In a previous note, we discussed two of the main business drivers for American Eagle Outfitters’ (NYSE:AEO) stock. [Read: Key Trends Behind American Eagle Outfitters’ Cheap Stock] We’ll continue the analysis in this article and look closely at other key drivers, including American Eagle stores’ profit margins (measured by EBITDA) and its direct-to-consumer revenues.
While we expect the margins to stabilize due to the mixed impact of inventory control, stable cotton prices and competitive factors, we believe that direct-to-consumer business is likely to see strong growth for the next few years.
- What Can Move American Eagle Outfitters’ Stock In The Next Year?
- By How Much Did American Eagle Outfitters’ Revenue & EBITDA Grow In The Last Five Years?
- How Has American Eagle Outfitters’ Revenue Composition Changed In The Last Five Years?
- What’s American Eagle Outfitters’ Fundamental Value Based On Expected 2016 Results?
- What’s American Eagle’s Revenue & Net Income Breakdown In Terms Of Different Operating Segments?
- How American Eagle Outfitters’ EBITDA Growth Outpaced Revenue Growth In 2015
American Eagle Stores’ Profit Margins
In profit margins we are referring to American Eagle Stores’ earnings before interest, taxes, depreciation and amortization (EBITDA) which is further adjusted to exclude operating lease expense and stock-based compensation. In 2011, there was a drastic decline in these margins due to a sudden rise in cotton prices and increased markdowns. The figure rebounded in 2012, as cotton prices declined and the retailer controlled its inventory. The following factors are likely to drive the margins in the future.
Lower Cotton Prices: 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 a result of this sudden price rise, manufacturing costs shot up which ultimately weighed on the margins. With China steadily building up its cotton reserves, we do not expect cotton prices to spike like this. Currently China holds a record cotton inventory of 10 million tonnes, which has brought the U.S. cotton prices down from 88 cents per pound in 2012 to 71 cents per pound in 2013.  With ample cotton reserves and lower prices, American Eagle Outfitters should be able to sustain its margins.
Inventory Control & Factory Store Expansion: As mentioned in the earlier note, maintaining optimum inventory levels can allow the retailer to operate with fewer markdowns, which can aid its margins. Since American Eagle Outfitters has stayed strong on this front, we expect it to launch new products timely and operate more full priced sales. As factory stores offer products at lower prices, they have lower margins. Although these stores are still at a nascent stage, their expansion can put pressure on the retailer’s overall EBITDA margins.
Fierce Competition: 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 earn 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. 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 can have a mitigating effect on American Eagle’s margins.
Stock Sensitivity – We currently estimate American Eagle’s margins to stabilize at 24.6%. For every +/- 2.5% deviation in the figure, there can be about 10% upside/downside to our price estimate. The margins can improve if the company continues to outperform its peers in all facets of the business. On the other hand, stiff competition, a customer shift to factory outlets and an inventory hangover can drag the margins down.
This refers to the revenues generated from American Eagle Outfitters’ Internet and catalog orders. Historically, direct sales have increased steadily due to the growing Internet usage and adoption of connected devices such as smartphones and tablets. This trend is likely to continue going forward due to the following reasons.
Increasing Online Apparel Sales: Currently, the apparel industry in the U.S. is being driven by a consistent growth in the direct-to-consumer channel. Players such as Urban Outfitters, Gap and Abercrombie & Fitch have thrived on this trend. The outlook on the industry is encouraging as eMarketer forecasts the online apparel sales to increase from about $45 billion in 2012 to $90 billion in 2016.  American Eagle Outfitters’ own direct revenues increased at an average annual rate of 18% during 2011-2012, and we expect this fast paced growth to continue. The demand from emerging nations, where the company ships directly, will also complement the growth.
Omni-Channel Retailing: Omni-channel retailing refers to a seamless shopping experience across all the available channels. It enables a retailer to engage with its customers irrespective of the shopping channel they prefer. On this front, American Eagle Outfitters is making substantial investments to improve and upgrade its technology. Its oracle-based global enterprise system will integrate its point-of-sale and merchandise system, providing customers with a consistent shopping experience across channels. The flexible system will also allow the retailer to respond much faster to changing needs of the business. The company will start its 1 million sq. ft. distribution center project in Pennsylvania in this quarter, which will enable it to directly ship products to U.S. customers within two days. This distribution channel is expected to be operational by mid 2014 and will play a crucial role in American Eagle’s omni-channel expansion plans. 
Stock Sensitivity – We currently estimate American Eagle Outfitters’ direct-to-consumer revenues to increase at an average annual rate of 10% and reach $870 million by 2019. For every +/- $150 million deviation in the figure, there can be about 5% upside/downside to our price estimate. While increasing competition in the U.S. apparel industry can limit the channel’s expansion, fashion responsiveness, inventory control and attractive pricing can fuel its long term growth.
Our price estimate for American Eagle Outfitters stands at $27, implying a premium of about 35% to the market price.Notes:
- 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 [↩]
- China’s Cotton Stockpiling Threatens To Devastate American Producers, Fox News, April 12 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 [↩]
- Retail Ecommerce Set to Keep a Strong Pace Through 2017, eMarketer, Apr 24 2013 [↩]
- American Eagle Outfitters’ Q1 fiscal 2013 earnings transcript, May 22 2013 [↩]