We started building a position in Aeropostale in late-October but I'm just getting around to writing about it now as I'm revisiting the thesis and thinking through potential risks. Let's just jump in...
Assumption 1: The Mall Continues to Deliver Captive Market of Teenage Consumers
The mall is now and will remain fertile sales territory for retailers peddling wares to teenagers. While the traffic counts might ebb and flow a bit, these temples for commerce seem to have staying power with the teen demographic. In short, we assume they will continue going to malls and doing so with varying amounts of cash in their pockets.
There is (and will continue to be) an important role for the value option for clothes in the mall. Indeed, it is a distinct market niche - as compared to full-price teen clothing retailing or value options outside of the mall - with its own set of unique properties and dynamics to consider.
If a business can offer acceptable alternatives to the full-cost, popular brands - and do so at significantly lower price points for similar lines of apparel - it will find eager buyers among teenagers and their parents. If nothing else, this is the point Aeropostale has proven in its 25 or so years of operations.
But it's a very difficult niche to fill. It requires a significant degree of operational precision from mimicking the popular designs, to executing quick supply chain turnaround, to driving inventory at incredibly high velocity in stores to overcome high rent expense.
ARO fumbled its way into this niche, as its history attests. It was a concept spun-off from a private label Macy's sponsored for affordable teen fashion. But it took more than a decade of trial and error (and continual capital investment) to truly understand the market opportunity and to refine the business operations to allow the company to exploit the niche through efficient operations.
Assumption 3: ARO is (and Will Remain) the Most Efficient Operator
The ARO business model can feel like a high wire act requiring constant operational precision to pull it off. Its gross margins hover around 35 percent versus about 65 percent for full-cost competitors like Abercrombie & Fitch. That means ARO must keep its operating expenses extraordinarily low (about 20 percent of revenue) to produce operating income comparable to full-cost competitors that spend upwards of 50 percent on SG&A.
The fat gross margins of the high-cost fashion brands hide all sorts of sins in bad inventory decisions, too much high-rent floor space, and expensive design departments. With 65 percent gross margins, you can make mistakes and get away with it. It's much more difficult to do that with 35 percent gross margins.
ARO chose this path and has spent years honing its operations to thrive in it. But the high wire act requires constant operational refinement with little room for error. We assume that ARO can continue as hyper-efficient operators of its business.
Assumption 4: ARO Will Face Pricing Challenges & Must Have Resources to Survive Battles
Assumptions one and two posit that ARO has a business whose market is not going to just suddenly disappear. Assumption three is an article of faith that ARO can keep on the same track that has provided its success to date.
Even though we assume ARO is not a direct competitor of the full-cost retailers (in some ways I'm mincing terms here, but let's go with it), that does not mean its immune to the problems they will inevitably face with their own inventory choices. In other words, ARO has to possess the financial wherewithal to lose sales when the full-cost brands miss on their merchandise selection and are forced to clear inventory at fire sale prices.
Indeed, this is the exact scenario ARO has faced for the past several quarters. When Abercrombie and American Eagle have to clear inventory, the value buyers go upstream for the deals. The full-cost brands try to avoid this, but it happens and most recently it has persisted through multiple selling seasons. Their businesses are hurting and the ripple effect has hit ARO.
ARO must have a very conservative balance sheet with little to no debt and sufficient cash resources to weather multiple seasons of bad sales. It's painful. But at some point it goes away and the selling environment normalizes. If ARO survives the onslaught, it rebounds nicely to previous levels of sales and earnings levels.
ARO saw its cash balances dwindle over the past year as it was forced to clear inventory at a cash loss then turnaround and buy more inventory for the following season. Management suspended its share repurchase program to conserve cash. They doubled-down on expense management. And while they never experienced an accounting loss, they benefited from maintaining sufficient cash on hand and no long-term debt.
They were positioned to weather the storm (which, frankly, may continue into the foreseeable future) and will have to maintain a similar philosophy for the inevitability of the full-cost retailers having inventory trouble again at some point.
Assumption 5: ARO Seems Protected Against New Value Entrants Into the Malls
While I believe the occasional pricing challenges from the full-cost brands is the bigger threat, we must also consider the possibility of new value-based competition trying to elbow its way into this niche mall market. I believe the ARO business works in part because it enjoys exclusive access to the niche. If a viable value competitor emerged, ARO would be a much less attractive long-term investment.
This exercise is about considering ARO's competitive advantages against new players. The over-arching barrier to entry is, I think, ARO's low-cost + low-expense + high-volume model. This is not the most attractive market to build a business (as discussed previously, the margin for error is incredibly slim) especially when a successful incumbent exists and would not cede market share without a fight.
That being said, I see these categories for hypothetical entrants...
A. The Fanatical Entrepreneur (see this previous post)
An entrepreneur with a fierce Sam Walton streak decides to start from scratch to compete for the value-minded customers in ARO's niche. It's easy to assume a rational businessman would take little interest such a venture. The margins are too thin. The infrastructure costs are too high to reach profitability without inviting a counter attack from ARO - an attack ARO is much better positioned to endure.
A rational agent is much more likely to compete with full cost brands, doing battle on fashion tasktes in hopes of commanding premiums, rather than fight it out with ARO on low price and efficiency.
Even a well-financed fanatic would struggle. My cursory analysis of the early ARO years suggests that the company needed almost ten years and more than 150 stores before it reached scale and enjoyed profitability. And that was in an ideal competitive environment (i.e., it wasn't going toe-to-toe with a competitor all too eager to do it grievous harm). At $500,000 per mall store in capex investment, the fanatic would have to be prepared to put to work somewhere in the area of $75 million of capital over a period of up to ten years before seeing profit.
Conclusion: Low risk due to low probability of a competitor - even a fanatic - succeeding in this.
B. The Adjacent Mover
It's much more likely that an existing value retailer - already structured to operate with thin margins and high volumes - would attempt an adjacent move into the teen market to compete. Indeed, this is modus operandi for clothing retailers that are saturating their core brands...they look for a new "concept" store to open new markets and drive growth while taking advantage of existing infrastructure for back office, management experience, supplier relationships, etc to reach profitability quickly.
Gap did this with Old Navy (though in off-mall real estate), Abercrombie with Hollister, American Eagle with Aerie, and ARO is in process of doing it with P.S. for Kids.
While we have to view this as a constant threat, there still exists the protection of how unattractive margins would be for taking this investment risk. There is no obvious player well-positioned to do this, but I see it as the biggest threat for a new entrant.
Conclusion: Moderate risk but low probability due to ARO's entrenched position and likelihood to fight back.
C. The Desperado
Call this a corollary of the Fanatic...the Desperado might be a full-price clothing retailer whose very existence is threatened because it business model doesn't work in its current market. It knows clothing and teenagers, but can't manage to stay at the cusp of new fashion trends. It has infrastructure. It has real estate. It has seasoned management. But it needs a new model.
Would it choose to go up against ARO? I'm skeptical. Again, the margins make the market less attractive. Plus the need to maintain such efficient operations would cast doubt on any management team unable to compete in a wider margin business.
However, it was truly desperado, it might make a stab at it...transitioning its mall real estate quickly, leveraging its existing suppliers, and using current technology. And while its long-term prospects would be dubious, it could certainly make ARO's job harder for a time.
I suspect the outcome would be similar to the full-price brands dumping inventory into the value niche through clearance sales. It would be painful for ARO, but conditions would eventually normalize.
Conclusion: Moderate risk but low probability of it happening.
Okay, there are the core assumptions in a painfully long post. Next we'll look at some ways to think about valuing ARO.
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