Description

Background:

Aéropostale, Inc. (“ARO”) is a mall-based specialty retailer of casual apparel and accessories in the United States. ARO sells high-quality, active-oriented, fashion basic merchandise at compelling values in a high-energy store environment, targeted at both young women and young men from age 11 to 18. ARO also recently launched Jimmy’Z Surf Co., a California lifestyle-oriented brand targeting trend-aware young women and men aged 18-25. In addition, the company launched an Aeropostale e-commerce business in May 2005. As of October 29, 2005, ARO operated 675 stores in 47 states, consisting of 661 Aeropostale stores and 14 Jimmy’Z stores, in addition to their e-commerce website, www.aeropostale.com

Valuation:

ARO is trading at 14.5x FY06 EPS and 12.1x FY07 EPS (consensus estimates). Excluding $2.38/share in cash, ARO is trading at only 13.1x FY06 EPS and 10.9x FY07 EPS. Current consensus 2007 EPS of $2.00 assumes minimal operating margin recovery over the coming two years, despite have lost close to 400bps in 2005.

Our FY07 EPS estimate of $2.20 (Goldman Sachs has already published a $2.30 “normalized” EPS figure) assumes that ARO only recovers 130 bps of operating margin by FY07 (roughly 1/3 of the operating margin lost in FY05, nearly 400 bps). Assuming $2.20 in FY07, ARO is trading at exactly 10x, excluding the $2.38 in cash on the balance sheet today.

Once ARO’s comps and/or merchandise begins to show signs of improvement this upcoming Spring/Summer, investors will believe a more normalized EPS number is achievable in 2007. A company poised to re-accelerate square footage growth to 14%-15% and EPS growth to 20%+ in 2007 will not trade at 10x forward EPS for long.

As it relates to ARO’s “throw-away” 4Q05, current guidance calls for EPS in the range of $0.55 - $0.61, assuming a negative low-single digit to negative mid-single digit comp. Recall that ARO posted a significantly better than expected +7.3% comp during November (vs. consensus of down 2%), driven by a clever “50% off the entire store” during the Black Friday weekend, which drove +30% comps during the final week of the month. We would not be surprised to see ARO use this promotion again during the final 2 weekends prior to Christmas, which should generate double digit comp results for these weeks. A positive mid-single digit comp is now possible for 4Q05, which would clearly put ARO at the middle-to-upper end of their EPS range, given gross margins that are tracking “in-line” with guidance. While analysts/investors consider “50% off” sales as giving the store away, ARO is actually able to generate gross margins in-line with their original guidance during such planned events. Lastly, if ARO posts a positive +MSD% comp for the quarter (driven by a mid-teens increase in units) they will exit 4Q05 with clean inventory levels, as promised, setting the stage for a Spring/Summer 2006 turnaround.

Merchandising: ARO’s “Veneer” Strategy Will Drive Higher AUR and Gross Margin in 2006.

In the past, ARO focused primarily on maximizing the gross margin dollar contribution by style and classification. Over time, in that pursuit, ARO became too basic and bought too many units, which were sold at deflating promotional prices (lower AUR). Management finally realized that they needed to re-introduce a fashion component into their assortment to stay relevant and exciting to their young Gen Y customer. In other words, ARO will begin assorting each classification with core, fashion, and veneer product.

New spring product flows, which begin arriving in stores mid-January, will incorporate the company’s new “veneer” product. Many analysts equate “veneer” with “fashion-forward” and increased “fashion risk,” but in reality, the product is just an embellished/detailed version of product ARO already carries. For example, this past spring, Aeropostale offered women’s basic camis in 10 colors. This spring, ARO will offer a basic cami in 7 colors (“basic”), a basic cami with a design in 5 colors (“fashion”), and an embellished cami with beading/extra detailing in 3 colors (“veneer”). Veneer product will account for roughly 5% of inventory during Spring and will grow to 10% by Summer 2006.

