable to ensure the revival of its growth, and the retailer is trying to do so. Its efforts to integrate more fashion collections in its portfolio are finally showing some promise. Aeropostale’s average prices are increasing, which reflects a drop in the level of promotional activities. This should have a greater impact on its EBITDA  margins once the traffic starts recovering and the company gains some operating leverage.

Business Rightsizing

Aeropostale stores are mainly located in shopping malls, where foot traffic has been weak over the past several years. Moreover, shoppers have abandoned the brand’s basic logo products in search of more fashionable merchandise offered by other brands such as Gap Inc (NYSE:GPS) and Urban Outfitters (NASDAQ:URBN). Since the company hasn’t been able to drive sufficient store traffic, it is shutting down stores that do not generate significant revenues in order to improve profitability. At the end of 2012, Aeropostale had 984 stores across the U.S. and Puerto Rico and it began consolidating this network beginning 2013. At the start of 2013, the company had planned to close about 15-20 stores by the year-end, but it increased this figure to 30-40 half way through the year. By the end of 2014, Aeropostale had reduced its mainline store count to 773 and it plans to stabilize this at around 700-750.

Apart from closing stores, we believe that Aeropostale will look to open stores at locations with better footfall, where it stands a better chance of delivering desired results. Hence, we expect the retailer to continue with store consolidation and simultaneous expansion in the near term. Closing stores that do not generate significant revenues but contribute disproportionally to SG&A expenses can help Aeropostale improve its EBITDA margins. New locations with better topline performance will further add to the company’s margin recovery, provided the retailer manages to sustain the improvement in its merchandise portfolio.

In tandem with its mainline store consolidation, Aeropostale is looking to restructure its P.S. from Aeropostale store fleet, that has been performing much better than the namesake brand. Although P.S. from Aeropostale brand was performing very well in mall locations, the retailer realized that there was an opportunity to further improve this performance by shifting to off-mall locations. Within one year, Aeropostale closed 126 P.S. from Aeropostale stores, bringing the count down to 25 at the end of 2014. Henceforth, we expect the retailer to expand this format as it has ambitions to grow this brand into a network of over 500 stores. Since these stores were delivering better EBITDA margins than the namesake stores, an increase in their proportion in the overall store fleet will bring about a positive change in EBITDA margins. However, P.S. from Aeropostale’s expansion is going to be slow given that it does not have enough cash at hand, and hence margin recovery will be gradual.

What If Margins Don’t Recover As Expected

We currently forecast Aeropostale’s EBITDA margins to gradually improve from 2.1% to 15% over the next six-seven years, driven by the ongoing recovery in its merchandise portfolio and restructuring of its store fleet. However, a few merchandise goof-ups are enough to lead Aeropostale astray and make its business rightsizing redundant. If the retailer continues to rely on heavy discounts on basic logo products and its fashion launches fail to entice customers, limiting margin recovery to 12% at the end of our forecast horizon, there can be a staggering 40% downside to our price estimate for Aeropostale. This vulnerable is the company at present.

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