Brief Company Overview
Headquartered in Pittsburgh, Pennsylvania, American eagle Outfitters, Inc (AEO) is a global specialty teen retailer founded in 1977 as a subsidiary of Retail Ventures, Inc, offering clothing, accessories and personal care products. Since going public in 1994, the company has grown to become a household name in North America. In 2000, the company opened its 500th store and hit $1 billion in sales the following year. Today, AEO operates 1,044 stores throughout North America, franchises 57 stores internationally, and sells merchandise through the company's website, available to 81 countries worldwide.
AEO operates four different business channels: American Eagle Outfitters, aerie, AEO Direct and AEO international operations.
My Original Investment Thesis
Throughout the course of the summer, I was very bullish on AEO. My original thesis contained three principal points:
The market was not giving enough credit to new management for the company's margin and demand advantage improvements from FY11 to FY12.
The market was incorrectly valuing AEO's aerie segment.
The market was incorrectly valuing its international franchise.
So What Happened?
I originally went long on the stock mid-July when it traded at around $18 and put a price target of $24. On August 5th, my heart sank when the stock fell roughly 17% in after hours trading after management alerted shareholders of an upcoming earnings disappointment. When management released its quarterly results on August 21st, the news and revised guidance further lowered the stock price to roughly $14, where it currently trades.
In AEO's Q2 FY13 earnings call, management stated: "a disappointing women's assortment primarily within our core and core fashion businesses, where we just didn't execute well...a choppy and unpredictable external environment, including highly promotional retail competition...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."
Comparable sales declined 7%, revenue fell 2%, and EPS declined 52% from last year. Short interest for the stock increased 12.15% representing 6.08% of float. Initially, it appeared the first point of my thesis rendered completely null as margins suffered from a 240 basis point increase in markdowns. After doing some due diligence, I decided to revise my original thesis to account for the current macro environment.
- AEO's brand quality and superior management will allow the company to persevere through the current environment plaguing the teen retail industry.
- The market incorrectly weighs the value of company's three non-core businesses (aerie, international, factory stores). Because they are less subject to the adverse effects (declining mall traffic leading to more markdowns leading to lower margins and comps) created by the current retail environment, the non-core businesses will help offset the core business's lackluster performance in the quarters ahead. Although I'm currently holding my position, I will go long on additional shares if management decides to allocate more capital toward organic growth in the company's non-core businesses.
Brief Sector Analysis
For teen retailers who operate stores located predominantly in shopping malls, declining store traffic in Q2 FY13 resulted in inventory levels exceeding demand. In an effort to reduce inventory, teen retailers began selling their goods at markdown prices, leading to the high promotional atmosphere the market witnessed. Theoretically, according to supply and demand, once firms achieve desirable levels of inventory, supply will decrease, and the market price of goods will increase. In the real world of business, however, events contrived through theory rarely align with actual events that transpire (look at the paradox of thrift, or efficient market hypothesis). Robert Hanson stated in AEO's Q2 FY13 earnings call "many of our competitors have introduced new collections at very deep discounts, fighting for the discretionary spending among our core target."
In the short-run, heavy promotional activities will put a strain on AEO's pricing power, and subsequently, margins. In the grand scheme, a business model revolving around capturing market share through extensive markdowns and promotions is business suicide. Price cutting results in competitors retaliating with similar price cutting measures. Unfortunately for AEO, the behavior will continue with the absence of some form of rational pricing discipline amongst these retailers (pricing discipline is unlikely in teen retail where many companies compete for a relatively narrow demographic). This is especially dangerous for teen retailers who market and sell their own brand of apparel, as cheaper clothing deleverages the quality of their brand name, the variable preventing products from being labeled as mere commodities.
