Although American Eagle Outfitters’ (NYSE:AEO) EBITDA margins (earnings before interest, taxes, depreciation and amortization) have fluctuated in the past, we expect them to remain stable in the long term. These margins decreased from 24.2% in 2008 to 23.3% in 2009 due to increased markdowns as a result of unfavorable economic conditions.  The figure remained stable in 2010 and dropped to 19.8% in 2011 mainly due to sudden rise in cotton prices. In 2012, the margins rebounded to 23.6% as cotton prices declined and the retailer maintained better control over its inventory.  We expect American Eagle Outfitter’s EBITDA margins to increase slightly in the near term and stabilize at around 24-25% as a result of mixed impact of lower cotton prices, lower inventory levels, fierce competition in the U.S. apparel industry and the expansion of its factory store network.
Lower Cotton Prices Should Help Sustain The Margins
From $0.84 per pound in July 2010, cotton prices rose to $2.30 per pound in March 2011.  The major factor behind this price increase was the drought in Hubei province of China, a major cotton producing area.  Government restrictions on exporting cotton out of India and a devastating flood in Pakistan further contributed to the shortage in supply.  
As cotton is one of the key raw materials for apparel retailers, a sudden spike in cotton prices resulted in an increase in manufacturing costs. However, cotton prices declined to $0.83 per pound by the end of 2012 as China recovered from the drought and India eased its regulation on cotton export. 
With China steadily building up its cotton reserves, we do not expect cotton prices to spike like this in our forecast.  Currently China holds a record cotton inventory of 10 million tons, which has brought the U.S. cotton prices down from $88 in 2012 to $71 cents in 2013. With ample cotton reserves and lower prices, retailers such as American Eagle Outfitters should be able to reduce their manufacturing costs and sustain their margins.
Better Inventory Control Will Result In Fewer Promotions
During 2011, high inventory levels proved to be a big issue for American Eagle Outfitters. The company had to usher massive promotions on its merchandise in order to clear off its pending inventories.  This eventually took a toll on its 2011 EBITDA margins. However, the retailer was able to finish 2011 with much lower inventory levels and has maintained its control since then. It reduced its inventory level by additional 10% in Q4 fiscal 2012.  This was the reason why American Eagle Outfitters went through 2012 with fewer promotional discounts. Going forward, we expect the company to have a better control over its inventory, which will allow it to launch new products timely, operate more full priced sales and in the process, maintain healthy margins.
While the above mentioned factors support the retailer’s margin growth, there are certain offsetting factors that will weigh on margins.
Expansion Of Factory Stores & Fierce Competition
American Eagle Outfitters is looking to aggressively expand its factory store network in the U.S. The retailer opened about 10 factory outlets in 2012 and plans to add about 40 in the current fiscal year.  As the name suggests, factory stores offer products at lower prices than other American Eagle Outfitters’ stores. As a result, the profit margins for these stores are relatively low. Although American Eagle Outfitters’ factory store network is still at a nascent stage, it will put pressure on overall margins as it expands.
The U.S. apparel industry is highly competitive where retailers are trying to out smart each other by employing various strategies. While Gap (NYSE:GPS) and Urban Outfitters (NASDAQ:URBN) are fueling their marketing, Aeropostale (NYSE:ARO) is aggressively working on improving its product mix.   Abercrombie & Fitch (NYSE:ANF) and American Eagle Outfitters have launched their loyalty and rewards program where customers earns reward points on their purchases.   Apart from these, we believe that pricing will be one of the key selling points as the U.S. buyers remain cautious about their spending.
This is why Aeropostale turned out to be the best performer among its peers during the recession of 2008-2009 as it offered basic products at lower prices.  As the U.S. economic recovery is expected to be slow in the near term, apparel retailers are likely to continue using attractive pricing to appeal to customers.  This will have a mitigating effect on American Eagle Outfitters’ margins.
What’s The Significance?
We currently forecast American Eagle Outfitter’s EBITDA margins to remain stable at 24-25% in the long term. However, if the company continues to outperform its peers in all facets of its business i.e. product mix, marketing, in-store experience etc., it might be able to operate with relatively fewer discounts. If this pushes the margins to 27% in the next five-six years, there could be 5-10% upside to our price estimate. On the contrary, if stiff competition, a customer shift to factory outlets and an inventory hangover drag the margins down to 22%, there could be 5%-10% downside to our price estimate.
Our price estimate for American Eagle Outfitters stands at $27, implying a premium of about 40% to the market price.Notes:
- American Eagle Outfitters’ SEC filings [↩] [↩]
- Cotton Monthly Prices, Index Mundi [↩]
- Cotton Gains on Reports of Chinese Drought; Orange Juice Falls, Bloomberg, May 19 2011 [↩]
- Cotton Prices Jump As India Bans Export, FT, March 6 2012 [↩]
- Losses Loom As Pakistan Flood Hits Cotton Crop, FT, Aug 19 2010 [↩]
- India Eases Restriction On Cotton Exports, Economy Watch, May 1 2012 [↩]
- China’s Cotton Stockpiling Threatens To Devastate American Producers, Fox News, April 12 2013 [↩]
- American Eagle Outfitters Q4 fiscal 2011 earnings transcript, May 7 2012 [↩]
- American Eagle Outfitters Q4 fiscal 2012 earnings transcript, March 6 2013 [↩] [↩]
- Gap’s New Campaign: “Be Bright”, Branding Magazine, Feb 16 2012 [↩]
- Urban Outfitters’ Q4 fiscal 2013 earnings transcript, Mar 11 2013 [↩]
- Abercrombie & Fitch launches loyalty club, exclusive online photos, other content, Business First, Aug 15 2012 [↩]
- American Eagle Outfitters’ Reward [↩]
- Aeropostale’s SEC filings [↩]
- On road to zero growth by 2050, Market Watch, Dec 4 2012 [↩]