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2014 Upside Seen for Urban Outfitters, American Eagle

Jefferies analyst Randal Konik upgrades shares of both firms while downgrading youth merchants Abercrombie & Fitch and Aéropostale.

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Urban Outfitters Inc. and American Eagle Outfitters Inc. are the teen retailers best positioned to rebound from the “promotional war zone” of 2013.

That was the conclusion of Jefferies analyst Randal Konik, who upgraded both companies to “buy” from “hold” while downgrading youth merchants Abercrombie & Fitch Co. and Aéropostale Inc. to “hold” from “buy.” He raised his price target for Urban to $54 and American Eagle’s to $19 while lowering Abercrombie’s to $30 and Aéropostale’s to $7.

Outside the teen sector, he lifted his ratings on both Ann Inc. and Chico’s FAS Inc. to “buy” from “hold,” and lifted their respective price targets to $45 and $23.

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U.S. retail holdings lost ground on the first trading day of the new year, with the S&P 500 Retailing Industry Group dropping 0.4 percent to 936.12, but Konik’s stock picks for 2014 easily outperformed the market at large.

Shares of Urban rose 1.8 percent to $37.78 while American Eagle’s were up 2.3 percent to $14.73. Abercrombie’s shares were down 2.7 percent to $32.01 while Aéropostale’s shed 0.1 percent to finish Thursday’s trading session at $9.08.

Youth retailing was among the few sectors left on the sidelines last year as the retailing index rose 43.9 percent to 939.81. Shares of American Eagle declined 47.1 percent, Aéropostale’s dropped 30.1 percent, Abercrombie’s were off 30 percent and Urban’s surrendered 5.7 percent.

Citing “an improving trajectory…driven by a strengthening housing market, rising household net worth and falling unemployment,” Konik was upbeat about the outlook for specialty retailers in general. Low interest rates, easy comparisons for the final three quarters of the new year and “still rising [free cash flow] profiles” will also help.

Urban, which registered profit improvement in the first nine months of the year as well as in its third quarter, is expected to provide a “turnaround story” at its Urban Outfitters division to go along with its “thriving” Anthropologie brand, and is seen as having “significant potential across multiple channels, especially direct-to-consumer,” the analyst said.

American Eagle’s profits declined in the third quarter and for the nine months, but Konik sees better prospects ahead. He said a strong management team, headed by chief executive officer Robert Hanson, “is well equipped to drive meaningful margin and earnings recovery against easy compares and restore brand momentum.”

He noted, “The numerous panels we conducted in the past 12 months have shown the company to be the most relevant teen brand. We also see strong valuation support at these levels and believe consensus estimates are too low.”

The teen sector has been weighed down by numerous obstacles in recent seasons, from the ascendancy of fast-fashion chains like H&M and Uniqlo to stubbornly high unemployment levels among teenagers. In November, when the national unemployment rate fell to 7 percent, the figures in the teen and young adult age groups remained at double-digit levels, with the rate for those aged 16 to 19 at 20.8 percent and for those in the 20 to 24 stratum at 11.6 percent.

The downgrade for Abercrombie reflects Konik’s belief that “it will take longer than anticipated to rejuvenate impaired brand relevance in the U.S., making it difficult to drive improved fundamentals in the business and curtail ANF’s aggressive promotional stance.” While much of the firm’s third-quarter loss and a 130 basis point decline in gross margin for the period were attributed to charges associated with the decision to close the Gilly Hicks stores, the firm’s projection for fourth-quarter comparable sales, including those registered online, was a “low double-digit decrease.”

Aéropostale’s numerous challenges include “deteriorating fundamentals and diminishing visibility on the timing of a turnaround that has yet to materialize,” according to the analyst. “In the meantime, merchandise changes have failed to connect with consumers, resulting in steep markdowns, heavy margin erosion and significant cash burn.”

The company began the fourth quarter expecting a net loss on par with or greater than the 24 cents a diluted share loss registered during the fourth quarter of 2012. In the first nine months of the year, gross margin declined to 19 percent of revenues from 27.1 percent during the first nine months of 2012.

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