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Investment Overview for American Eagle Outfitters (NYSE:AEO)
WHAT HAS CHANGED?
- American Eagle reported its second quarter results on August 17, 2016, wherein it beat consensus estimates for both EPS and revenue. The company reported its eighth consecutive quarter of profit improvement, primarily due to a large demand for its Aerie line of lingerie, and personal care products. Comparable sales in the brand soared 24% in the quarter, a fifth consecutive quarter of 20% plus growth, much higher than the 3% overall comparable sales growth, and a 1% increase in its namesake brand. The company managed to attain higher selling prices and transaction size across all of its brands, and this coupled with lower product costs, helped to achieve an improvement in the merchandise margin and profitability.
- The company's game-changing campaign in 2014 for its Aerie brand, where the lingerie brand decided to feature only unairbrushed models in its ads, has paid off for the company. The sales increased immensely thereafter (20% growth in FY 2015), and shows no signs of slowing down. Amid an otherwise dismal retail environment, Aerie's sales increased 32% in Q1 2016, as compared to a growth of 12% in Q1 2015, surpassing what most analysts had predicted. AEO anticipates a sales rise to $500 million in the coming years. While that is small compared to lingerie giant Victoria's Secret's sales of $7.7 billion, strong growth in the Aerie brand is making it a viable competitor.
- As is the case with other apparel retailers, AEO is gradually shrinking its store count, and focusing more on the high margin e-commerce channel. A soft and gradual reduction in its brick-and-mortar footprint, as opposed to a large closure in one go, is a good decision as it would not result in a steep fall in sales. The company's digital sales registered a 20% growth in FY 2015. This lends credence to the decision to develop its omni-channel presence by investing in digital marketing, and improve its website and mobile app. During FY 2015, the company invested $29.1 million in developing its e-commerce capabilities, and is expected to spend more in FY 2016. The direct business continues to perform well for the company, contributing to 30% of the company's revenues in Q1 2016, and has been a major driver in its sales growth, especially since the mall traffic has been soft.
- American Eagle Revenue per Square Foot: American Eagle revenue per square foot increased to $463 in 2011, and to $521 in 2012, largely driven by the company's specific item promotional strategy that began in the second half of 2011. However, the figure declined substantially to $467 in 2013 on account of a few missed fashion calls, an overall weakness in the U.S. apparel industry, and fickle consumer behavior. In 2014, American Eagle's troubles continued as buyers left for relatively fashion-forward brands such as Zara and Forever 21. Meanwhile, the retailer persistently focused on basic logo inventory, which failed to intrigue customers. As a result, its revenue per square foot declined to $448 in 2014.
However, we expect the revenue per square foot to gradually improve and reach $561 by the end of the Trefis forecast period, as American Eagle has shown some progress on merchandise and is gradually heading towards a better fashion portfolio. However, competition among teen apparel retailers is exceedingly fierce, and a single merchandise goof-up can cost the company its market share. Moreover, with prevailing weakness in the U.S. economy, buyers are searching for a balance between fashion and affordability, and American Eagle isn't the ideal solution for them given its existing portfolio. If the retailer's revenue per square foot remains low and the figure reaches just $515 by the end of Trefis forecast period, there can be about 10% downside to our price estimate. However, consider a scenario where American Eagle maintains its merchandise well with proper inventory control and eliminates under-performing stores from its fleet. If this lifts the revenue per square foot to $585 by the end of the Trefis forecast period, there can be about 5% upside to our price estimate.
- American Eagle Stores EBITDA Margin: Though American Eagle Stores' EBITDA Margins declined drastically in 2011 due to an increase in cotton prices owing to floods in major cotton producing areas, it rebounded to the 2010 level of 26.1% in 2012 with an improvement in cotton prices and the company's firm inventory control. However, the year 2013 was marked by heavy promotional activities throughout the U.S. apparel industry and American Eagle was no exception. Heavy discounting dragged the retailer's margins down to 19.5%.
Surprisingly, EBITDA margins improved to 21% in 2014 and 23.1% in 2015 as the company was able to improve its gross margins with fewer promotional activities. Lower expenses due to store consolidation also helped.
