SmartMoney.com
Smells Like Teen Spirit
Tuesday September 9, 12:13 pm ET
By Trevor Delaney
IT WAS JUST A few years ago that old Navy was all the rage among the high school and college crowd. With its unpretentious, basic style and its kitschy commercials featuring the late fashion editor Carrie Donovan in her signature bug-eyed glasses and a dog named Magic, the Gap's discount sister had managed to tap into a cheap-chic zeitgeist, becoming the first apparel retailer to reach $1 billion in annual sales in less than four years.
But then, just as quickly, Old Navy's fortunes reversed, with same-store sales tumbling 11% in 2000 and another 16% in 2001. What went wrong? Just ask one of the store's target customers, 18-year-old Melissa Watts of Colonia, N.J. "Old Navy used to be really cool when performance fleece had just come out. But it got really old when the next year performance fleece was back, and the next year it was back again." Though sales have rebounded recently, Watts, for one, wouldn't be caught dead in the store. "Friends don't let friends wear Old Navy," she sneers.
And so it goes for clothing retailers selling to the fickle Generation Y market. One minute you're in; the next, you're "so five minutes ago." Sometimes, all it takes is a new band, TV show, you name it, to start a new wave. Moviegoers watched Keanu Reeves don a pair of pitch-black wraparound shades in The Matrix, and presto, a fashion trend was born. "The question is, what happens 12 months from now when kids move on to the next thing?" says Joe Grabowski, a retail analyst with Strong Capital Management. "Sometimes these things can go cold as fast as they go hot."
With that kind of unpredictability, why then are retailers lining up in droves to sell to young people? Sheer numbers, for one thing. The teen population is growing almost twice as fast as the total population and is projected to reach about 29 million by 2010. They have money to spend too — an estimated $120 billion last year — and by some counts a stunning 40% of that goes toward clothing and accessories. If you count the full Gen Y spectrum, which includes people up to 26 years old, you're talking about a group that rivals the Baby Boomers in size at more than 70 million. "The demographics are relatively easy in this market," says Michael Collins, a vice president in the retail practice group of management consulting firm Bain & Co. "It's the psychology that's difficult."
Those same issues make this sector a slippery one for investors, too. Share-price swings come hand in hand with the release of monthly sales figures, and one season of fashion faux pas can hammer a stock. But if you tap into a company that, in turn, has tapped into what kids want, the results can be lucrative. For evidence, look at retailer Pacific Sunwear of California. Its stock has ridden the skateboarder-and-surfer fashion wave to a 132% return over the past three years — a period when the S&P fell 34%.
To come up with a list of stocks that we felt were in tune enough with teens to have staying power, we put the field through a grueling weeding-out process. We started by talking with fashion experts about where trends are headed and interviewing money managers and analysts about which companies seemed to be on top of those changes. And we listened to Gen Y-ers themselves. We worked with Buzz Marketing Group, a specialist on the teen market, to conduct a survey and focus group, and spent a Saturday at the Garden State Plaza mall in Paramus, N.J., where we talked to teens and checked out many of the stores we were considering.
To narrow the list to the top stocks, we graded each contender on three factors:
Valuation:
By looking at such ratios as price/earnings, price/sales and price/earnings-to-growth — a measure of how much investors are paying for projected earnings growth — we assessed whether the stock was trading at a bargain.
Fundamentals:
To get a sense of each company's underlying financial and management strength, we measured debt levels, return on equity, long-term growth rates and same-store sales — the change in revenue at shops that have been open at least a year, a key indicator in retail.
Buzz:
Based largely on our interviews with teens and industry insiders, we gauged the excitement surrounding each brand and whether it seemed to be on an upswing. Once we totaled up the scores, five stocks wound up at the head of the class.
Abercrombie & Fitch (NYSE:ANF - News)
Stores: 344 Abercrombie & Fitch, 166 abercrombie, 104 Hollister
Valuation: A
Fundamentals: B-
Buzz: A-
The first thing you notice when you walk into the Abercrombie & Fitch store in Garden State Plaza isn't the clothes. Not the faded jeans, the polos, the hoodies or the T-shirts sporting vintage logos. No, the first thing you notice is the help — petite blondes in tank tops and military shorts, and a hunky guy with his shirt unbuttoned to reveal well-toned pecs. It's like seeing the retailer's controversial catalog, the one you must be 18 to buy, come to life — sans nudity, of course.
