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3 Attractive Stocks in the Apparel Business

Wednesday - 5/8/2013, 3:31pm  ET

The apparel retail arena is highly contested. Three major worldwide players, Limited Brands , Gap and Abercrombie & Fitch , offer interesting investment opportunities and are trading at reasonable price-to-earnings ratios while offering substantial dividend yields. Let's take a closer look at these firms and try and decide whether they are worth our trust or not.

A catching brand

This retail giant is known worldwide for its Gap, Banana Republic and Old Navy clothing and accessories brands. Despite its financial strength, profitability, and growth history, I, like Zacks, would recommend holding Gap’s stock. This view is principally on account of the intense competition from newer specialty retailers and some merchandising errors that have led to five years of revenue declines and flat or negative comps (except for 2010’s 1% upsurge).

However, these mistakes are being rectified by a new merchandising strategy that has garnered encouraging early results over the last 12-to-18 months. As stated by Morningstar analysts:  

If management continues to improve merchandise and inventory turns while growing the operating margin through supply chain improvements and increasing higher-margin international and e-commerce sales, Gap may be able to compete better with fast-fashion retailers like H&M, which may help it regain its core consumer and attract a new audience, while remaining loyal to its traditional Western fashion focus.

So, keeping an eye on this stock for a future buy is not a bad idea.

Additional concerns about Gap’s risk package lead me to believe that holding is the best thing to do at the moment. Namely, these worries are:

1.) A high exposure to the volatility in commodity prices, especially cotton and labor

2.) Rising inventory levels that will most likely impact on the firm´s margins

3.) Exposure to weak markets, like Europe, where customers’ spending capabilities are highly limited by austerity measures

4.) Susceptibility to oscillations in foreign currencies, as it operates in multiple locations outside the U.S.

5.) Limited spending capacity for discretionary items (like apparel) in the U.S. bolstered by a high unemployment rate

Notwithstanding, as consumer spending capabilities increase, the industry is starting to recover. Gap will probably lead the sector due to its strong brand recognition and revenue growth. For now, I would hold Gap while still keeping it on my stock shortlist, especially as an operating margin of 12.4% and return on equity of 39.2% rank considerably above the industry median.

A stock to keep an eye on 

Just like Topeka Capital analyst Dorothy S. Lakner said, although Abercrombie & Fitch seems to be headed in the right direction, I would hold this stock, at least until expense initiatives for the 2013 fiscal first quarter are revealed.

The opinions regarding this company are pretty divided among equity analysts. While Morningstar and Barron's recommend overweight positions in this stock, Zacks advises holding. I will incline for this last opinion because comps have been declining over the past two years and have been attaining negative results for four consecutive quarters now. This trend is expected to continue as company projections for the 2013 Q1 call for high single-digit comp drops.

Similarly to Gap´s case, macroeconomic headwinds, like the aforementioned unemployment issue in the U.S., could strongly affect Abercrombie´s earnings. In particular, the unemployment rate for 16-to 19-year olds, which has persistently been in the mid-20% range, considerably constrains spending among the company´s main demographic

The firm is highly exposed to political, social and economic fluctuations as it operates (both manufactures and sells) in several overseas markets.

However, a wise investor should also keep an eye on Abercrombie's stock as growth prospects begin to ameliorate. Its last reported quarter produced diluted earnings of $1.82 per share, up 727% year-over-year, and 109% from the previous quarter. FY 2013 EPS growth is projected at more than 17% too.

This improvement is most likely to continue for several reasons. Most importantly, like Morningstar´s Jaime M. Katz assures, a  “..certain allure remains around the company's namesake brand, which will likely make it more resilient through fashion cycles as long as strict inventory management prevails.

Despite improving gross margins that reached 63% in Q4, beating Gap´s 39%, I would recommend holding on this stock, at least until 2013 Q1 results are revealed by mid-May.

A market leader

I once heard that “there´s nothing limited about Limited Brands,” especially not its growth prospects. Although I am not sure this company’s stock is a definite buy, I would advise an overweight position, inline with Barron's and Morningstar’s recommendations, especially for those interested in long-term returns.

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