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SECTOR SCOPE by James A. Anderson October 25, 1999

Is It Bargain-Bin Time for Apparel Stocks?
Recent declines for leading companies may make for a good opportunity to get in

In fashion, a business that's all image, no stumble is tolerated. One trip on the runway and the critics are aghast, and a new clothing line ends up a heap.

In recent weeks, you might say that Gap (GPS) and Abercrombie & Fitch (ANF), two of the hottest apparel retailers around, have committed the same kind of faux pas -- on Wall Street. They've both put out sales figures that have confounded analysts -- and dragged down their own stocks and those of their peers. And after all the ruckus, they may both be priced so low as to look like steals in an outlet mall.

The fire sale in the two stocks started nearly a month ago, when reports surfaced that Gap's trendier Old Navy and Banana Republic stores were snatching away business from the company's flagship stores. The news didn't help Gap shares, which so far this year are off 14% compared with a 4% gain by the Standard & Poor's 500, quite a letdown for a stock that rang up a 322% total return for 1997-98.

SEASONAL CYCLES. Abercrombie's problems were similar, if different in degree. While the leisure-wear maker continues to be a hit with teens and twentysomethings, it fell from investors' graces by announcing that sales in stores open a year or more would rise 12%. For most clothiers, that's a phenomenal climb. Yet it was a disappointment to analysts, who expected 15% or more. That news -- plus a shareholder suit alleging that the company leaked early word of the results to analysts at Lazard Freres -- hacked $6 off of Abecrombie's stock price, to 21 and change, which leaves it near the bottom of its 52-week trading range and well below its 12-month high of $50.75. That's a serious comedown from its 126% increase in 1998.

Chalk some of the pessimism up to seasonal cycles. When the economy is strong and consumers are looking to dress to the nines, apparel retailers tend to get a bump in the spring. By summer, things become more somber. "Every year, there's a worry on the Street that Christmas just isn't going to come," says Karen Sack, an analyst with S&P. "Often between Thanksgiving and the end of the year, there's an opportunity to buy these stocks." If shoppers stock up during the holidays, apparel retailers bounce back. If not, they hibernate.

Indications are that this year's worries might be overblown, and that the retreat from apparel retailers is a bit too hasty. For instance, cast an eye on the industry's fundamentals: The economy looks spiffy, and consumer confidence is strong. That means more money for clothing in household budgets. Todd Slater, an analyst with Lazard Freres, says a strong economy helped apparel retailers log a 9% sales increase from January to September in stores that have been open a year or more, the key number that Wall Street monitors. To put that in perspective, consider that blazing retailers such as warehouse clubs and discounters delivered 8.9% and 8.1%, respectively.

Another thing that works in the favor of chains such as Gap, American Eagle, and The Limited is vertical integration, the business strategy currently in vogue on Wall Street. By putting design, manufacturing, and sales under one roof, specialty retailers can undercut department-store prices and still earn a healthy markup. Interest rates? For now, they're of little concern to apparel marketers.

GENERATION Y. Another factor is propelling the hottest stocks in the group: teen appeal. The ranks of Generation Y are expected to grow 2% to 2.5% a year from now to 2005, when there will be an estimated 30 million teenagers yearning to get to the mall. That's good news for specialty retailers, considering that adolescents make about one-third of the clothing purchases at their shops compared with 13% in department stores, according to statistics for 1998 compiled by NPD Group, a firm that tracks retail trends.

If you're looking for direct plays on Generation Y, two of the Street's favorites are American Eagle (AEOS) and Pacific Sunwear of California (PSUN). Analyst Lee Backus with Buckingham Research Group says American Eagle, which sells jeans, shirts, and khakis and has slumped from $58 a share to last weeks's close of $46.75 on the heels of Abercrombie & Fitch's announcement, looks like a bargain. "They're fast becoming the place to shop for teens," he says. "They've done a better job than the competition at changing fashions and boosting same-store sales."

It doesn't hurt, Backus adds, that American Eagle is increasing square footage in its chain by about 25% a year. American Eagle is currently rated a strong buy or buy by 12 of the 13 analysts that follow the company, according to Zacks Investment Research, and Wall Street consensus estimates put the retailer's average annual earnings growth at 25% over the next five years. Backus thinks the stock could hit $60 over the next 12 to 18 months.

Pacific Sunwear, meanwhile, has made inroads in malls with a selection of surf-wear that has boosted sales 40%-plus in each of the past two years. Wall Street likes the concept, and loves the results. Currently, all 17 analysts who follow Pac Sun rate the stock a strong buy or buy, with the Street predicting 26.7% average annual earnings growth over the next five years, according to Zacks. Look for the stock to hit $35 a share over the next 12 months, says Backus, up from 31 and change at the moment.

MUTUAL-FUND DOWNER. Of the industry's two mainstays, Abercrombie and Gap, the latter may have the strongest legs right now. Abercrombie's story seems solid. But because the company releases same-store sales only quarterly, it'll be hard to regularly assure investors that growth is holding up.

As for Gap, Lazard Freres' Slater says concerns that customers are migrating from one of the company's chains to another are overblown. At worst, he says, Gap's flagship will suffer a $50 million retreat in sales, while the overall company will see revenues rise $1.3 billion or more this year. That's "a trade-off I'd make any day of the week," Slater says.

Meanwhile, management is looking to get in on the fall's hot trend -- leather -- and has the kind of product mix that will help get Gap back on track. Currently, 13 of the 21 analysts who follow the company rate it a strong buy or buy, and Wall Street looks for the its earnings to grow 20% annually over the next five years. Slater thinks the company should hit a price of $60 a share over the next 12 to 18 months.

If you're looking to play the group via stock mutual funds, you're in a jam: It's hard to avoid getting a broader list of stocks than you want to buy. Retailing mutual funds end up spreading their bets across department stores, discount outfits, and sometimes even grocery chains. That's great for hedging. But given apparel's strength, it will also dilute your investment in the clothing chains.

The leader in three-year average annual total returns, according to Morningstar, is Fidelity Select Retailing (FSRPX), which has a 24.24% return. The latest data available from the fund, dated the end of February, shows Gap as its largest apparel holding, and No. 8 in the fund's overall portfolio, accounting for some 5% of assets. However, the fund is off 3.25% so far this year.

James Anderson teaches journalism at the City University of New York

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