Given macro uncertainty and little predictability in fashions, investors have reason to be weary about American Eagle (AEO) and The Gap (GPS). Since I first spoke about the unpredictability here, the former has underperformed the S&P 500 by nearly 450 basis points. Analysts have now lowered estimates for both firms, rating them negatively. In particular, Gap is rated closer to "sell" than it is to a "buy". Based on my multiples analysis and DCF model, I share this same bearish outlook.
From a multiples perspective, Gap is the cheaper of the two. It trades at a respective 10.6x and 10.5x past and forward earnings. American Eagle, meanwhile, trades at a respective 13.7x and 11.7x past and forward earnings. With that said, American Eagle offers a meaningfully higher dividend yield at 3.4%, in addition to slightly lower volatility. For comparison, Abercrombie & Fitch (ANF) and Aeropostale (ARO) trade at a respective 10.5x and 14.3x forward earnings.
At the third quarter earnings call, AEO noted strong performance:
"In the quarter, consolidated sales increased 11%, reaching a record sales level for the third quarter, and comparable store sales rose 5%. EPS of $0.27 was at the high end of our guidance. We made meaningful progress in several major areas of our business. Merchandise improvements, combined with powerful promotions during peak shopping periods, led to a strong sales results. Our inventory investments in key items were spot on, enabling us to capitalize on traffic and maximize sales. This resulted in record conversion rates and double-digit unit sales growth. Importantly, we continued to see a positive customer response to both strong value and on-trend fashion assortments.
Strong sales growth enabled us to overcome significant pressure from higher cotton costs and resulted in a slight decline in gross profit of just 1%. As anticipated, cotton prices will continue to affect merchandise profit in the fourth quarter, and it will be well into the spring season before we start to see a correction. However, we do expect to benefit from lower cotton costs beginning in the second half of 2012".
With peak promotions will be timed right around the decline in cotton prices, the 2H12 is gearing up to be an inflection point for the firm. The company followed solid third quarter results with stellar performance in November. Comps for the month were 20% - even 40% for the Thanksgiving weekend - and this continued partially into December. Weakness, however, came during Super Saturday and had the effect of muting an otherwise strong holiday season. Even still, we are seeing strong brand demand and a healthy balance sheet to promote further demand.
Consensus estimates for American Eagle's EaPS are that it will decline by 15.7% to $0.86 in 2012 and then grow by 23.2% and 17.9% in the following two years. Of the last 26 revisions to estimates, all have gone down for a net change of -8.1%. Assuming a multiple of 14x and a conservative 2013 EPS of $1.02, the rough intrinsic value of the stock is $14.28, implying 10.1% upside. Modeling a 7.01% CAGR over the next three months and then discounting backwards at a WACC of 9% yields a fair value figure slightly higher at $16.01.
The Street is rightfully more bearish about Gap, which, unlike American Eagle, appears to be losing brand appeal. December comps were worse than consensus at -4% with weakness across all the brands. Merchandising has not met the latest fashion demands, which has heightened uncertainty about performance during a recovery. Inflationary costs are crushing margins and top-line growth has proved challenging. With international comps at -6%, Gap is not providing the attractive hedge against domestic stagnation. With that said, management does have a strong control over expenses and inventories. Capital allocation is predicted by analysts to become more aggressive in the second half of the year.
Consensus estimates for Gap's EPS are that it will decline by 21.3% to $1.48 in 2012 and then grow by 16.2% and 9.3% in the following two years. Of the latest 19 revisions to estimates, all have gone down for a net change of -0.9%. Assuming a multiple of 12x and a conservative 2013 EPS of $1.68, the rough intrinsic value of the stock is $20.16, implying 10.4% upside. If the multiplier were to hold steady and 2013 EPS turns out to be 10.5% below consensus, the stock would fall by 10.6%. This is more than enough to discourage an investment.