American Eagle: Great Brand At a Low Flying Price

American Eagle Outfitters is a retailer selling casual clothing targeting the 15 to 25 year old age group through its flagship “American Eagle” or “AE” lines. In 2006, American Eagle launched the “aerie” sub-brand of dormwear and intimates that targets 15 to 25 year old girls, who make up American Eagle’s core customer base. Additionally, the company is in the opening stages of developing the “Martin + Osa” brand of leisure clothing meant for 25 to 40 year olds.

The investment thesis for AEO is that a company with such a strong brand, excellent double-digit growth prospects, and a management team able to execute should not be trading below the average market multiples in general or at single-digit cash flow multiples.

From the time current American Eagle CEO James V. O’Donnell took sole control of that position (he had previously been co-CEO) the company has set new records for sales and profitability in every year; sales per square foot have increased 53% to $524 even as American Eagle increased the number of stores by 13% to 911 and overall square footage by 22%. Annualized return on equity (RoE) has been above 28%, cash and cash equivalents on the balance sheet have increased 40%, long-term investments have tripled, and all long-term debt has been eliminated.

In a survey of 12 to 19 year olds by Teen Research Unlimited released in Spring 2007 of the “Coolest Brand,” American Eagle came in second place with 13% of total votes behind only Nike (ticker: NKE), which had 21% of all votes. Breaking down the vote demographically shows more impressive results for American Eagle, however, as they captured 17% of the girl vote. Given that more than 60% of sales volumes come from women’s apparel, accessories, and footwear, this popularity bodes well for future sales as well as for the success of American Eagle’s new sub-brand, aerie, which targets their core customer, a 15 to 25 year old girl.

One can compare a sampling of American Eagle’s clothing line and the offerings by Abercrombie & Fitch (ANF) and notice striking similarities, yet at the same time Abercrombie goods sell for 20-150% more (see p.8 of the report).

Normally I would favor the company that has the pricing power to sell things for more than competitors, but this is an exception. Even though American Eagle clearly undercuts Abercrombie on pricing, American Eagle is still able to deliver margins that either equal or (more frequently) exceed those earned by Abercrombie. The higher prices Abercrombie needs to sustain earnings become vulnerable in any weak economy or retail environment, as was evident from 2000 to early 2004 or so, when American Eagle handily beat Abercrombie in just about every same-store metric available.

In the current strong wave of retail expansion (which I believe is decelerating like the economy in general), both Abercrombie and American Eagle have shown excellent sales growth numbers and same-store comparables increases. Such results can be expected when everything is good. A retailer’s ability to hold up financially when consumer spending slows is an extremely valuable trait - one investors should pay up for - and I believe American Eagle has that trait, whereas Abercrombie & Fitch does not. ANF, however, trades at a 21% premium to AEO using EBITDA multiples and a 28% premium using EPS multiples. Similarly, ANF trades at a 24% premium using estimated forward P/E multiples - why does the market place a premium on the more vulnerable stock?

Management describes aerie as a “significant market opportunity” that is “consistent with the AE lifestyle.” Given that the average American Eagle customer is a college-age girl, new offerings specifically geared to that demographic seem prudent given the easily apparent synergies and opportunities to leverage brand recognition. To put the growth potential of aerie in perspective, consider the fast success of PINK, a Victoria’s Secret sub-brand that has the same demographic focus as aerie (Victoria’s Secret is a subsidiary of Limited Brands, ticker: LTD). In 2005, its first year, PINK had sales of over $500 million.

ROIC has generally been trending up, with the decline in TTM results vs. FYE 2007 primarily due to a seasonal fluctuation in cash flows. Overall, this is a positive sign and the overall high level of ROIC the company earns is a testament to their strong niche position.

Right now, my valuation model implies that the market is pricing 1-2% long-term growth from American Eagle, along with a very conservative exit multiple that values the company at a sharp discount to the general market. Given that American Eagle seems to be an above-average company in almost all respects (management, balance sheet strength, growth opportunities, etc.) one would presumably believe that the market will eventually correct this apparent mispricing. Using more aggressive targets that may better match actual growth prospects, one could arrive at a value of $40 per share for AEO, although the conservative approach allowing a healthy margin of safety is obviously preferred. Using the conservative approach values the company at approximately $30/share.

AEO 1-yr chart:

This article is based off of the full-length stock report I published on American Eagle last week. You can view the full PDF file (15 pages) for free on my website.