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Investment Overview for American Eagle Outfitters (NYSE:AEO)

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1. Latest Earnings

American Eagle Outfitters (NYSE:AEO) bucked the declining retail trend in its second quarter, posting an increase of 2.7% in its revenues, and comparable sales growth of 2%. The retailer managed to beat consensus expectations on both revenue and EPS, coming in at $21 million above revenue estimates, and 3 cents higher than predicted for earnings per share. However, while the latter is down considerably year-on-year, the news of the beat brought a cheer, with the stock of the company rallying in the wake of the earnings announcement. It was indeed a solid quarter, better than the performance seen for a number of apparel retailers, with AEO delivering a tenth consecutive quarter of comps improvement. The Aerie brand was again the driver for much of the growth seen in the company, and the work undertaken by the management places AEO in a better position than most in this blighted sector to deliver sustained growth.

2. Aerie's Campaign

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 (26% comps growth in Q2 2017), and shows no signs of slowing down. This growth figure is all the more impressive when compared to those delivered by its competitors. While the brand is much smaller in terms of sales when contrasted with Victoria's Secret, the latter posted a comps decline of 14% this quarter. New product lines of Aerie carried on the success of the lingerie business, with the swimwear, including Chill.Play.Move, delivering growth that exceeded expectations. The successful marketing campaigns run by the brand resonate well with the consumers, making it poised to carry on its growth in the future. This segment of the company has also benefited from the immense growth of the online business, which represents 40% of the sales posted by Aerie.

3. Direct Business

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. For the company as a whole, the digital sales now account for 26% of the total revenues, up from 19% last year. Effective digital marketing, as well as growth in mobile continued to accelerate growth. Given the high growth rate seen in this segment, the company had also launched an exclusive online-only range, which was well received. The company has taken a number of steps to ensure a seamless online experience, which was also an important factor driving the sales, especially since the mall traffic has been soft.

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1. American Eagle Revenue per Square Foot

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. The declining trend has continued in the following years. In 2016, the metric stood at $393. This has been a result of a move towards the online channel, and hence, a decline in the mall traffic being witnessed throughout the retail industry. However, we expect the revenue per square foot to decline in the coming years, before gradually improving and reaching $369 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 $281 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 10% upside to our price estimate.

2. American Eagle Stores EBITDA Margin

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. This metric further improved in 2016 to 24.2%, achieved through favorable product costs and sourcing efficiencies, and maintaining tight inventories through more strategic and targeted promotions.

Going forward, however, we expect margins to decline gradually 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. ${header:summary}

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, China, Hong Kong, and the United Kingdom, and 176 licensed stores in 23 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.

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The American Eagle stores provide most value to the company, followed by the Internet & Catalog Business.

Revenue per square foot of Aerie higher than that of American Eagle stores

An immense demand for the Aerie brand products has resulted in a shift in the business. 2016 saw the revenue per square foot of Aerie exceeding that of American Eagle stores for the first time. The metric for American Eagle stood at $393, while that of Aerie was $462. While the relatively young Aerie brand has just 102 stores, American Eagle stores have a much broader geographical presence, with close to 950 stores across the U.S., Canada, and other regions. While weak mall traffic and a soft macro environment have negatively impacted other brands, Aerie has been gaining market share. According to Jen Foyle, Global Brand President of Aerie, the company wants to be "a real player in the intimates sector." 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.

Internet & Catalog Orders' revenue growth is faster than American Eagle's mainline stores

With the rise of internet shopping, the Internet & catalog revenues as a share of the total revenues for American Eagle has been on the rise, accounting for 27% of the company's overall revenues in the fourth quarter. From $307 million in 2008, the retailer’s direct revenues increased to $970 million in 2016, according to Trefis estimates. The US apparel industry is gradually shifting towards omni-channel retailing, which refers to providing a seamless shopping experience across stores and the online channel. This is becoming an inevitable move for US apparel retailers, including American Eagle, which is working hard to develop its omni-channel platform and has shown significant progress so far. 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. This lends credence to its decision to develop its omni-channel presence by investing in digital marketing, and improve its website and mobile app. During FY 2016, the company invested $28.8 million in developing its e-commerce capabilities, and is expected to spend a similar amount in FY 2017.

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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.

International Expansion.

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 2014, 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.

Store consolidation

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.

During FY 2016, the company opened 12 AE stores, 13 Aerie stand-alone stores, and 21 Aerie side-by-side stores, in addition to three Tailgate stores, and one Todd Snyder store. AEO meanwhile continued to close underperforming stores, including 18 AE stores and eight old format Aerie stores. American Eagle is undertaking an analytic review of its store fleet, to seek opportunities to consolidate markets where it makes sense, and undertake closures of unprofitable locations. The company currently estimates just 46 stores which were not profitable at year end, 26 of which come up for lease renewal or expiration within two years. Furthermore, in its entire portfolio of 1,050 stores, 580 come up for lease expiration in the next three years, giving the company the flexibility to implement its aggressive store closure plans. 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, particularly of its Aerie brand.

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How does my dragging the trendline on the chart impact the stock price?

1. We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
2. We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.

See more on: DCF Methodology

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