The Opportunity in This Sector Won’t Last Long…

You can’t blame a number of retailers for waving the white flag. Already battered by tight-fisted consumers throughout the year, they had to contend with a traffic-sapping massive East coast snowstorm as the year came to an end. The predictable result: same-store sales for many retailers were pretty lousy in December. The unpredictable reaction: investors seemed caught off-guard by the results, handing some stocks their biggest pounding in quite some time in Thursday trading.

Wet Seal (Nasdaq: WTSLA) and Pacific Sunwear (Nasdaq: PSUN) shed more than 10% on Thursday, while Zumiez (Nasdaq: ZUMZ) and Gap Inc. (NYSE: GPS) fell by almost as much. Yet for investors willing to take a broader view than monthly sales trends, these sell-offs have created a compelling entry point for some of these stocks.

As a quick recap of an article I wrote six months ago, many retailers have taken advantage of the downturn to tighten up their operations by reducing inventories, throttling back risky growth plans and cutting any fat from overhead. Some retail stocks are already benefiting from this trend, especially the ones that cater to upscale shoppers. But many teen-focused retailers have yet to mark any gains due to still-weak spending. If employment trends start to improve in 2011, as many suspect, it’s precisely these lagging retailers that may see the greatest gains as job creation extends to younger workers.


Here are three teen retail plays that you should be focused on — despite the tough holiday selling season that just passed…

Hot Topic (Nasdaq: HOTT)
This retailer fell more than 10% in the last two weeks of December and now trades just $1 above the lows seen of the last decade. Hot Topic posted stellar annual results early in the last decade, but sales have barely budged in the past five years. Sales are actually likely to fall in the fiscal year that ends in a few weeks, due in part to a decision to start closing underperforming stores. And therein lies the value proposition for this teen retailer…

Hot Topic is culling the 40 weakest stores from its roster, a process which should be complete by the end of April and should yield $10 to $15 million in annual savings (or about $0.25 a share). At the same time, Hot Topic will be coming up against very weak sales comparisons from 2010, and management believes that same-store sales can start to start to move up this week, especially as the assortment of merchandise is getting greater focus.

Unlike other teen retailers that focus solely on clothing, Hot Topic also sells a range of edgy accessories, most of which carry higher gross margins. Spending on accessories had fallen in the economic slowdown but should bounce back as the economy improves. As an added kicker to growth, the company is just moving into Canada, where a few Toronto stores are performing above plan. That may compel management to follow through on up to 30 new stores in Canada during the next year or two.

Analysts expect earnings per share (EPS) to rebound to $0.18 in the fiscal year that begins in February, but that outlook doesn’t appear to incorporate the cost cuts noted above. Analysts at B.Riley think EPS will be closer to $0.30. Using EBITDA as a measure, they think shares are especially cheap, trading for less than four times that metric. If the economy shows improvement in the next few years, EBITDA should rise nicely higher and create an even lower projected multiple.

Wet Seal (Nasdaq: WTSLA)
A slightly negative sales performance led to a sharp drop in shares for this retailer, which has now traded down to just two times cash. This company has been trying to boost sales for a very long time, but the top line is still below where it was 10 years ago. Analysts at Brean Murry have been tracking the company’s moves and think Wet Seal is finally on the cusp of an upturn. “We have waited a long time, and we are now more confident than ever that the equation for Wet Seal of: improving comps + material store rollouts + better product offerings = material top and bottom-line upside,” they wrote in a recent research report.

Even as the retailer invests in the turnaround, there are ample funds left over for a buyback. The company has bought back nearly one million shares, with plans to buy back another five to six million shares in 2011. The December sales weakness represents a modest stumble on the road to recovery, though management noted that the second half of December was far stronger than the first half — a possible positive omen for sales in 2011.

Aeropostale (NYSE: ARO)
Lastly, I remain a big fan of this retailer, which I discussed in an article about stock buybacks a month ago. [Read more of my analysis here]

A number of analysts remain cautious on Aeropostale, thanks to lagging sales performance against rivals such as Abercrombie & Fitch (NYSE: ANF). But even as the top line has challenges, the bottom line remains very healthy. Management has always been focused on cash flow, which has again allowed it to reiterate bottom-line guidance even as December sales came in a bit below plan. (Which explains why shares rallied on Thursday, despite the weak comps.)

Aeropostale has been the subject of recent buyout rumors. Some suspect the stock would fetch $30 or more in such a scenario. But shares should be appealing without any such buyback plan: Aeropsotale is on track to generate more than $250 million in free cash flow (FCF) for the second straight year, and FCF would like move up above $300 million or even $350 million when employment trends materially improve. As long as shares fail to budge, that just means that management can keep sharply reducing the share count through buybacks.

Action to Take –> The retail sector was in favor a few weeks ago, but dismal December sales are pushing stock prices back down. But for those with an 18 to 24-month time horizon, these sell-offs are creating compelling entry points.