Apparel makers have had a rough year, as deterioration in consumer spending on discretionary goods exacerbated issues stemming from already-tough industry dynamics. Despite a difficult retail environment, these stocks have performed quite well, fueled by increased consumer confidence and a more optimistic outlook for 2010. The stock prices of apparel manufacturers rated by Morningstar have increased more than 40% on average over the past 12 months, outperforming the S&P 500, which is up approximately 13% during the same period. While we believe the worst is over for most of these firms, we don't expect a significant rebound in results and project modest growth levels going forward. Currently, we believe most of these firms are moderately overvalued, with a median price to fair value ratio of 1.3. Over the longer term, however, we think the firms with the most potential are the ones that have kept their brands relevant and consumers engaged during the downturn. Additionally, we think manufacturers that possess a diversified portfolio of strong brands, as well as an extensive distribution channel with a broad geographic reach, will have a leg up and are likely to outperform their peers over the long run.

Top- and Bottom-Line Pressures
Several changes have occurred in the apparel industry in recent years that have negatively affected the manufacturers. National brands that are typically sold through department stores began to feel the pinch in the mid-2000s as a wave of department store consolidation resulted in a number of store closures and increased buying power from remaining chains like Macy's (NYSE:M - News), which is a big buyer of branded apparel. In an effort to differentiate products from competitors, department stores also pushed branded apparel aside in favor of private or exclusive label merchandise. Additionally, we believe the increased popularity of specialty retailers among shoppers also negatively affected sales at department stores and apparel manufacturers in turn. As apparel manufacturers were adapting to these changes in the retail sector, the macroeconomic environment began to deteriorate. Retailers cut orders sharply as demand for discretionary products waned amid the downturn, creating added top-line pressure for apparel manufacturer's sales. Retail bankruptcies, like Goody's and Mervyn's, also hurt revenues for some apparel manufacturers. On a different playing field, manufacturers that make basic apparel such as Hanesbrands and Gildan Activewear (NYSE:GIL - News) were also faced with steep revenue declines, thanks to reduced orders from wholesalers and mass merchants like Wal-Mart (NYSE:WMT - News).

Furthermore, profitability has suffered as retailers pushed for additional concessions on price after running steep promotions to drive sales. As a result, apparel makers have reported fairly substantial gross margin compression over the past year, especially during the extremely promotional 2008 holiday season. To help preserve margins, apparel manufacturers have engaged in several rounds of cost-cutting as well as reduced inventory levels. Some firms, like Liz Claiborne (NYSE:LIZ - News) and Jones Apparel (NYSE:JNY - News), have divested or discontinued unprofitable lines to help lower expenses and boost cash flow, undoing a lot of their acquisitive growth over the past several years.

Easing Pressures in the Near Term, but Tough Industry Dynamics Remain
Although we don't expect a spike in sales for these apparel manufacturers, we believe top-line pressures will subside over the next couple of quarters, as these firms start to lap easier year-over-year comparisons. Additionally, we anticipate they will benefit from retailers restocking in 2010 as consumer spending starts to recover. Similarly, we expect margin pressures to ease as demand returns. While we believe the retail environment will remain quite promotional through the remainder of 2009, the magnitude of markdowns should improve, as inventory levels become better aligned with demand.

In the longer term, however, we believe pricing pressures will remain a challenge. To avoid heavy markdowns at the end of each season, we have seen some manufacturers work with retailers to open at a lower price point right out of the gate. While promotional activity will still be part of the sales cycle, this should help create more stable merchandise margins for both parties and improve the planning process.

Additionally, we believe the days of brand ubiquity are over. In our opinion, brands will have to fight harder in order to keep their floor space, considering that department stores are quick to stock the labels that consumers prefer in order to compete with other department stores and specialty retailers. We also believe that stores will continue to emphasize private and exclusive labels, and expect apparel manufacturers will attempt to profit from this phenomenon. We have seen firms keen to partner with retailers recently, including Liz Claiborne's decision to make its namesake line exclusive to J.C. Penney (NYSE:JCP - News) as well as Polo Ralph Lauren's (NYSE:RL - News) move to develop and launch the American Living brand solely for J.C. Penney's customers. In a similar move, Jones Apparel decided to reposition its l.e.i. brand to be an exclusive label at Wal-Mart.

Despite the increased emphasis on exclusive lines, we believe there will always be a place for branded apparel at department stores. We think the most successful companies will be ones with a solid portfolio that have successfully kept their brands relevant amid a changing industry landscape and fickle consumer tastes.

VF Corporation and Polo Ralph Lauren Are in the Best Position
In our view, VF Corporation (NYSE:VFC - News) and Polo Ralph Lauren, both of which have narrow economic moats, are well-positioned to benefit from an upturn in the retail industry. We think VF's well-diversified portfolio as well as its expansive geographic and sales channel reach will serve it well as consumer demand comes back on line. Additionally, we believe VF has done a great job of realigning its brand portfolio by divesting unprofitable businesses like its intimate apparel segment, while investing in growing brands like The North Face. Polo, on the other hand, has had great success by maintaining a presence in a wide range of distribution channels without materially diluting the brand. We think this has helped Polo deliver resilient figures relative to other firms in the space, as lower-priced offerings such as Chaps sold through Kohl's KSS and American Living sold through J.C. Penney have performed well amid the weak economic environment. Given that it is difficult for competitors or new entrants to replicate VF and Polo's well-established brand portfolio and distribution network, we believe these two companies will be able to generate returns in excess of their cost of capital for many years.

Meanwhile, we expect an uphill battle for firms like Liz Claiborne and Jones Apparel, which have lost touch with their customers. Despite recent attempts to revive their brands with new designs and fresh merchandise, it has been difficult for them to reconnect with their customers in an environment where shoppers, particularly women, have been reluctant to spend on discretionary goods. Furthermore, these firms' heavy debt loads also limit their ability to invest in existing and new brands, in our view.

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