Abercrombie, as you may have guessed, is about more than selling clothes. It's about selling an image, an attitude that teens want to be a part of. And as the "aspirational" brand in its category, the company can charge higher prices. For the most part, kids eat it up. In each of the past four semiannual surveys conducted by U.S. Bancorp Piper Jaffray, high schoolers named Abercrombie & Fitch their favorite clothing brand. And with $1.6 billion in revenue, it is now the largest teen apparel retailer on the block.
Abercrombie takes pains to protect the brand's mystique: no television commercials and no aggressive discounting. "The management team is very savvy," says Francisco Alonso, a retail analyst with T. Rowe Price. "They're maintaining their price integrity to protect their brand, which is their most valuable asset." That strategy may have cost the company during the downturn — same-store sales have declined 7% a year, on average, over the past three years — but should serve it well long term. And by not discounting, the chain has kept its operating margin near 20%, one of the highest in the industry. Abercrombie & Fitch clothes may be expensive, but the stock certainly isn't. Its P/E of 15, based on 2003 earnings estimates, makes it quite a bargain. And that's assuming only moderate 12% earnings growth this year. Analysts think the pace will pick up after that, to a 17% annual clip over the next five years.
Credit CEO Michael Jeffries for directing the expansion of the New Albany, Ohio-based company from 36 stores, when he took over in 1992, to more than 600 today. The question now is this: Having nearly saturated its market, how can the company sustain that kind of growth? Jeffries thinks he has the answer in the chain of Hollister stores his company launched three years ago, featuring more moderately priced beach-inspired California-look clothing. The move allows him to capitalize on the popularity of this laid-back style while keeping the status of the Abercrombie & Fitch brand intact.
With their tiki-hut facade and dimly lit interiors, Hollister stores certainly stand out in the mall, and customers seem to be responding. Monthly same-store sales figures routinely show double-digit increases, and the brand has already risen to the No. 5 spot in the Piper Jaffray survey. CEO Jeffries plans to expand the chain rapidly, opening at least 80 stores both this year and next. Ultimately, he thinks the chain could reach 600 to 800 — twice the current number of Abercrombie & Fitch stores.
The company has another chain, called abercrombie, aimed at the 7- to 14-year-old crowd, and is developing a fourth concept. Though Jeffries has been tight-lipped about details, analysts expect that the new chain will target the over-25 set. That would allow customers to grow with the company, from childhood to adulthood.
Aeropostale (NYSE:ARO - News)
Stores: 413 Aeropostale
Valuation: B-
Fundamentals: A
Buzz: B-
Like its customers, Aeropostale is young and growing. That means this relative newcomer, started in 1987 and debuting on the Big Board in May 2002, still has plenty of untapped potential. Its stores have cracked 40 states but are mainly concentrated in the Northeast, with only a small but expanding presence in the largest teen markets of California and Texas.
Aeropostale's casual athletic styles are undeniably similar to what you'll find at Abercrombie & Fitch or American Eagle Outfitters. But this New York-based retailer differentiates itself by being the lower-cost alternative. "In the last few years, teens have become a lot more value conscious," says Strong Capital's Grabowski. Not all Gen Y-ers are willing to pay for Abercrombie's cachet, particularly on the younger end of the spectrum, the 12- to 16-year-olds that Aeropostale focuses on.
This company isn't looking to set fashion trends. Instead, it wants to deliver styles that have already proved popular. In a recent conference call with Wall Street analysts, CEO Julian Geiger explained it this way: "Like our customers, we too are fashion followers." Sure, that means the company will never get in on the front end of a wave, but the strategy also lessens its potential for a total fashion misfire.
But there was a stumble. Last fall, just four months into its life as a publicly traded company, Aeropostale was caught off guard by a sudden downturn in mall traffic and was forced to sharply lower earnings guidance. Investors panicked, and shares fell nearly 60% in one day, to $6.50. "Clearly, the stock was oversold," says Brian Tunick, a retail analyst with J.P. Morgan. But since then the company has been careful not to overpromise and has beaten consensus estimates every quarter.
Even being guarded, the company says it expects to expand square footage by more than 20% annually in the next few years, and Geiger would eventually like to increase the chain to include as many as 900 stores. With nearly $100 million in cash on the books and no debt, Aeropostale has some cushion should it encounter any more growing pains.
