Excessive Promotions To Result In Reduced Earnings For American Eagle

by Trefis Team
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AEO
American Eagle Outfitters
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The weakness in the American retail industry does not bode well for American Eagle Outfitters (NYSE:AEO), which is set to declare its second quarter (three months ended July) earnings on August 23. While relatively flat revenues are expected, the earnings per share is estimated to plummet by over 30%, implying pressured margins. Excessive promotional activities and a shift to the digital channel pressured the margins in the first quarter, and this trend is expected to continue in the subsequent quarter as well. The company has also guided for comparable store sales to be in the flat to a low single digit decline range, and an EPS of $0.15 to $0.17. In the aftermath of the first quarter earnings declaration, wherein the company provided its second quarter results expectation, the stock price plunged over 12%, seemingly as a result of the weak guidance. Below we’ll highlight a few trends that may impact the quarter.

Focus On The DTC Segment

Increasing rates of internet penetration have facilitated the move from store to web shopping, as well as the proliferation of smartphones and tablets. As a consequence of this movement, American Eagle Outfitters‘ direct-to-consumer (DTC) business has grown rapidly, accounting for 26% of the total revenues in the first quarter, up from 19% in the corresponding period of last year. Effective digital marketing, as well as growth in mobile, has continued to accelerate growth. Given the high growth rate seen in this segment, AEO has also launched an exclusive online-only range, which has been well received. The company has taken a number of steps to ensure a seamless online experience, which has also been an important factor driving the sales.

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 apparel retailers, including American Eagle, which has been working hard to develop its omni-channel platform, and has shown significant progress so far. Impressive performance of the DTC segment has been one of the growth drivers for American Eagle in recent quarters. According to Trefis estimates, the company’s online business will continue to grow at a high rate, reaching $1.63 billion by 2023.  Aerie, in particular, has benefited immensely in the online space, resulting in a 47% online penetration in the first quarter, up from 35% in the prior year period.

In 2017, the company intends to undertake capital expenditure to the tune of $160 to $170 million, roughly half of which is expected to be spent to support the digital business, and omni-channel tools. Given the rise of its DTC business, and the ongoing mall traffic declines, the company continues to assess its store locations. AEO’s fleet of stores are largely profitable, but it continues to look into cases where the company is over-stored or there is a high likelihood of sales migration. 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. During FY 2017, the company intends on closing 25 to 40 locations, and is meanwhile, selectively opening stores. These include Aerie stores, and a handful of American Eagle stores in the US and Mexico. Internationally, the company is expected to open 45 stores, and close two licensed store locations.

Aerie To Continue Its Phenomenal Performance

American Eagle’s Aerie brand, which is the company’s lingerie and activewear segment, has been performing strongly for the past several quarters. The first quarter of 2017 was another breakout one when the brand delivered a 25% growth in comparable sales, representing a 13th straight quarter of double digit comps growth. This rate sounds even more impressive when a tough comparison to the 32% growth delivered in the same period last year is taken into consideration. New customers, as well as increased traffic, both online and in stores, resulted in the impressive performance. A new apparel collection – Chill. Play. Move. – was launched in the quarter, which posted strong results. The digital penetration increased to 47%, from 35% last year, signaling the importance of the online segment for the company.

Aerie currently operates approximately 190 stores in 13 states, including the recent expansions into new markets of Denver and Hawaii. The company sees an opportunity to increase this number to 300 plus stores over time. 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.”

Margins To Remain Pressured

Weak consumer traffic at malls has continued to hamper the business of apparel retailers. American Eagle is no exception to this trend. As a consequence of this, the company has resorted to excessive promotions to drive the traffic at its stores. Such a strategy has been wreaking havoc at its margins, which have remained pressured for a couple of quarters already. In Q1, the gross margin fell by 270 basis points, 200 basis points of which were the result of increased promotions. Even in the second quarter, the company has factored in a lower merchandise margin, due to this strategy, into its earnings guidance.

Furthermore, a focus on the digital business also comes with its own pitfalls. While concentrating on the online channel makes sense, an inherent problem associated with this strategy is the increased pressure on margins. Undertaking investment to develop the e-commerce capabilities, as well as for improving the online experience, just means higher costs. Furthermore, in order to compete with companies, such as Amazon, retailers will also need to cut down the prices of products sold online. This results in a higher promotional environment, which does not do the margins any favor. With a rise in the contribution of online sales to the total revenue, the profit and margins will continue to be negatively affected.

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Notes:

1) The purpose of these analyses is to help readers focus on a few important things. We hope such communication sparks thinking, and encourages readers to comment and ask questions on the comment section, or email content@trefis.com
2) Figures mentioned are approximate values to help our readers remember the key concepts more intuitively. For precise figures, please refer to our complete analysis for American Eagle Outfitters
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