From a pricing standpoint, ARO will sell their veneer at full-price and continue to promote the remaining 90% of the basic and fashion assortment. In order to accomplish this, ARO will likely be LOWERING the ticket prices on most basic and fashion items in their store. For example, basic/fashion camis currently ticketed at $19.50 will now be ticketed at $16.50 and sold at 2 for $25, or $12.50. Embellished camis (veneer) will now be ticketed at $19.50 and sold at full-price. Rest assured that sticking beads on camis does not cost the company an additional $7 per cami, so there is markdown room built into the price should the company hypothetically need to promote it.

Many analysts/investors question ARO’s ability to get the customer to buy something without a compelling “50% off promotion,” when in reality ARO’s customer has been buying product at single price points even lower than the 50% off price. Those that frequent the stores know that the company has been transitioning from a “% off” to a single price point promotion strategy. In addition, ARO’s recent announcement that marketing and e-commerce will report directly to CEO Julian Geiger has enabled Chief Merchant, Chris Finazzo, to refocus his full attention on improving the merchandise for 2006. The e-commerce launch will certainly enable the company to more easily test new product styles/classifications (as is common practice at most retailers with e-commerce businesses). On the marketing front, ARO has committed to double its efforts in 2006 – take a look at the most recent issues of Seventeen and Teen People for new ARO ads. Lastly, the company has also hired an SVP of Planning and Allocation, with more than 25 years of retail experience, to be announced over the coming two weeks. We are encouraged by the new hire and believe that she will be able to improve ARO’s inventory planning and perhaps introduce regional sizing, pricing, and planning initiatives (similar to AEOS and ANF).

Comps: ARO Faces Easy Same-Store Sales Comparisons in 2006.

Analysts are currently estimating a 3% comp in 2006; however, ARO is likely to post same-store sales in the mid-single digit range or better for the following 4 reasons:

1. Conservative Inventory Plan Will Drive Higher AUR. Many Gen Y retailers planned inventories too aggressively in 2005 (especially ANF, AEOS, ARO, and URBN) and it is widely anticipated that they will plan inventory per square foot down in 2006. If this proves the case, there will be fewer units to sell through and less pressure to take markdowns earlier in the season, which should enable retailers to maintain or increase AUR. Due to their heightened inventory level and off-trend fashions, ARO experienced a HSD% decrease in AUR during most of 2005. The company has already indicated that they will plan inventory conservatively for 2006, which will enable them to improve AUR, and therefore comps, without assuming much improvement in their fashions. For example, if ARO can sell more basic/fashion camis at 2 for $25 ($12.50 per unit when buying 2, or $16.50 when buying 1) vs. 50% off ticket price in 2005 (50% off $16.50, or $8.25), the AUR opportunity is clearly compelling.

2. Veneer Strategy. Veneer will account for roughly 10% of ARO’s assortment in 2006 and given the higher quality and fashion it should fetch a higher price than those 10% non-veneer units generated in 2005. In addition, the veneer product and price points will further validate the values on ARO’s basic/fashion assortment, enabling them to drive sales of these styles at a lower level of promotional activity.

2. Benefit from New Store Openings. ARO will have the benefit of another 110+ stores (2005 openings) entering the comp base in 2006, which should provide a boost to same-store sales. These 2005 store openings likely came out of the gate at sub-par sales levels given the company’s poor fashions and so the comp opportunity in 2006 is even greater than normal. Note: ARO has opened more than 210 stores over the past 2 years alone, which means that they young store base has additional opportunity for strong comp growth.

4. Weather. ARO’s value customer buys closer to need than most other specialty retailers. Recall that ARO transitioned to their spring offering in January and suffered through unseasonably cool weather from March to June. In 2006, ARO will assort the store with more wear-now product, which should drive greater conversion and SSS.

Accelerating Share Repurchase in 2006: Reduction in Inventory Investment and Store Opening for 2006 will Enable ARO to Redeploy FCF to Share Repurchase.