AEO's Competitive Position
Continuation of the current competitive landscape will be destructive for all teen retailers. The promotion activities will continue until consumer demand improves, less companies exist in the marketplace, or companies engage in rational pricing discipline. The billion dollar question is "when will those events occur?" No one will know and rational pricing discipline is unlikely. Until then, AEO's competitive position will allow them to persevere through the existing climate. In my opinion, AEO's position in the marketplace is stronger than that of competitors Abercrombie & Fitch (ANF) and Aeropostale (ARO) based on the strength of its brand and superior management.
Strong Brand. Having a fashion obsessed teenage sister and being a teenager myself not too long ago provides me with a decent perspective into the fashion sense of AEO's target demographic. My sister and I can both generally agree that American Eagle apparel is popular among college, high school and middle school students. If you have a teenager, glance in their closets, there's a good chance you will find an American Eagle product. The Company's iconic eagle brand is the competitive advantage that has allowed AEO to sustain healthy margins in the past. At this point in time, with Abercrombie requiring major PR efforts following the CEO's damaging comments and Aeropostale's repeat inability to adapt to the newest teen trends (evident in YoY declines in gross margins from 2010-present, strong evidence indicating brand deterioration), AEO remains the most popular and reputable of the three among teenagers.
New Management. New management is transparent, takes responsibility for results out of their control, and has a solid track record for increasing shareholder value, all indicative of superior management which align its interests with shareholders. Weeks prior to reporting Q2 FY13 earnings, AEO's CEO Robert Hanson warned shareholders of an upcoming Q2 disappointment, demonstrating commitment to transparency. Next, looking at ARO, ANF and AEO's Q2 FY13 results, it's abundantly clear slumping women's sales were a significant downward driver of comps. While ARO's and ANF's management pointed their fingers at macro-related conditions, Robert Hanson blamed himself and his management for improper execution. It is more likely that not poor women's sales were a result of macro-retailed tailwinds. The fact Hanson directs the blame on himself and his management for an outcome out of their control indicates accountability. Independently, these notions are not substantial enough to derive a sound conclusion about AEO's management as actions speak louder than words. The second component supporting my argument of superior management rests in Hanson's own track record. Robert Hanson's first initiative upon assuming the role of CEO in 2011 was to strengthen the company's brand name. In FY11, high material cost adversely affected all clothing retailers. As a result, AEO, its competitors ANF and ARO, all witnessed roughly a 400 basis point decrease in gross margins. As cotton prices normalized in FY12, AEO, ANF and ARO's gross margins normalized (~to around 40%) as well. While margins for all three companies benefited from lower cotton prices, AEO's margins further benefited from improvement in overall markdowns and inventory improvements by 120 and 80 basis points, respectively. For retailers, fewer markdowns combined with higher comparable store rates indicate that AEO is attracting more customers who are willing to pay a premium for a product. Material improvements in margins and comps provided me with solid evidence supporting my hypothesis that AEO's new CEO Robert Hanson's initiative to strengthen AEO's brand and quality was an overall success.
How does a company create shareholder value through revenue growth? By expanding into new markets. As a means of offsetting American Eagle Outfitter's declining sales, the company should direct its capital investments toward organically growing its aerie and international franchise segments, two of AEO's overlooked, underweighted and undervalued gems, whose performances were hindered by the poor performance of the company's core business. In addition, the company focuses on opening new American Eagle Outfitters locations domestically via the "factory store" format to mitigate declining mall traffic.
The second and third points of my initial investment thesis detailed why the market incorrectly valued the company's aerie and international franchise segments. The two points continue to hold their respective weights following each segment's success in Q2 FY13. While comps for aerie decreased 2% in Q2 FY13, the segment is still on track to deliver double digit EPS. Positive results continue to materialize for the international segment as international licensing revenue increased 30% in Q2 FY13 vs. Q2 FY12.
