Trendy Teen Retailers Make Totally Hot Stocks

Roosevelt Field, a shopping center in Garden City, N.Y., on Long Island, looks like any upscale suburban mall on a busy Saturday. But study the teenagers inside and you might just glean enough valuable information to give your portfolio a boost. That's why Brian Sozzi, a 28-year-old analyst for Wall Street Strategies, an independent stock-market research firm, often spends weekends at the mall, scoping out teenage fashionistas and the trendy retailers they patronize.

Acting on the simple assumption that investors prosper most by buying what they know, Sozzi seeks to become a better investor in retailing stocks by getting to know the likes, dislikes and shopping patterns of teeny-boppers. In 2010, teens spent $79 billion, mostly on apparel, according to TRU, a firm that specializes in youth research. But in good times, that number can approach $200 billion -- and that doesn't count the formidable influence teens have on the spending habits of their better-heeled parents.

SLIDE SHOW: OUR 5 FAVE FASHION STOCKS

On this spring weekend, the specimens are flourishing in their natural habitat. Sozzi approaches two girls in Aeropostale, a roomy shop with pop music playing: "The wide tops and the skinny jeans with the colorful sneakers are really in, right?" he asks. The teens nod. Duh.

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Of course, it's wise to mix more traditional investing homework with mall gazing. "If you combine observing stores with other research, such as studying financial reports and listening to company conference calls, you can really make some powerful calls on stocks," says Sozzi.

Winning Recommendation

Sozzi counts among his successes a February 2010 recommendation to buy shares of Decker's Outdoor (symbol DECK). Decker's sells Uggs-brand footwear, including those ubiquitous shearling-lined suede boots that pad down the hallways of seemingly every high school in America. Sozzi recommended the stock after noticing some new styles, and more Uggs overall, on department-store shelves. Since the call, Decker's shares have climbed 180%, compared with a rise of 55% for the Standard & Poor's Apparel Retail index and 26% for Standard & Poor's 500-stock index (stock prices and related data are through May 6).

So what nuggets does Sozzi glean from his mall walk today? Young shoppers may be hitting the mall, he says, but like other consumers, they're seeking value. Products that offer consumers high quality at a reasonable price have been the top driver of retail sales. Before the recession, teens grabbed any item they liked regardless of the price and bought it -- so-called impulse shopping. That behavior changed as the economy soured. The teen jobless rate, at 25%, remains the highest among all age groups. Moreover, parents may give their kids less money for shopping these days than before the recession. Now teens debate their purchases. "'Can I get this? Should I get this?' They're rationalizing," says Sozzi.

Back at Aeropostale (ARO), two girls breeze past the full-price merchandise to the sale rack. In Hot Topic (HOTT), another retailer, three girls examine necklaces with dangling charms of monkeys, hearts or four-leaf clovers. "Necklaces that are $15 can get marked down to $6, and they're really pretty and good quality," says 12-year-old Jen Ventura, of West Hempstead, N.Y.

The good news for retailers is that although it often takes a sale to move merchandise, the discounts usually aren't as deep or as widespread as they were during the height of the recession. Discounts of 25% to 30% are moving merchandise now, compared with 40% to 50% then.

The most successful retailers are creative with sales, doing the least amount of damage to the bottom line while at the same time luring more customers into stores. Take Abercrombie & Fitch (ANF). Instead of offering a flat percentage off its merchandise, the store offers tiered discounts that increase with the amount of money spent at the store: 20% off a $100 purchase, 25% off a $150 purchase or 30% off a $200 purchase.

In retail, if companies don't get the fashion right, sales tank. On this score, Sozzi thinks Urban Outfitters (URBN) has a problem. The evidence is in the store. "What does it do for the female consumer to spend $60 on this?" Sozzi asks as he examines a light-brown, tunic-style sweater. "Is this a dress? It's an odd shape. No wonder Urban Outfitters is having trouble."

A quick gander at financial measurements, including stock price, confirms the retailer's struggles. Sales and earnings fell short of analysts' expectations in the quarter that ended January 31; gross profit margins (sales minus the cost of producing goods, divided by sales) slipped two percentage points last year, and inventory rose 24%. The stock, at $32, has fallen 12% over the past 12 months, despite a decent showing for the company's accessories and home-furnishings lines. "Women's clothing is what drives Urban's business," says Sozzi. "It needs to get its merchandise right."