At a P/E of 21, shares are priced at the high end of the sector. But with earnings expected to rise 36% this year, the company's price/earnings-to-growth ratio, or PEG, is among the lowest, at 0.91.
Hot Topic (NASDAQ:HOTT - News)
Stores: 450 Hot Topic, 40 Torrid
Valuation: C
Fundamentals: A
Buzz: B-
Stroll into a Hot Topic and you might hear "The Anthem" by pop-punk band Good Charlotte blaring throughout the store: I don't ever want to be you/don't wanna be just like you. It's a fitting battle cry for a company that caters to the alternative teen crowd. Its bestselling items are T-shirts for such bands as AFI, Linkin Park and Weezer, but you'll also find studded bracelets, skull print handbags and blood-red hair dye.
"Hot Topic is doing a lot of things that nobody else in the mall is doing," says T. Rowe's Alonso. "They're not just selling sexy jeans to 17-year-old girls." For one thing, the City of Industry, Calif.-based company obtains exclusive licenses to sell the merchandise of some top bands. About 80% of its rock T-shirts can be found only at Hot Topic. "Otherwise, you might have to wait several months for a concert to come through town," notes customer Ezra Galston, 18, of Bethesda, Md.
"They are very good at recognizing what the trend is," adds Strong Capital's Grabowski, "whether it's music or kids wanting to dress like Kelly Osbourne." One way the company does that is through in-store feedback cards. Another method: Employees are reimbursed for concert tickets if they report what the kids and the performers were wearing.
Once a trend is spotted, the company acts fast. Such was the case with The All-American Rejects, who recently emerged from obscurity as a local Oklahoma band to have a hit and an appearance on The Tonight Show. Hot Topic had the band's merchandise in stores in a matter of weeks. "We use primarily domestic suppliers, which enables us to get an item in the stores in four to eight weeks," says CFO Jim McGinty. "A lot of our items, like the T-shirts and tops, have even shorter lead times — as short as two weeks."
Since taking over from the founder in 2000, CEO Betsy McLaughlin has led the company in new directions. Just a year into the job, she spearheaded the launch of the spinoff chain Torrid, which provides edgy clothing for plus-size young women. It's not exactly a mainstream market, but it's a drastically underserved one. "If anyone were to pull it off, it would be a company that is as close to its consumer as Hot Topic is," says J.P. Morgan's Tunick. Management is expanding Torrid at a moderate pace and plans to open 25 stores this year, along with 70 Hot Topics. While Torrid is not yet profitable, it has strong potential and could start helping the bottom line as soon as next year.
Alternative teens have proved to be a relatively recession-proof market. Even with mall traffic declining, last year Hot Topic's sales grew 32% and same-store sales were up 5% — the seventh consecutive year of positive growth. That's likely to continue this year. Net sales for the 22 weeks ended July 5 were up 25% from a year ago. With results like these, Hot Topic is pricey — a P/E of 22 versus the sector's 18. But the company has historically traded at a premium.
Pacific Sunwear (NASDAQ:PSUN - News)
Stores: 644 PacSun, 75 PacSun outlets, 112 d.e.m.o.
Valuation: C
Fundamentals: B
Buzz: A
Teen rocker Avril Lavigne's top-10 hit "Sk8er Boi" was about just the kind of guy who might shop at PacSun. The Anaheim, Calif.-based retailer specializes in skateboard and surf apparel, stocking everything from knee-length board shorts to denim skirts and sunglasses. So that puts it smack on top of one of the latest waves. "Teens are really looking for West Coast- inspired fashion, which is more surfer-looking," says Zu Cowperthwaite, a retail analyst with Evergreen Investments. "[PacSun] led the style, and they had the most unique offering in the mall in terms of the look." One sign of that: In the survey we had Buzz Marketing Group take of Gen Y trendsetters, PacSun wound up as their favorite brand, once the near-exclusive lines it carries were figured in.
While the company designs some of its own clothing under the labels Bullhead for men and Tilt for women, two-thirds of sales are generated by outside brands, including Billabong, Hurley and Quiksilver. Its well-established ties with key lines give it a big advantage over the Johnny-come-latelies. Teens want the authentic brands — the Etnies sneakers or the Volcom T-shirt — because that's what the pro skaters wear, and that's what PacSun carries.
