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American Eagle Outfitters’ (AEO) Q1 fiscal 2013 results reflected the impact of the payroll tax increase and prolonged cold in the U.S. The company’s comparable store sales declined by 4% as demand for spring clothing fell and buyers remained watchful of their spending. However, the silver lining was the healthy increase in online sales and the improvement in gross margins. American Eagle’s weakness was mostly due to something that has troubled the entire industry and is not likely to persist for long. We expect better results in the near term driven by the retailer’s strong direct-to-consumer channel and a fashion responsive team. Over the longer run, American Eagle’s initiatives for omni-channel retailing and growth in its Aerie brand and factory store network will support its overall growth.

A Brief Overview Of First Quarter Performance

Even with the timely launch of its spring collection, American Eagle was not able to attract enough store traffic. The main reasons were low demand for spring clothing due to prolonged cold and weak consumer spending resulting from the payroll tax increase. As a result, the retailer’s revenues and comparable store sales fell by 5% and 4%, respectively. [1]

However, online revenues jumped 24% - offsetting some of the weakness during the quarter. Gross margins also improved by 30 basis points despite heavy promotional activities driven by product cost benefits and supply chain efficiency. [2] On the product side, the company saw the benefit of 240 basis points in the costs while the increase in the number of markdowns was only able to cause an offset of 70 basis points. [2]

What Will Drive The Company In Future?

We believe that American Eagle’s growth fundamentals are strong enough to drive its future sales (read: What Justifies American Eagle Outfitters' 25% Upside?). Additionally, the following factors should also help.

A Fashion Responsive Team And Strong Supply chain

Although the sales were weak this quarter, customer response to American Eagle’s fashion was encouraging as the company was quick to add relevant trends to its products. [3] The retailer stated that its team is working aggressively on identifying prevailing trends, right styles, fits, colors, fabrics and patterns. To enhance its responsiveness, American Eagle increased its product development cycle from four to six times a year. [3] Additionally, it lowered the cycle period by about four-six weeks and increased its open-to-buy stock levels by 20%. [3] An open-to-buy system uses stock turn requirements and sales forecast to determine optimum inventory levels. [4] The retailer is now unveiling new fashion on a monthly basis with a focus on shopping patterns and holidays. Based on the spring results, the women’s merchandise team tracked 40 different fashion choices for the second quarter and the summer collection has already arrived with fresh fashion. [3]

American Eagle is maintaining strong discipline in its fabric platforming and production capacity to improve product flow efficiency. Fabric platforming refers to holding a limited number of fabrics and washing and treating them in different ways for different products. This way, the company requires relatively fewer resources and it helps in speeding up the process. American Eagle’s TradeStone PLM software, which allows the company to control its design-to-delivery process effectively, recently went live. [5] With the new merchandise planning tool, the retailer will be able to buy, plan and allocate its merchandise with greater precision according to local demand. [3] These initiatives will align American Eagle’s product assortments with prevailing fashion, changing seasons and customer demand.

Initiatives For Omni-Channel Retailing

Omni-channel refers to a seamless shopping experience through all the available channels such as physical stores, mobile, Internet, catalog, etc. It enables retailers to engage customers irrespective of the shopping channel they prefer. American Eagle is making substantial investments to improve and upgrade its technology and is working on implementing its global enterprise system. This oracle-based system will integrate its point-of-sale and merchandise system, providing customers with a consistent shopping experience across channels. The flexible system will allow the retailer to respond much faster to the changing needs of the business. [3]

American Eagle’s Teradata CRM system is set to go live this quarter, which will build a foundation to support personalized customer data. Later this year, the retailer will launch the IBM Sterling Order Management System to support its omni-channel capabilities. [3] This system provides a single view of demand and supply, customized fulfillment process and a single source of order information. [6] It will allow the company to strike a balance between order promising and fulfillment, thus improving customer satisfaction. American Eagle stated that this initiative will drive greater inventory utilization and will be incremental to sales. [2] The retailer will also 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. [2] 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.

Growth Of Aerie And Factory Store Expansion

Despite a weak quarter, Aerie’s comparable store sales increased by 4% and profits almost doubled. [3] This growth is attributable to several initiatives the brand took to improve its famous-for intimate lines and swim category, which resonated well with the customers. American Eagle stated that the response to Aerie’s new swim line, which was based on its best-selling bra styles, was pleasing. [3] Although this business is still small, it has grown at a healthy pace and still presents immense potential. For the brand’s growth, the company will continue to reposition the store fleet and close underperforming stores. Additionally, it will look to maximize side-by-side and shop-in-shop locations and also alter the brand’s online shop. [3] During the first quarter, Aerie’s new online swim shop resulted in a 38% increase in the brand’s revenue from the e-commerce channel. [3]

Although American Eagle’s factory stores are still at a nascent stage, they have performed better than its mainline stores. [3] The company stated that its made-for-factory merchandise performed well this quarter. Therefore, the retailer plans to increase the penetration of these products in its overall merchandise range and speed up the factory store expansion. In Q1 fiscal 2013, out of the seven stores opened in North America, five were factory stores. [3] We note that both these businesses are not big enough to drive the company’s stock at the moment. However, with their steady growth, things may change in the longer term.

Our price estimate for American Eagle Outfitters stands at $27, implying a premium of about 30% to the market price.

Disclosure: No positions.

Source: American Eagle Outfitters: Fundamentals Remain Strong Despite A Weak Quarter