American Eagle Outfitters (AEO) is a specialty apparel retailer in the U.S. Its price correction over the past one year has created an opportunity for investors to own the business with a potentially attractive return.
American Eagle's customers are 15 to 25-year old men and women. Its main product assortment is denim, which is complemented by other categories including sweaters, fleece, outerwear, graphic t-shirts, footwear and accessories. American Eagle also owns aerie brand, which is a collection of intimates and personal care products for women. The sales channels for American Eagle include its brand stores and factory outlets. Recently, it is also expanding its sales via e-commerce channel.
Specialty apparel retail targeting the young generation is a competitive industry. Companies in the industry need to provide on-trend clothing at affordable prices to win the pockets of young men and women. American Eagle is competitive among its peers, as reflected from its decent ROE for the past decade. Nonetheless, companies make mistakes. American Eagle is no exception. For example, American Eagle had a tough year in 2011, where it saw its margin contracted by more than 300bps due to higher product costs and promotional activity (see below table). When companies are in trouble, their turnaround depends critically on whether their managements would admit the issues and fix them. For American Eagle's case, its management definitely did. Consequently, we saw its margin reverted to the norm in 2012.
Unfortunately, the company saw its margin contracted again during the first half of 2013 (see below table).
CEO Robert Hanson explained the causes in the second quarter's earnings call:
"Needless to say, we're not at all happy with our second quarter performance, which was a result of 2 factors. First, a disappointing women's assortment primarily within our core and core fashion businesses, where we just didn't execute well. And second, a choppy and unpredictable external environment, including highly promotional retail competition, which has continued into the third quarter. Store traffic in North America was uneven and below expectations with further deceleration in July. With this as the backdrop, combined with weak execution in women's, deeper and broader promotions led to an increase in markdowns, which pressured second quarter earnings."
Clearly, management admitted that it did not execute well, where the heavy promotional environment worsened the company's performance. Hanson explained the execution in detail: "the team was overly focused on fashion and did not pay enough attention to the foundational key items." This misstep is fixable. The management has addressed it by updating the company's product assortment for the upcoming seasons. On top of that, Hanson re-emphasized the company's focus on regaining the momentum across its foundational brick-and-mortar North American business while it is transitioning towards a global omni-channel competitor. This is definitely an important focus for the company. In all, investors should be confident in the management's abilities in turning around the company in the next 1-2 years.
Management's incentives for the turnaround are also in place. As the company's proxy filing shows, Jay Schottenstein, Chairman of the Board, owns 5.2% of the common stocks; key members of the executive team, i.e. Robert Hanson and Roger Markfield, own signification common stocks as well. On top of that, the executive team's performance decides its total compensation. These incentives make sure that the management will focus on delivering value for the shareholders.
It is important to understand the impact of American Eagle's margin dynamics on its share price. When its traffic or conversion rate decreases, American Eagle's operating margin will decrease fast due to the big fixed costs of rent and SG&A. The associated promotional activity under this negative sales environment will affect further its operating margin. As a result, American Eagle's operating income will decrease quickly, which leads to the fast drop of its share price. When the dynamics reverse direction, we will see that American Eagle's operating income and share price will increase equally fast.
For the upside, we can assume that American Eagle's revenue and operating margin recover to the 2012 level in 1-2 years once management fixes the issues. These assumptions are conservative, given management's guidance of 7-9% topline growth per annum and 15% operating margin. For the downside, we can assume the business does not recover much and stays at the 2011 level. Both cases are listed below, where the normalized tax rate is 35%:
Based on the above table, we can value the company under three scenarios:
Cash per Share
Base scenario uses the estimated EPS from the upside case of the business recovery and a conservative P/E. Up scenario uses the same EPS but an optimistic P/E. Down scenario uses the estimated EPS from the downside case of the business recovery and a depressed P/E. All three cases add one-year after-tax (35% tax rate) dividend and net cash on the balance sheet to the total price. Using the current price $14.8/share, we have decent risk/reward from these scenarios.
American Eagle is experiencing downturn due to the management's misstep. Management has both the ability and incentive to fix the issues. Investors should take advantage of the current price correction for a potentially attractive return.