For teen apparel retailers, 2011 proved out to be a year full of nightmares. Starting with the jump in cotton prices to the economic slowdown in U.S. and Europe, different combinations of negative factors ensured that investors remain bearish on the teen apparel stocks throughout the year. Aeropostale (NYSE:ARO) was the biggest loser among these companies, losing nearly 40% of its stock value since January 2011 and was followed by Urban Outfitters (NASDAQ:URBN) and Gap Inc. (NYSE:GPS). Abercrombie & Fitch (NYSE:ANF) stood strong until November, when it got smacked after its European growth began showing signs of tapering, and finally ended the year 15% below its value in January 2011. American Eagle Outfitters (NYSE:AEO) was the only gainer among teen retailers in 2011, ending the year with a meager increase of 7%, thanks to a late surge after promising Q3 and holiday sales results.

Below we look at the major hurdles and silver lining for teen apparel retailers in 2011, and how prominently we expect each of these factors to impact teen retailers going ahead in 2012.

See our full analysis for Abercrombie & Fitch | Urban Outfitters | Aeropostale | American Eagle Outfitters | Gap Inc.

Threats

Cotton Prices: Cotton was at $0.84 per pound in July 2010 and peaked at $2.30 per pound in March 2011. ^[1] The major factor behind the cotton price increase was the drought in the Hubei province of China, a major cotton producing area followed by government restrictions on exporting cotton out of India to safeguard domestic supplies and a devastating flood in Pakistan.

As cotton is one of the key input material for apparel retailers, a sudden spike in cotton prices resulted in shooting up of Average Unit Cost (AUC). Value based retailers such as Aeropostale and Gap were hit harder because they were not able to pass the cost pressures to their customers compared to others like Abercrombie, and resulted in a massive decline in their margins.

Though cotton prices began to decline after March 2011, teen apparel retailers are still struggling with high AUCs majorly due to inventory hangover.

Inventory levels will be one of the major factors to watch our for teen apparel stocks this quarter because ultimately the pending inventories will decide how long a company will take to realize the benefit of declining cotton prices.

Highly Promotional Domestic Apparel Market: Just when the apparel retailers were struggling with hike in cotton prices, the U.S. economy started showing signs of weakness. This resulted in customer becoming highly choosy, which echoed through a decline in comps across the board. The promotions which started as an alternative to woo the customers, resulted in excessively fierce competition in the domestic market, with each retailer outsmarting the others with bigger promotions. The result was that teen apparel retailers which were already wincing with high input costs were left with lesser Average Unit Retail (AUR) too, resulting in further dent into their margins.

The market remains full of promotional activity and we expect the status quo to remain the same unless the economy recovers fully. Though the U.S. economy is showing the signs of recovery, the process has been painfully slow, which may remain a troublesome issue for teen retailers in 2012.

Slowing European and Chinese Economy Derailed The Bandwagons of Many in 2011: This was a major factor behind the decline of Abercrombie and somewhat of Gap. While Abercrombie continue to grow strongly till November banking on astounding European growth rate, the company’s stocks got smacked by nearly 20% after its European growth began to taper off. Gap which was banking on Chinese operations to provide some respite from declining domestic business found itself wrong-footed, when China deliberately slowed its economy down to control surging inflation.

Going ahead both European and Chinese economy seem to be on a tight rope. While Germany showed some improvements recently, other major markets such as Italy are still struggling with macro-economic pressures.

Merchandise Botch Also Cost Retailers: This was a major factor behind the decline of Aeropostale and Urban Outfitters. Aeropostale’s lack of balance in its offerings resulted in company being forced to offer more depth and width on its promotions, thus exacerbating the margin decline even further. On the other hand, a lack of freshness in Urban Outfitters’ merchandise caused its women apparel inventory to swell massively.

Opportunities

Direct Business: Direct business was the only silver lining for teen apparel retailers in 2011. While performance in brick and mortar stores started to crumble, direct business in the form of e-commerce, m-commerce and lately f-commerce stood out as a real growth driver. An increase in direct business not just helped teen retailers in increasing their sales but also provided some respite in margins as direct sales carry higher margins compared to that of retail sales. The apparel companies also seem to have understood the importance of direct business with the growth of direct channels featuring on the top of teen apparel retailers’ strategies.

As already evident from this holiday season where growth in direct business was much better in comparison to its retail business, we expect the trend to remain the same in 2012. The growing number of smartphone users and increasing penetration of facebook among netizens ensure that 2012 is going to be excessively competitive in this channel.

We note that in our estimates for Gap and Abercrombie, Internet sales now account for around a quarter of the equity value.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Cotton Prices: Source: Index Mundi [↩]