During 3Q05, ARO repurchased 1.1 million shares of common stock for approximately $24.5 million. Year to date, ARO repurchased $35.6 million and program to date have repurchased $99.3 million.

In conjunction with the 3Q05 earnings report, the Board of Directors authorized an additional $50 million of share buyback, bringing the total availability under the current repurchase program to $150 million ($50.7 million remaining, roughly 2 million shares).

Since 2002, the company’s FCF yield has averaged 6%. In 2004, ARO generated $90 million in FCF. While 2005 has certainly proved disappointing, the company will still generate roughly $27.3 million in FCF, according to Citigroup estimates.

In 2006, reduced inventory commitments and store opening plans will translate into greater operating cash flow and lower CapEx, respectively. We believe that the company will use this incremental FCF to aggressively repurchase shares at current levels. More importantly, ARO is quickly approaching the tipping point, at which their square footage growth will begin

Solid Store Growth for Aeropostale Brand: 675 stores today  1,000 store potential.

ARO has grown their Aeropostale store base significantly since its sale to the current management team in 1998. The company currently operates 675 stores in 47 states, representing an estimated saturation level of 68%, providing it with nearly 4 more years of store unit growth of the core concept. Management has indicated that Aeropostale can grow to 1,000 stores, which seems reasonable given that 1) ARO is under-penetrated in 3 key teen states: Florida, Texas, and California, and 2) targets a younger, value-minded customer which should enable them to expand profitably into small malls and outlet strip centers (PacSun is closing in on 1,000 stores and AEOS, despite its older target customer and higher AUR, already has roughly 800 stores).

ARO has not adjusted their long-term store opening plans the Aeropostale brand, which calls for 80-100 new stores per year. We believe that in 2007, Aeropostale will re-accelerate their store openings from 60 Aero and 5 Jimmy’Z in 2006 (10% growth) to 100 Aero and 10 Jimmy’Z in 2007 (14% growth).

Visual Merchandising Strategy: Expect ARO to Update 200-300 Stores for Spring.

ARO’s new visual merchandising strategy should re-invigorate the in-store appearance until full-scale remodels begin in 2008 as ARO’s 10-year leases begin coming up for renewal.

The company has successfully tested the following visual strategy in 10 stores: 1) increase in number of mannequins (helps drive UPTs by selling outfits, a similar mannequin rollout also underway at PSUN), 2) more accessible 2-level table fixtures (vs. unsightly, product-packed, 3-level fixtures previously), 3) more ambient lighting, 4) improved music selections, and 5) enhanced visual appearance of graphic tees and hoodies – now folded on walls (like AEOS and ANF) instead of hanging from racks. The test has enabled ARO to increase the “cool” factor and drive improved conversion with minimal CapEx spend. The company will likely rollout the new store look to an additional 200-300 stores this Spring.

Longer Term: Management Believes that Operating Margins Will Exceed FY04 Peak of 14.1%

Over the long term, CEO Julian Geiger believes that ARO’s operating margins can exceed previous peak margins of 14.1%, owing to the 1) new merchandising strategy and conservative inventory planning, which will drive higher gross margin, 2) SG&A leverage on positive comps over the coming years – ARO needs only a low single digit comp to leverage occupancy, 3) reduced labor hours in stores given the focus on AUR over units – heightened inventory levels required additional labor hours to keep stores in order during 2005, and 4) increasing bargaining power with vendors and ability to leverage corporate overhead as the company grows its core Aeropostale business from 650 stores  1,000 stores.

Jimmy’Z: A Free “Call Option.”

We believe that management’s decision to open another 5 Jimmy’Z stores during 2H06 could be interpreted as a vote of confidence in the new test concept. Nevertheless, analyst estimates do not currently incorporate any significant store growth or bottom-line contribution from the concept. Longer term, Jimmy’Z has the potential for 300-500 stores.

Catalyst

Accelerating same-store sales and margin recovery