What If Aeropostale’s Margins Don’t Recover As Much?

Aeropostale‘s (NYSE:ARO) EBITDA (earnings before interest tax depreciation and amortization) margins have plummeted from 25.7% in 2010 to 2.06% in 2014, due to a sudden rise in cotton prices in 2011 and persistent reliance on heavy discounting thereafter. However, going forward, the expansion of the P.S. from Aeropostale brand and the gradual improvement in its fashion component can help the company recover its EBITDA margins to an extent. We currently project margins to rebound to 11% over the next five-to-six years, but there exists a tremendous downside risk.

Aeropostale’s weak capital capacity can restrain P.S. from Aeropostale’s expansion.  And its relatively weak design and supply chain system can hinder the infusion of fashionable apparel into it merchandise line-up. It is is less able to overcome its “cheap basic brand” image, buyers will spend less on its fashion-forward apparel. Under such a scenario, if the retailer’s margins recover to 9.5% instead of 11%, there can be a downside of about 50% to our price estimate for the company. It is clear that Aeropostale’s future is highly depended on the future uptrend in its EBITDA margins.

Our revised price estimate for Aeroposatle is at $2.22, implying a significant premium to the current market price.

See our complete analysis for Aeropostale

Why Aeropostale’s Margins Stumbled

Facing difficulties in attracting customers, Aeropostale has tried to compensate for its lack of fashion depth and product variety by aggressively cutting its product prices. Buyers across the industry have not only scaled back their spending on apparel, but have also changed their spending patterns. With the emergence of fast fashion brands, teenagers and young adults are frequently turning over their wardrobe. They are not wearing a particular piece of clothing more than a few times and are buying cheaper clothing regularly.

For instance, instead of spending $100 on a single dress, a consumer is buying four different types of dresses or other apparel for $20 each. Overall spending has come down but the number of units have increased. While Aeropostale is getting its prices inline with how much consumers want to spend, it is still missing out on the important aspect of variety. Fast fashion brands are succeeding because of their huge product variety that has allowed a buyer to fulfill his/her need for four apparel pieces under a single roof.

Aeropostale on the other hand does not have the variety to enable customers to buy all the four pieces of clothing from its stores. They are buying one or at best two pieces from Aeropostale and subsequently moving to other retailers. Hence, despite its formidable attempts to add a greater fashion variety across the board, the company still largely depends to heavy discounting to keep its inventory running. This has weighed heavily on Aeropostale’s EBITDA margins.

Why We Expect Margins To Recover

When things were going well for Aeropostale, its margins were at 25.7%, and expecting them to recover to just 11% over the next six-seven years seems valid from mathematical perspective. The company is trying hard to improve its fashion variety, so as to have a positive impact on store traffic and number of units purchased per transaction. This should ultimately bolster its EBITDA margins. Aeropostale has seen some success with its Bethany Mota, Pretty Little Liars and Tokyo Darling collections, and we expect it to launch more such collections in the future.

Also, the company is planning to expand its P.S. from Aeropostale store base in the U.S., to grow the concept to a size comparable to the mainline format. For the purpose, Aeropostale has already closed almost all of the brand’s mall locations, where foot traffic is persistently weak. At the end of Q2, the count was at just 26, and this is likely to go up henceforth, as the retailer identifies lucrative expansion opportunities. Going forward, with a higher proportion of better performing stores, Aeropostale can realize higher margins.

Downside Risk, Slightly Slower-Than-Expected Margin Recovery

While Aeropostale has tried several fashion launches so far, it has not seen any notable positive impact, thanks to its longstanding brand perception. The number of transactions and units per transaction both continue to decline, implying that new fashion has not been too effective in garnering customer response. Hence, even though the company will continue to add more fashion to its inventory, its mediocre design system and a long product development cycle will keep buyers uncertain about the brand.  And thus, the proportion of discounts will remain high, keeping margin recovery painfully slow.

Furthermore, Aeropostale has been making huge losses since 2012, which hasconstrained its capital capacity. As of Q2 fiscal 2015, the retailer had just $86 million in cash and cash equivalents, with a debt of over $142 million and contractual lease obligations in excess of $500 million. Aeropostale is even finding it hard to raise capital in public markets, which indicates that it is terribly short on cash to invest in the expansion of P.S. from Aeropostale. Therefore, it is likely that the expansion pace of the format will be slow going forward, which can keep the recovery in margins at bay.

Aeropostale’s value is highly sensitive to its EBITDA margins, which is evident from the fact that just 1.5 percentage point change in long term margin forecast shrinks the value by close to 50%. Hence, it is clear that every basis point improvement in EBITDA margins counts for the company.

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