Going forward, however, we expect margins to decline gradually (with the exception of 2016 when margins are expected to rebound further due to fewer promotional activities) as the industry scenario remains highly promotional and the company incurs additional expenses due to the growing proportion of web sales. However, if the company manages to stabilize its margins at the current levels, there can be a 5% upside to our price estimate. Conversely, if margins decline further to 19% owing to heavy promotions and higher costs of operation, there can be about 5% downside to our price estimate for American Eagle Outfitters.
American Eagle Outfitters is a leading specialty apparel retailer that operates under the American Eagle Outfitters (AEO) and Aerie brands. The retailer designs, markets, and sells its own brand of high quality, on-trend clothing, accessories, and personal care products at affordable prices, while targeting 15-25 year old customers. Through its Aerie brand, the company offers a collection of intimates and personal care products for girls. Aerie emphasizes comfort rather than glamor when it comes to women's lingerie.
Most of American Eagle's retail presence is confined to the U.S. and Canada. It operates a few retail stores in Mexico and 141 franchise stores in 22 countries. In addition to this, it operates web-based stores for its different brands, through which it ships its merchandise to 81 countries across the world.
The American Eagle stores provide most value to the company, followed by the Internet & Catalog Business.
Revenue per square foot and number of American Eagle stores higher than Aerie
As compared to its relatively young Aerie brand which has just 99 stores, American Eagle stores have a much broader geographical presence, with close to 950 stores across the U.S. and Canada. Also, revenue per square foot of American Eagle stores at $444 is much higher than that of Aerie stores ($371). This can be attributed to the fact that American Eagle stores have a wider product variety, and Aerie isn't an upscale lingerie brand like its counterpart Victoria's Secret is.
Internet & Catalog Orders' revenue growth is faster than American Eagle's mainline stores
Although Internet & catalog revenues account for just 17% of the company's overall revenues, they have grown at a rapid pace over the past few years. During 2009-2015, AEO direct revenues are estimated to have grown by more than 14% annually driven by growing popularity of online apparel shopping.
Weak brand loyalty for American Eagle
The U.S. teen apparel market is currently highly promotional, where each retailer is trying to outsmart the other one with a broader and deeper set of products. As a result, U.S. buyers have shown low brand loyalty as they have been readily shifting to the brands that provide relevant fashion at affordable prices. This trend has helped the growth of fast-fashion companies such as Gap Inc, Urban Outfitters, Zara, Forever 21, and H&M. On the other hand, companies such as American Eagle Outfitters, Abercrombie & Fitch, and Aeropostale have been at the receiving end of this trend.
Greater focus on fashion offerings
While American Eagle’s core products have struggled, its limited fashion range has found good acceptance among customers. As a result, the company is looking to strengthen this product category with more innovation in distinct finishes, fabrics, and washes. The company is looking to gradually shift its product portfolio from basic to fashion and has already seen some success. American Eagle is planning to simplify its designing system to respond to changing customer tastes quickly and effectively. It is removing layers within its designing teams, reorganizing the structure to implement direct accountability, and enhancing its speed sourcing capabilities. One such development on this front is the retailer’s fast-track fashion capsules, whose designing to in-store receiving process takes just 60 days. By effectively leveraging these factors, the company will be able to increase the proportion of fashion products in its portfolio.
Growth of young brand Aerie
American Eagle Outfitters sees huge potential in its relatively new brand, Aerie. The company is looking to capitalize on the lack of competition in the young women's intimates specialty format. About 15% of the total female population in the U.S. are between ages 15 and 24. The overall lingerie market in the U.S. stands well over $12 billion, and is currently dominated by only a few established brands. The encouraging trend is that U.S. buyers have continued to spend on intimate products even during the sluggish economic environment. In 2015, Victoria’s Secret registered robust growth for its intimate products, even though the apparel industry remained weak overall. Even Aerie performed slightly better than American Eagle’s namesake brand during the year. With the right push, we believe that Aerie can follow in the footsteps of Victoria’s Secret. The brand can fend off the fierce competition in the intimates market as its products are affordable and more about usability than glamor.
