Investors in American Eagle Outfitters (AEO) are facing a renewed disappointment as third quarter weakness is prolonging towards the so important fourth quarter, resulting a renewed sell-off in its shares.
While the short term future is not bright, the long term growth, fair valuation and solid financial positions are long term drivers for the stock. I remain cautiously optimistic.
Third Quarter Results
American Eagle Outfitters generated third quarter revenues of $857.3 million, down 5.8% on the year before. Despite the fall in sales, revenues came in ahead of consensus estimates at $840.7 million.
On the back of the declining sales, earnings took a serious beating. Adjusted earnings per share more than halved, falling from $0.41 per share to $0.19 per share. GAAP earnings came in at $0.13 per share on the back of costs associated to the close of the distribution center in Warrendale. GAAP earnings came in at $24.9 million.
CEO Robert Hanson commented on the third quarter performance, "Our financial performance is clearly unsatisfactory and not consistent with our objectives. As we continue to navigate through an intensely promotional North American retail landscape, we are making improvements in merchandising and marketing, while aggressively pursuing efficiency gains, expense reductions and ensuring disciplined inventory management."
Looking Into The Results ...
Reported revenue growth fell hard on headline numbers. The fall in revenues would have come in the low single digits adjusted for the 53 working weeks last year. Yet underlying conditions and performance has been difficult with comparable sales falling 5% compared to a year earlier.
As a result of higher promotional activity and negative sales leverage, operating earnings are plunging. Gross margins fell by 670 basis points to 34.9% of total revenues. Fortunately, the company kept a tight lid on operating expenses which actually fell 10 basis points to 24.0% of sales despite the negative sales growth. All in all, operating earnings halved to $61 million, coming in at 7.1% of total revenues.
... And The Final Quarter
Fourth quarter earnings are seen between $0.26 and $0.30 per share. This guidance is based on a mid-single digit decline in comparable sales. Note that last year's adjusted earnings came in at $0.55 per share and that the guidance excludes the potential for asset impairment and restructuring charges.
Consensus estimates for fourth quarter earnings stood at $0.39 per share, clearly indicating that the market has been anticipating some sort of a recovery.
American Eagle ended the third quarter with $357.2 million in cash, equivalents and short term investments. The financial position of the firm remains rock solid as American Eagle has no debt outstanding.
A slight worry among investors is the built up in inventories. Despite the fall in sales, inventories rose by 7.8% to nearly $519 million.
Revenues for the first nine months of the year came in at $2.26 billion, down 4.0% on the year before. Earnings plunged and came in at $72.5 million, down 47.2% on the year before. At this pace, annual revenues are seen around $3.3 billion. Full year earnings are seen around $130 million.
Factoring in losses of 10% on the back of the disappointing third quarter results, American Eagle Outfitters is valued around $2.85 billion. Operating assets of the firm are valued around $2.5 billion when backing out the net cash position of the firm. This values the equity in the firm at 0.75 times annual revenues and 19-20 times annual earnings.
American Eagle Outfitters currently pays a quarterly dividend of $0.125 per share, for an annual dividend yield of 3.4%.
Some Historical Perspective
Long term investors have seen their ups and downs. On the back of the strong economy in the years following the burst of the internet bubble shares have steadily risen from $6 in 2004 to highs in their low thirties by 2007. Shares fell back to $10 in 2009 during the recession and recovered to highs of $23 in September of last year. Ever since, shares have retreated by about a third.
Despite the poor results and the retreat on the back of this news, shares are still trading above October's lows of $13 per share.
Between 2009 and 2013, American Eagle is set to increase its annual revenues by a cumulative 12% to $3.3 billion. Earnings fell by nearly a quarter in the meantime.
Shares in American Eagle continue to suffer, like many other clothing retailers which are focused on U.S. teens and young adults. Other firms like Aeropostale (ARO) and Abercrombie & Fitch (ANF) are facing tough times on the back of cheaper and "fresher" competitors. European competitors like H&M, Zara and Inditex offer trendy clothes at low prices, taking market share from established US players.
To compete American Eagle has resorted to discounts, taking a huge chunk out of earnings. Many of the products at its stores are on sale at the moment. "Tepid" consumer demand and an "intensely promotional" retail environment are challenging the short term results.
To combat the tough market conditions, American Eagle relies on a 17% increase in comparable sales for its internet activities and plans to sell cheaper stuff to consumers, as they desire lower prices at the moment. On top of that, American Eagle aims to close 50 stores next year, while opening 26 factory stores. The company furthermore aims to boost outlet production, selling clothes with slightly lower quality merchandise to boost margins.
Furthermore, American Eagle has hired Chad Kessler to head the merchandise and design activities at its main brand. Kessler who previously worked at Urban Outfitters (URBN), a hugely successful competitor, will start his activities in February of next year.
Obviously investors in American Eagle have seen very disappointing returns so far this year on the back of negative sales growth and the impact of operating leverage and markdowns on earnings. Despite the poor returns, shares are not cheap yet at a valuation of nearly 20 times estimated earnings.
Still, investors should not be too worried. Current earnings are impacted heavily on the poor operational environment, with earnings being cut in half. Luckily, the retailer has a very solid financial position and pays out very attractive dividends, yielding 3.4% at the moment.
All of this combined with the long term growth trajectory of the business and commitment to change and improvements, and I am cautiously optimistic about the firm's prospects.