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Subject: Aeropostale Q4 2011 Date: 3/18/2012 2:36 PM
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It’s been a volatile couple of years for Aeropostale. Two years ago, ARO was at historic highs around $30 per share. And why not? ARO was coming off some of the best comps and growth in its history with 19% increases in same store sales in 2009, 18% for 2010 and revenue growth at 18% in 2009-2010.

2011 was not as kind. The price dropped from over $30 to a little over $9 in September 2011. The decline coincided with the first quarters under the leadership of the new CEO Tom Johnson. ARO lost what might have been the heart and soul of the company as Julian Geiger stepped down as CEO [and went to the board] in 2009 and in December 2010, Mindy Meads promoted to co-CEO quit. This was much like the loss of Mickey Drexler at the Gap. The chief with the fashion vision and sense leaves and the company founders.


ARO’s decline started in 2010—just as the six months of product under Geiger’s tenure was running down. Comps slowed in the back half of 2010 and turned negative in 2011, reaching –14% by July 2011.

Management was slow to recognize what needed to happen to fix the problems in merchandising. In the early spring of 2011, they were talking about the great spring season they were expecting and looking forward to strong back to school in the summer and fall of 2011. Spring and summer sales were some of the worst in the company’s recent history and ARO was forced to mark down heavily all the way through Christmas 2011.

It was clear Areropostale had lost its way for most of 2010 and through 2011. Even though they are merely followers of fashion and live by knocking off what fashion leaders are doing, they couldn’t spot the trends that were in front of them at competitors and get them on their own shelves fast enough to keep customers happy. ARO stuck with the uniform of the logoed hoodie/graphic tee and denim long after the party was over.

Consequently they got stuck with huge piles of Aeropostale logo-splasehed hoodies and graphic tees in muted. dull colors and loads of tired looking denim. They carried few to no dresses and skirts and were slow on the uptake in yoga wear.

In the recent conference call, Tom Johnson finally gives us some clues on what’s hot and what’s not. In the past, he spoke in generalities about:

• freshness
• newness
• optimism
• the color palette
• being true to the core customer
• more fashion
• better silhouettes

He briefly mentioned a few months ago that stores were a bit heavy into denim and merchandising would be rethinking the uniform. The uniform is their term for what customers buy over and over. For a few years it was denim, graphic tees and hoodies. Stores including Aeropostale and American Eagle Outfitters made a good living off the core customer and the three must-have uniform units.

Unfortunately, Johnson [and AEO] missed the turn and was stuck for a year with uniforms the core customer was tired of wearing and could only be persuaded to buy at huge discounts. That has been cleared off the shelves and a stroll through their website now reveals lots of skirts in interesting colors and prints, dresses, very little denim and some colored denim. Colored denim has been a developing trend for several quarters at competitors. ARO also has better graphics on the tees, brighter colors overall, fewer hoodies and prettier camis and tanks. It is a far better presentation of clothes than the drab clearance Aeropostale tees, distressed denim and lifeless hoodies we were seeing in the first quarter of 2011.

With aggressive promotional sales as ARO’s only alternative for moving inventory, gross margins went subterranean. There were also record high cotton prices to contend with raising costs. It was ARO’s misfortune that high raw material prices coincided with some of the worst clothing and fashion missteps in the company’s history. It produced the lowest gross margins and dworst comps of the past 8 years.

1/12 10/11 7/11 4/11 1/11 10/10 7/10 4/10
====================================================================
sss -9% -9% -14% -7% -3% 0% 4% 8%
gross 24.3% 27.1% 24.4% 29.1% 35.5% 36.6% 37.3% 39.4%


If I had been convinced of Tom Johnson’s rapid response, on-target fashion sense and ability to make the right choices for 2012, I would have bought at $9. But his failure to be specific during conference calls and his tendency to speak in grand generalities made remediation of ARO’s troubles look like a long slow crawl back to better business. I am still not convinced he has the turnaround firmly in hand, but the clothes do look better this quarter. He finally discussed some specific errors in the most recent conference call.

They stayed too long and overloaded denim. The selection at the website has now been decimated. The ubiquitous company logo as a dominant style statement has given way to better more colorful graphics. Hoodies are down to just a few styles from dozens. Unfortunately most of them still say Aeropostale on the front and more interesting graphics are still missing. Graphic tees have better and more colorful designs. The colors are brighter. Gone are muted greys, dark maroons, washed out pastels, and browns.

At some point clothing stores may figure out the coolness factor of wearing and advertising a brand is not what it used to be. Abercrombie & Fitch is another company that splashes its logo everywhere --- getting customers to pay to be walking billboards.

ANF sales have also been disappointing. Same store sales for Q4 were flat and gross margins were 7.5% lower, driven primarily by lower than expected sales and higher markdowns in the same promotional environment that has plagued ARO.

From Tom Johnson:

The dominant logo business throughout the entire store was something that we needed to broaden our assortment and that's what we did and we are certainly not walking away from our core business.

ARO has added a nice assortment of skirts and dresses in prints and bright colors with no Aeropostale ‘87 anywhere to be found. Six months ago they had one ugly plaid uniform-style miniskirt online.