Cutting-Edge Styles

One retailer that has been getting things right quarter after quarter is Guess (GES). Its styles scream cutting edge. Guess stores also create the illusion of exclusivity by keeping a sparse display of merchandise on clothing racks. "The company has some interesting takes on classic merchandise, whether it's fabric or style," says Sozzi, as he picks up a pair of indigo pants with a distinctive sheen. Sales at Guess jumped 17% in the fiscal year that ended January 2011, while profits rose 19%; analysts project that sales and profits will increase 11% and 8%, respectively, this year.

The hands-down winner for fashion among teen retailers is Abercrombie & Fitch, says Sozzi. Walk through its dark Roosevelt Field store, featuring loud, catchy music and pictures of hunky male models, and you'll understand why. "I love the styles," says 16-year-old Lisa Cortez, from West Hempstead, N.Y. "The belts are great. Abercrombie is my favorite store."

Just across the sales floor, Kristen Pulley, 13, and Caroline Debonis, 14, both from the New York City borough of Queens, are examining bathing suits. "I love the colors," Kristen exclaims. "Look at the pink and floral patterns." Telltale signs of the store's success: large crowds, picked-over shelves, few markdowns. It's the same scene at Abercrombie's lower-priced chain, Hollister.

Quality counts, too. One of the first things that Sozzi does when he enters a store is feel the texture of the jeans, because jeans are the core of every teen's outfit. He does so as he enters an American Eagle Outfitters (AEO) store. "The material is thinner than last year," he observes. Jeans and shirts have gotten thinner at just about every teen retailer except Abercrombie. As the cost of cotton rises, apparel makers and retailers are skimping on material to preserve profit margins. The risk is that the chains may protect profits now, only to lose customers over the long term because they are turned off by the deteriorating quality of the merchandise.

But Abercrombie hasn't sacrificed the quality of its clothing in response to rising costs. "It can't do that because it's a premium brand," says Sozzi. Instead, Abercrombie is quietly raising prices on newer merchandise. The price of a men's cotton button-down shirt has risen 11%, to $78, since mid 2010, and Abercrombie has introduced pricier versions of its polo shirts. But customers are still buying. Sales at Abercrombie rose 18% in the fiscal year that ended in January, and earnings improved 17%. Analysts on average project that sales for the current fiscal year will rise nearly 16%, and that earnings per share will surge 43%. The stock has advanced 84% over the past 12 months.

The Wisdom of Crowds

Savvy retailers aren't just selling clothes. They're selling a lifestyle and an experience. A crowded store is confirmation that customers are buying in. Pacific Sunwear (PSUN) sells California-inspired sports clothing, but its Roosevelt Field store is as empty as the beach on a rainy day -- a red flag for PacSun's sales and earnings.

Sozzi recalls that the same thing happened during the winter holiday season. On Black Friday, after Thanksgiving, he didn't see much traffic. He returned later to find prices slashed. This didn't bode well for earnings, Sozzi warned clients. Not long after that, Pacific Sunwear issued its own warning: Profits would not be as robust as previously thought. The stock swooned. "It's a lost brand that needs to turn around perception," says Sozzi.

You'll find the crowds that PacSun is missing at Zumiez (ZUMZ), which sells surfing, skateboarding and snowboarding clothes and accessories. Although Sozzi doesn't cover Zumiez officially, he follows it as part of his research on PacSun. Zumiez is decorated to feel like a local hangout, with couches where teens can chill without being pressured to buy. That's because Zumiez execs know that the more time kids spend in the store, the more likely they are to buy something eventually. Zumiez is building a social experience -- one, for instance, that lets customers talk to a skateboarding expert in the store free of charge.

The strategy is paying off. Zumiez's earnings soared 166% in the fiscal year that ended January 29, and sales jumped 17.5%. The stock dipped recently, then recovered to $28, after the company hinted that rising costs for materials would cut into profits. Still, for the current fiscal year, analysts expect sales to rise 14% and earnings to leap 34%, to $1.06 per share.

But even the best of retailers are facing the challenges of an uncertain economic rebound, rising material costs and soaring gas prices. Sozzi is cautious on the retail sector overall.

In fact, the only teen retailers he's recommending are Abercrombie & Fitch, American Eagle Outfitters and Guess. For retailers we think are good values now, see SLIDE SHOW: Our 5 Fave Teen Fashion Stocks. And for firsthand hints about who will succeed -- or fail -- in the trendy world of teen retailing, take a trip to the mall.

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