Aerie. Aerie is the company's female intimates segment accounting for ~9% of total revenues. Every research report on AEO will detail how aerie is a driver of growth going into the future. After some due diligence, it is my belief that aerie's value is weighed incorrectly by the market. Aerie produces intimate apparel targeting the demographic of 15-21 year old females. Their product lines emphasizes functionality rather than looks, similar to Victoria's Secret. Although most bras and underwear may be classified as more or less a commodity item, Victoria's Secret business model of emphasizing functionality has been the primarily driver of their success. As aerie follows a similar business model, it is my belief that aerie's product differential (functionality as opposed to looks), small market share (2% of intimates market share, 1 aerie store for every 7 Victoria's Secret location), and low cost products (aerie products are cheaper than Victoria's Secret's products) will be the primary drivers of growth. There is a substantial amount of evidence warranting the claim. Demand for aerie's products exists beyond its current geographical presence. Consumers with no access to a physical aerie retail store want aerie products. This is warranted by aerie direct's (online business) and aerie's Q1 FY13 comparative sales figure of 38% and 4%, respectively, resulting from new product launches and brand awareness initiatives (both the online business and retail stores reporting positive comps strongly indicates that cannibalization didn't occur). Retaliation from Victoria's Secret is unlikely in short-run as aerie will take market share from manufacturers who produce commodity bras.
International Franchise. Again, every report on AEO discussed the company's expansion overseas; however, they neglected the means by which the company intends to scale. The company strategically expands its international presence via franchise partnership agreements. Although the market acknowledges the company's overseas expansion effort, it neglects the franchise aspect of the strategy, and thus the benefits resulting from it. The franchise business model will be the key driver of growth for this segment. The strategy will allow AEO to rapidly expand its international presence with little or no negative consequences related to the speed in which they desire to scale. In the past, retailers undergoing rapid expansion ran the risk of becoming overleveraged, both financially and operationally. This will not be the case with AEO because the franchise agreements do not involve capital investment from the company and require minimal operational involvement. The company simply collects royalty revenues from its franchise partners based upon a percentage of their merchandise sales. A successful international franchise will over time expand AEO's margins and generate high FCF. It will also mitigate risk by spreading exposure throughout multiple global economies and lessen the risks related to volatile cotton prices that adversely affect margins. Revenue from this segment is not included in the company's comparable store sales figure, thus reported comps aren't accounting for the whole picture as they are not receiving the benefit from international growth. So will the company's international franchise be successful in the long run? Before he was AEO's CEO, Robert Hanson was President of Levi's Global Brand. His knowledge of international retail, combined with his proven track record of good leadership and brand strengthening, indicates a strong likelihood of success.
Factory Stores. Of the 20 new stores opened in Q2 FY13, 18 follow the factory store format. The Company currently operates 98 factory stores and intends to double its fleet in the next few years. Factory stores are attractive because of their ability to produce a higher four-wall margin and are less subject to the hazards created by the current mall retail environment.
While AEO's Q2 FY13 results were disappointing, they were not as bad as ANF and ARO. The market still discounts AEO similarly.
Comparable Store Rates YoY
Given AEO's strong position in a weak sector and the multiple channels that could potentially offset their core business' declining revenues, the steep discount applied to AEO is somewhat unwarranted and irrational.
It is difficult to place a definitive value on AEO given the unpredictable tailwinds in the future. Another Seeking Alpha article used "private-market-value" multiples to assign a value to AEO, which begs the question "is AEO is a potential acquisition target?" Its brand recognition, low valuation and high FCF yield certainly make it look attractive. A potential acquirer may look to speed up growth in the company's 3 non-core business channels, all of which have attractive characteristics and are in good positions to grow.
At an enterprise value of 4.6x EBITDA, it is clear how the market is anticipating AEO's future earnings. Management anticipates that the retail environment witnessed in Q2 will likely continue going forward into Q3, revising their guidance and outlook accordingly. With a valuation that appears the market already factored in the worse case scenario, a strong competitive position, continued growth in the aerie, international and factory store segments, and an attractive capital structure make it a buying opportunity for long term investors looking for a security in an out-of-favor sector with an asymmetric risk/reward profile.