- The potential success in the omni-channel implementation, the shipment store project, and the international stores expansion.
- A great bargain with 10% FCF yield per year.
- A highly lucrative buyout opportunity as a free option.
At first glance, American Eagle Outfitters (NYSE:AEO) is a stock to avoid. However, if we look through the near-term volatile earnings releases, we will find AEO to be a true bargain buried within today's sluggish apparel industry.
Why AEO plunged 7.8% after the latest 4Q 2013 earnings release
The following disappointment is the main reason:
The company posted fourth-quarter fiscal 2013 adjusted earnings of 27 cents per share, plunging 50.9% from 55 cents in the prior-year quarter. Fiscal 2013 adjusted earnings came in at 74 cents per share, reflecting a 46.8% decline from $1.39 earned in fiscal 2012.
It is not a surprise for anyone following the apparel industry to expect lackluster 4Q 2013 earnings. Plus, any kinds of excuses, especially ones related to weather and the poor employment market for teenagers, are not going to give the management team any free pass. With all the negatives, I find a slight positive in the adjusted selling, general and administrative (SG&A) expenses, which decreased 14.7% to $215.9 million. In such a horrible retail environment, the main control management can exercise is to effectively manage its costs to minimize the negative impact on its earnings.
Takes Guts to Make Investment in today's challenging retail environment
However, as a long-term investors in AEO, I really admire that AEO takes the long-term view to invest in building the important omni-channel capabilities, which are part of the successful M.O.M strategy implemented by Macy's (NYSE:M). I understand how difficult it is to report an expected $230 million Capex in 2014 while reporting a lackluster earnings result in 4Q 2013. As the recent SeekingAlpha article indicated, nearly half of the Capex in 2014 will be utilized for an Oracle-based merchandise system, a Teradata CRM system, an IBM Sterling Order Management System for the completion of the distribution center and omni-channel project.
But what excited me the most is the new distribution center in Pennsylvania, which has the capability to directly ship products to U.S. based customers with expected 2-days delivery. Michael R. Rempell gave further insight in this shipment store project below:
Yeah. You know Mary mentioned earlier our shipment store project and I will tell you that one of many projects that we have, that we are pretty excited about in terms of the potential to drive top line, improve margin and make more efficient use of our inventory so we were an early adapter at shipping inventory being -- and allowing the customer to be in our store and order through our distribution center. We plan to improve that capability going forward.
We are in pilot in 20 stores now with shipment store capability and we think given our record stores, the ability to service the customer and the challenge with staying in stock we think it's a massive opportunity for us in the back half of the year. And Mary also mentioned earlier that we are building a new distribution center that's going to service e-commerce in 2014 and ultimately e-commerce and retail from a single pool of inventory in 2015, that's how we plan to run our operations in the U.S. and that is actually how we are setting up our operations globally.
I believe that developing this shipment capability and investing in omni-channel to provide seamless shopping experience for customers are absolutely essential to make AEO relevant in the teen apparel industry in the future. For any company to continuously thrive in its respective industry, it is critical to identify what elements will drive future sales and invest in them in order to be ahead of your competitors. With the economies of scales in AEO, I believe that it has made a wise decision not to concern itself too much about the short-term earnings disappointments but instead focus sharply on what are future growth drivers and invest accordingly.
In fact, critics might argue that public companies have tended to over-invest in technology or infrastructure and leave shareholders with the losses. However, Jay L. Schottenstein, the interim CEO and executive chairman of the board, has recently bought 500,000 AEO shares at $12.84. This clearly shows confidence in the future of AEO.
As we all know, the crown jewel of AEO is its denim jeans, the bottom business. However, the bottom business is an SKU intensive business. In other words, AEO has to carry many different types and sizes of jeans in order to satisfy and fulfill its customers' orders. As a leader in the teen denim jeans market, AEO has done the right thing to strengthen its shipment capability to reduce its SKU in stores, which will eventually improve profit margins and increase customers' satisfaction.
What's more, the management has already indicated that capex will return back to more normal levels of $150 million per year in 2015 once the heavy investment in 2014 is finished.
All Our Stores Are Cash Positive
As Jay L. Schottenstein said, they really like cash. In order to generate more cash per stores, management has made a decision to close more stand-alone Aerie stores and combine them with its American Eagle Outfitters stores. As a result, AEO can claim that today all their stores are cash positive. The following is what Mary M. Boland, the CFO, said:
All our stores at the end of the day are cash positive and we have only a handful of stores that are actually in a loss position. So we need to balance that with a long term view of the capacity and the overall Tee market but we are sitting in a position where as I said our stores are all cash positive.
This indeed is a great achievement not that many retailers can accomplish. Nevertheless, the Street has failed to notice the nitty-gritty details and to assess the proper future value of AEO.
As I said earlier, I see why most investors will avoid AEO. However, if we research further into the financials, we will find some true value in AEO. In fact, AEO can generate on average $226.21 million Free Cash Flow "FCF" per year as shown below:
Cash From Operations
Source: Company 10K
This creates a base case that AEO is capable of generating an attractive 10% FCF yield. As I pointed out above, AEO is cash positive for all its stores, and it has no debt. The financial strength of AEO almost ensures that AEO can ride through today's challenging retail environment. If I can further foresee that AEO is capable of at least reverting back to its average performance in the past, AEO investors are almost certain to earn a 10% FCF yield annually. In my opinion, this is a bargain. Needless to say, if the investment in the omni-channel, the shipment store project or the international stores expansion are successful, investors can get even higher return.
How Lucrative and attractive a buyout deal is for any Private Equity Funds
I totally agree that investors should not invest solely based on any buyout speculation. However, in the case of AEO, I believe that AEO is worth at least its current stock price of around $13.00. The possibility of a buyout is a free option for AEO shareholders.
I will simplify the rationale behind the attractiveness of a buyout deal and illustrate the potential 266% return for any PE funds, which can successfully pull this buyout deal off the table.
Assume that any prospective buyers can make a 25% down payment and finance the remaining capital with a 20% premium to buyout all outstanding AEO shares at $15 per share. The buyers only needs to pay $3.75 per share as a down payment. Since AEO has around 14% of market cap as cash and cash equivalents and no debt, the buyers can easily load up AEO with debt and pay themselves special dividends to lower their capital base, for instance 50%, to $1.875 per share.
With my simple calculation, AEO merits at least 8x EV/EBITDA resulting in $20 per share when AEO considers an IPO for the buyers to cash out. A $5 per share price difference between the buy and sell price divided by the capital base of $1.875 per share results in a total 266% potential return.
Although the above simple model is by no means precise, I just want to illustrate the significant profit in a potential buyout opportunity.
Some analysts might argue that the significant operating leases obligations might deter some potential buyers. However, since all AEO stores are cash positive, the prospective buyers will have no incentive to close out stores to preserve cash, which will make the operating leases obligations as less likely a concern.
The Bottom Line
With or without a buyout, it is almost certain that AEO can survive today's brutal retail environment. As a long-term investor, the survivorship and the attractive 10% FCF yield are enough to compensate for the near term earnings risk. With a long-term horizon, I believe that my beloved eagle will fly high again.