Those outside lines also give President Tim Harmon a resource to tap to stay on top of emerging trends. Between those and his own brands, he says, "we probably have 10 major design teams working on products for the future." Two years ago Hurley and Volcom let PacSun know they were having success selling trucker-style hats in small surf and skate shops. So PacSun began to test-market them. It took almost 18 months, but eventually the hats caught on big in Middle America, too, and PacSun was ready to capitalize.
The company has been selling a lot more than hats lately. Through the 22 weeks ended July 5, same-store sales grew 13% from a year earlier, and total sales were up 23%. Management is now working to boost profits by increasing its proportion of female items from 45% to 50% by year-end. This ratio is key since those clothes carry higher margins and women shop more often.
How long will skate-and-surf clothing be the "in" look? Piper Jaffray retail analyst Jeff Klinefelter thinks it's here to stay. "Abercrombie wouldn't be rolling out Hollister [which features similar clothing] so aggressively and wouldn't be betting the future of their company without knowing that there are legs to this and that it's not a six-month surf trend."
Even so, Pacific Sunwear isn't banking its fate on it. One of its most promising concepts is its five-year-old chain d.e.m.o., which carries the increasingly popular roster of hip-hop brands, including J. Lo, Sean John and Eminem's Shady Ltd., which debuted this summer. That addition will draw customers like Brady Holt, a 17-year-old from Montgomery, Ala. "I love Eminem, so I'm sure I'll buy his stuff," she gushes, "and I'll make my boyfriend wear it." Now in just 20 states, d.e.m.o. has plenty of room to grow, and the company is looking to at least double its size eventually. Same-store sales are up 23% so far this year. "[The hip-hop] brands are gaining momentum in nonurban, nonmetro markets, which is where their best d.e.m.o. stores are located," says analyst Dawn Stoner of Pacific Growth Equities.
The impact has trickled down to the bottom line — and to the stock price. Shares are at a 52-week high. But when you consider that earnings are expected to grow 30% this year, the stock, with a P/E of 22, looks pretty reasonably priced.
Quiksilver (NYSE:ZQK - News)
Stores: 215 Quiksilver Boardriders Club, 3 Hawk Skate Shop
Valuation: B
Fundamentals: B-
Buzz: B
Here's another company benefiting from the fact that surf's up. Athletes such as surfer Kelly Slater and skateboarder Tony Hawk have helped raise the profile of its beachy casual wear. And movies such as Blue Crush and the MTV reality series Surf Girls — coproduced by Quiksilver — have brought the sport into vogue with women shoppers, too. Goodbye, Gidget.
Unlike the other companies on our list, Quiksilver is primarily a manufacturer. Its garb is sold in department and specialty stores, not just in the U.S. but throughout Asia, Australia and Europe. Its biggest outlet is PacSun, which accounts for 6% of sales. The company's own stores, Quiksilver Boardriders Club, are a small part of its operation — just 10% of revenue. Their main function: to promote the image of the brand and the board sports — surfing, skateboarding and snowboarding.
A chief reason Quiksilver stands above the pack is the credibility its brands carry within the board-sports community. This stems from its sponsorship of many of the top surfing pros. Teens want what Kelly Slater is wearing, not a no-name imitation. "The athletes are our eyes and ears into the marketplace," says Steve Brink, Quiksilver's CFO. Tony Hawk even lends his name to three stores the company operates.
That kind of authenticity is a big part of why so many outlets carry Quiksilver and its brand for women, Roxy. "Quiksilver benefits from the department stores' desire to increase their hook on the teen market," says Bill McVail, who owns shares as lead manager of the Turner Small Cap Growth fund. "It's one of the few brands that really drives that traffic."
The Huntington Beach, Calif.-based company continues to boost both its top and bottom lines at an amazing rate. In the fiscal second quarter ended Apr. 30, it reported a 40% increase in sales from a year ago, and earnings spiked 43%. Investors have noticed, so shares aren't a screaming bargain. Still, once you factor in that earnings are expected to grow 29% this year, Quiksilver's P/E of 18 matches the sector, and its PEG ratio of 0.96 beats the industry average. "It's more expensive than some other names," says McVail, "but for that you get broader distribution, higher-margin product and a brand that's hitting all cylinders right now in terms of the style and fashion." |
