Seeking Alpha
Long/short equity, special situations, value
Profile| Send Message|
( followers)  

Summary

  • American Eagle reports better than anticipated second quarter results.
  • Low expectations and a solid guidance triggered quite some enthusiasm among investors.
  • Long term appeal remains if the company can stabilize and boost margins, short term appeal is limited after recent momentum.

American Eagle Outfitters (NYSE:AEO) reported relatively solid second quarter results in a very difficult retail environment as the first positive signs in its turnaround start to appear.

I like the longer term value which shares can deliver if the company continues to transform but I do think short to medium term appeal is limited after recent momentum.

Second Quarter Highlights

American Eagle reported second quarter sales of $710.6 million, a 2.3% decline compared to last year. Analysts believed that sales would fall to levels as low as $689.7 million.

Reported net earnings dropped by 70.3% towards $5.8 million with earnings plunging by seven cents to $0.03 per share. Despite the steep earnings decline the modest profits have been better than anticipated with analysts anticipating a break-even result.

Looking Into The Numbers

While the headline topline sales hardly fell, the underlying results have been weaker than the topline sales numbers reveal. Comparable sales fell by 7% on top of the 7% decline already reported in the year before.

Despite the continued declines in comparable store sales, CEO Jay Schottenstein noted that results have been slightly better than anticipated. The company was happy after clearing its spring and summer merchandise, being comfortable with its current inventory position.

Gross margins fell by 40 basis points to 33.4% of sales on the back of the de-leverage of buying, occupancy and warehousing costs. This was partially offset by lower markdown rates.

Selling, general & administrative expenses rose by 110 basis points to 26.7% of sales. Higher advertising expenses as well as omni-channel initiatives resulted in the increase in costs.

All in all these effects as well as higher depreciation charges resulted in severe margin pressure with operating margins being down by 240 basis points to 1.7% of sales.

Third Quarter Guidance

For the current third quarter, comparable store sales are seen down in their mid-single digits, a slight improvement from the 7% decline in comparable store sales as reported in the second quarter.

Adjusted earnings are seen between $0.17 and $0.19 per share, which compares to non-GAAP earnings of $0.19 per share as reported last year. Analysts expected the company to guide for earnings of $0.18 per share.

The company did not provide a full year earnings outlook. By now the company operates some 1,072 stores, anticipating to end the year with a 1,041-1,051 stores following previously announced store closures.

Valuation

American Eagle Outfitters ended the quarter with $263 million in cash and equivalents while it does not have any debt outstanding with exception of relatively modest amounts of deferred leases.

On a trailing basis, American Eagle has now posted sales of about $3.25 billion while earnings over the past twelve months totaled just $45 million.

With nearly 195 million shares outstanding, and shares increasing to current levels at $13 per share, equity in the business is valued at little over $2.5 billion which values operating assets at $2.3 billion.

This values operating assets of the firm at 0.7 times annual revenues and 50 times trailing earnings.

A History Of Steady Growth, But Recent Stagnation

Over the past decade, American Eagle has managed to increase revenues by some 70% from $1.9 billion in 2004 to $3.2 billion on a trailing basis. Yet this does not explain the entire picture with sales ranging from $3.0 to $3.5 billion since 2008, essentially being stagnant in the latter half of the past decade.

As earnings peaked at $400 million in 2008 profitability has steadily become under pressure although the company has been profitable in each calendar year ever since. Yet profits have largely vanished, with trailing earnings being down 90% since 2008. A very small offsetting factor for investors was the fact that the outstanding share base has been down by 10-15% ever since.

The annual dividend of $0.50 per share currently provides investors with a very attractive 3.8% yield, as the company has paid out attractive dividends in recent years.

Yet this has provided little comfort to investors with the wrong sense of timing. Shares peaked at $30 in 2006 amidst the peak of consumer spending in the US. They fell to $10 during the recession with shares trading in a roughly $10-$20 range ever since.

Final Recommendation

American Eagle has seen its fair bit of struggles and to be honest will the company anticipates things to improve slightly in the upcoming quarter, the long term trend remains negative. Comparable sales have been falling for quite a while now, but the fall of 10% in the first quarter slowed down to 7% for the second quarter, and might come in around 5% for the third quarter.

For years revenues have stagnated as earnings have fallen, a direction which finally appears to have woken up management which is cutting costs and closing unprofitable stores. At the same time a key area of focus have become the e-commerce and omni-channel operations of the company.

With incoming and interim CEO Schottenstein, American Eagle finally appears to have gained some operational momentum although signs of an improvement are still very much premature with the company suffering from sales declines and fierce competition. Besides the minor positive trends in growth, the 15% cut in inventory levels is very promising as well. At least this development eliminates the overhang of a potential very bad quarter driven by huge markdowns.

Fortunately the company has no debt while it holds a comforting cash position, allowing American Eagle to make this progress without operating in financial distress which can very quickly be disastrous for a clothing retailer. Since their lows in June shares have rebounded some 30% on the back of this news and a recent stabilization of the sector, yet shares are still down 50% from the highs in 2012.

For now the dividend yield remains compelling although traditional valuation metrics cannot justify the valuation given the low reported margins. Yet if the company can report earnings of $150 million per annum, resulting in net margins of about 5% after tax, this valuation becomes perfectly justifiable. I note that the company posted +10% after tax margins over the past decade during the good years, but I also believe that is no longer realistic as the retail environment was structurally different at that point in time.

I remain long term cautiously optimistic, notably on the valuation grounds in combination with anticipated margin expansion going forwards if the business stabilizes. Yet after the recent momentum, the risk-reward for the short to medium term is subdued.

Source: American Eagle Outfitters - Investors Celebrate As Green Shoots Emerge