The apparel market in the U.S. is highly saturated and competitive with a large number of established brands. Moreover, the sluggish economic growth has been a big worry for the entire industry. Last year in particular, apparel retailers struggled to achieve positive growth as cautious consumer spending and changes in spending patterns have weighed on sales. Given the situation in the U.S., exploring opportunities in international markets is warranted. It will not only open new revenue channels for the company, but will also help diversify the business risk geographically. With slightly better macroeconomic conditions and lesser competition, international markets might provide American Eagle with the opportunity to operate more full priced sales.
Early in 2012, the company assumed control over its six franchise stores in China and appointed Kitty Yung as the president of its Asia-Pacific operations. The same year, American Eagle also announced the opening of its first store in Mexico. Additionally, the retailer entered the Philippines in 2013 and announced its plans to enter Thailand in the same year. Also, American Eagle opened its first retail store in the U.K. towards the end of 2014 and continued its franchise expansion in 2015.
Development on omni-channel platform
With e-commerce not turning into a big business for many retailers despite continued robust growth, the need for omni-channel retailing has emerged. The entire apparel industry is gradually shifting towards this concept, which appears to be the future of retailing. Over the past couple of years, American Eagle has taken several steps towards the development of its omni-channel platform and all of them have shown good promise so far. Its "buy online and ship from the store" pilot program has helped it attract those customers, who could have shied away from the retailer if the inventory pool wasn’t integrated across all the channels. The initial roll out was slow, but the company soon went aggressive on its deployment.
The retailer reported that its BOSS program has exceeded all expectations, and this might help it operate with fewer markdowns and better inventory utilization in the future. Also, American Eagle has improved its delivery time significantly and it now delivers products in two days or less to more than 90% of its customers. It opened a new "state of the art" fulfillment center in Pennsylvania in July 2104, that has played an important role in improving capacity and delivery efficiency. In addition, American Eagle has several other projects planned that are intended to optimize shopping experience across online and mobile channel. It is in the process of adding new features to its website including 360 degree product view and more on-body product display. The company is relaunching an updated version of its mobile app, that will now run faster and have a better interface.
All these efforts, along with the anticipated growth in online apparel sales, are likely to help American Eagle improve its store productivity.
American Eagle operates a vast network of over 900 mainline stores in the U.S. While such presence enables the company to encompass a large customer demographic, it also increases the chances of self-cannibalization. There also exists a possibility that the retailer operates certain stores in regions where foot fall is significantly lower than what the stores can handle. Under such situations, stores do not operate at their full capacity, which results in low RPSF and higher SG&A expenses. Since American Eagle is already struggling to attract customers due to low brand loyalty, it is planning to close under-performing stores to offset the impact of low store traffic.
In its Q1 2014 earnings call, American Eagle’s management stated that it has identified 150 stores to close in the next three years out of its 300 stores whose lease will expire by 2017. By shutting stores that do not run at their full capacity, American Eagle will be able to reduce its square footage at a faster rate than its revenue decline. This will result in an improvement in its revenue per square feet. Also, its SG&A expenses will come down at a faster rate than its revenue decline, positively affecting its operating margins. However, the company cannot close stores beyond a certain limit, as it needs to have a store network capable enough to support its omni-channel needs. Hence, we believe that American Eagle will continue to open stores simultaneously at lucrative locations, and might not close any more stores after it is done with these 150 outlets. Towards the end of 2015, the company announced that it was on track to close 150 stores by the end of fiscal 2016.
Factory channel is promising
American Eagle’s factory channel, which was launched not too long ago, has been generating better sales than the company’s mainline stores. During 2013, factory stores delivered positive comparable store sales, despite the tough retail environment, and the retailer saw improvement in 2014 as well. Although currently this channel is not big enough to have a material impact on American Eagle’s results, the U.S. market does provide huge room for its growth. The retailer opened 39 factory stores in 2013, another 26 in 2014 and opened an undisclosed number of factory stores in 2015, as well.
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