Last year they were top-heavy in distressed denim and plain denim in dozens of styles—now severely pared back. In the meantime, colored denim began showing up at other chains six months ago in some remarkable shades and hues. While ARO says they beat the competition to colored denim and were ahead of the trend, that’s not quite true and the selection is still poor -— 3 colors blue white and tan[at least online no stores here to check]. ARO has some way to go even as a dedicated follower of fashion and not an innovator

Forever 21 is a leader in fast fashion and can be relied on to front run emerging tastes and trends. Their colored denim selection is broad and available over a good cross section of styles. ARO is not there yet. By the time they do get inventory, it may be on its way out – such are the hazards of following trends with long lag times. Aeropostale needs a lead time of 3 to 6 months from conception and ordering to shelf; Forever 21 can respond in days to weeks.

http://www.forever21.com/Product/Category.aspx?br=f21&ca...

From the CEO:

As far as the product Stacy, we're pleased as, but as Marc said, we can't comment obviously into February, but we're pleased with the reaction to the fashion as I mentioned earlier, particularly thanks for noticing the colored denim. We were happy we had it out the second week of January before most of our friends


Overall, the clothes are vastly improved this quarter.

Fourth Quarter 2011

It was not a good quarter. Net sales decreased 4% and same store sales were down 9%. Net income was $26.1 million down 69% and diluted EPS was $0.32 including a $0.12 asset impairment charge. Without the impairment net would still be down 58%. Not exactly a banner quarter. Cost of sales is still eating them alive. Cotton was a factor but promotional activity and markdowns were the real destructive force.

E-commerce fell off after 7 quarters of 17% to 20%. In Q1 it was 8%. The company blames technical IT glitches and expects improvement.

Gross margins continue to be devastated by raw materials and heavy discounting. ARO has been in markdown mode for nine months in an all out effort to clear the shelves of fashion-miss product purchases.

GAAP Margins

1/12 10/11 7/11 4/11 1/11 10/10 7/10 4/10
=====================================================================
gross 24.3% 27.1% 24.4% 29.1% 35.5% 36.6% 37.3% 39.4%
operating 5.0% 6.7% 1.2% 5.9% 17.1% 16.0% 14.4% 16.2%
net 3.2% 4.0% 0.6% 3.5% 10.0% 9.7% 8.8% 9.8%

Not normalized for the non-cash impairment

The intent of the heavy promotions through Christmas was to jettison stale inventory. ARO made heavy margin sacrifices to get the hoodies and denim out the door. It worked and inventory levels look better than they have for over a year.

1/12 10/11 7/11 4/11 1/11 10/10
======================================================
DIO 24 56 64 39 26 57
AR/revenue 20.2% 44.4% 53.1% 30.3% 18.7% 39.7%

Days in inventory are down and the receivables to inventory ratio is is low.

Guidance Games

Guidance has become something of a guessing game -— guessing just how much they are low-balling every quarter to benefit from a positive surprise when they beat.

Q3 2011 guidance from the Q2 2011 CC:

Tom Johnson

I will now discuss our guidance outlook. For the third quarter, we expect earnings per share in the range of $0.9 to $0.15 per diluted share. This guidance assumes a share count of $82 million, and a tax rate of 40.5%. We expect the effective tax rate to normalize as we move through the second half of the year.

While our trends have improved slightly since the second quarter, we believe it is prudent to take a cautious view of the third quarter and the remainder of the year as uncertainty surrounding the macroeconomic and competitive environment remains, and we continue to work through our merchandising initiatives


As it turns out, Q3 was not as bad as guidance made out. After they pre-announced actual Q3 earnings the first week in November, ARO went on to $17 from lows at $9 as the forecasted 9¢-15¢ turned into 30¢ in earnings---double the high end of guidance.

Guidance for Q4 2011 predicted continuing negative same store sales and compressed margins. Projected EPS was $0.35-$0.38 compared to $0.95 in Q4 2010 –- it looked fairly bleak. Actual EPS [adjusted for non-cash impairment] for Q4 2011 was $0.44 again blowing through guidance. Every time they manage to beat guidance, the price climbs in spite of the ongoing negative comps and contracted margins. ARO is now at $20 and not far from its pre-cash pricing of $26. It’s a remarkable return from the dead considering the store is still seeing the worst margins in 8 years, negative revenue growth, negative same store sales and assets that were written down when cash flow was stress tested and fell short.

Q1 20120 guidance

EPS is expected to range between $0.08 to $0.10, compared to earnings of $0.20 last year. That’s 50% less than one year ago. In spite of the guidance, ARO’s price per share did not drop and I suppose that the market is expecting better—-twice bitten. I am going to hazard a guess that ARO may earn as much as $0.13-$0.15 in Q1 and keep the string of missed guidance alive and the stock price moving up.

Obviously one of the analysts was suspicious of more underpromise/overdeliver:

Kimberly Greenberger - Morgan Stanley:

Tom, just stepping back and looking at the big picture trying to understand why given the very encouraging start to Q1 would earnings be down 50% this year after a 60% decline last year, it sounds like there are a lot of things being encouraged by and the average unit retail or average unit costs won't be quite as fierce here in Q1 as they were in Q3 and Q4, so could you just help us understand the context within which you're giving this guidance?

By Q3 and Q4 2012 high raw materials costs will work through and out of the system. Product ordered last quarter and this quarter starts showing up on shelves in six months and the lower input costs will increase margins. Couple that with what looks like better merchandise and clearance of the dead inventory, and Q3/Q4 may see Aeropostale return to positive same store sales and higher margins. Whether $20 is good deal is debatable. The market is expecting an earnings surprise and is pricing in some of the good news for the back half of 2012. However, never underestimate the power of beating guidance and if they do, $20 could turn in to a few dollars more.
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