American Eagle Outfitters - A Great Business At A Fair Price

| About: American Eagle (AEO)
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Introduction to American Eagle:

American Eagle Outfitters (NYSE:AEO) is an U.S. based clothing retailer operating in all 50 states with a growing international presence. The company brings in over $3 billion in sales annually with significant seasonal effects driving the bulk of revenues in the third and fourth quarters. AEO consists of two primary brands, the flagship American Eagle brand, focused on 12 - 25 year olds, and Aerie, which sells female intimates similar to Victoria Secret but with a younger focus group. The bulk of AEO's sales come from brick and mortar stores located in malls through its American Eagle, Aerie, and American Eagle Factory mall locations, often located side-by-side. Additional sales are contributed by American Eagle Direct, the online offering and a focal point for the company's growth strategy.

Size:

The company manages about 1,000 stores total, averaging 6,000 sq. feet each of which 4,750 sq. feet are selling space. Floor space growth is down 1.4% Y-o-Y. As of the last 10-K, AEO employs approximately 44,000 employees with 37,000 as part-time or seasonal. The $3 billion in annual sales represents about 1.4% of total U.S. retail clothing sales (a portion of AEO's sales are international but this is a trivial amount of the total). The majority of the stores in Europe are franchised and are not included in the company's consolidated earnings. AEO runs three distribution centers: a new 1 million square foot facility in Kansas supporting retail and direct (online) distribution, a distribution center in Pennsylvania for retail, and a distribution center in Canada. A fourth center is opening in New Mexico to support growing Mexico operations.

Supply chain:

AEO's supply chain begins with 3rd party off-shore production from Asia for all its clothing, and utilizes 3rd party shipping to the U.S. along with rail and truck services for final delivery to distribution centers and malls. The company attempts to run a globally responsible operation, requiring minimum standards that must be met at factories and monitored actively. We do not see a competitive advantage or disadvantage relative to peers on these operations.

Investment opportunity:

AEO is selling 37% below its 52-week of $22.83 due to very weak third quarter sales and tightening gross margins. We believe that the following positive factors provide a positive asymmetric risk/reward profile over the next 12 months with future earnings releases.

Ticker: AEO
Price as of writing: $14.34
Target price: $17.50
Recommendation: BUY

- Management has clearly laid out goals which are reasonable for the industry.

- The company has significant resources to pursue its strategic goals.

- Recent underperformance provides an attractive entry price and dividend yield for long-term investors.

On the latest earning call and in the 10-Q, management lays out the following goals:

  1. Revenue CAGR = 7% - 9%
  2. EBIT CAGR = 12% - 19%
  3. ROIC annually = 14% - 17%

We believe these targets are reasonable and achievable over the next 12-24 months and will address each.

Revenue CAGR

AEO is a mature company in a mature industry, and we do not see it taking major market share from, nor losing share to, competitors. We believe the teen apparel clothing sector is saturated, highly competitive, and dominated by a few large players, with a minority of market share contested by niche entrants. In this environment, the dominant players are simply trying to maintain market share as there is little differentiation possible amongst the well known brands (AEO, Abercrombie & Fitch Co. (NYSE:ANF), Aeropostale, Inc. (NYSE:ARO), and The Gap, Inc. (NYSE:GPS)). In fact, this is readily visible as promotions are matched within the industry often dollar for dollar, driving down industry profit margins.

We assume market share will remain flattish and revenue growth or contraction will be driven by industry metrics. The recovering U.S. economy supports additional retail spending, which is also supported by increased consumer confidence, income effects, better employment, and consumer re-leveraging. Thus, we expect to see greater discretionary spending by teenagers to the benefit of teen clothing retailers. The improvement in spending can be seen in the table below, with U.S. retail sales from the Federal Reserve Economic Database (FRED):

Nominal sales in millions of dollars:

Period Ended

AEO Annual Sales

U.S. Retail Sales

31-Jan-09

2,948.68

214,978.0

30-Jan-10

2,940.27

205,300.0

29-Jan-11

2,945.29

215,603.0

28-Jan-12

3,120.07

231,713.0

2-Feb-13

3,475.80

243,098.0

Annual sales growth:

Period Ended

AEO Annual Sales Growth

U.S. Retail Sales Growth

30-Jan-10

-0.29%

-4.50%

29-Jan-11

0.17%

5.02%

28-Jan-12

5.93%

7.47%

2-Feb-13

11.40%

4.91%

Although we would prefer a larger data set, the data is confined by the AEO sales available from AEO's investor relations website to the five periods. We ran a regression nonetheless, with U.S. as the X (independent) and AEO sales as the Y (dependent):

Regression summary:

SUMMARY OUTPUT

Regression Statistics

Multiple R

0.923964647

R Square

0.85371067

Adjusted R Square

0.80494756

Standard Error

101.9139386

Observations

5

Coefficients

Standard Error

t Stat

P-value

Intercept

-56.7021101

752.4795577

-0.07535

0.944677

X Variable 1

0.014147595

0.003381216

4.184173

0.024879

The R squared indicates a high relationship of U.S. retail clothing sales to (85%) to AEO's performance (in danger of stating the obvious), and X is significant in determining Y. I have confidence this relationship will hold with a larger data set.

Looking at the growth numbers, where AEO grew 6% in 2011 and 11.4% in 2012, the goal of 7-9% revenue growth seems plausible in a recovering economy (if you believe the U.S. is on that track...).

However, not to be one to glaze over the risks, trailing twelve month (TTM) numbers for AEO are actually lower than the year ago period. We believe this is one major reason for the sell-off and could be corrected with fourth quarter sales. The third quarter was choppy for the U.S. economy as Fed tapering talk peaked and the U.S. government shut down during September and October, driving down the stock market and sharply cutting consumer confidence. This likely had a huge effect on family discretionary spending. There was a positive reversal in consumer confidence in November, tied together with positive realized and forecasted Holiday sales (Black Friday was reported as very solid by retailers, and Cyber Monday saw record numbers). These positive effects should benefit AEO nicely, as long as intra-industry competition does not dissolve all margins.

EBIT CAGR

To us, this is the most questionable goal. TTM EBIT is below the prior period, and forecasted industry CAGR is 2.22% from my favorite resource, NYU Professor Aswath Damodaran's data from his website. I'm sure he is wrong to the upside or downside, as he will admit to as well, but by a factor of 6 and knowing his methodology is a culmination of other analysts work, I believe that is unlikely. I generally consider his estimate a good ballpark.

That said, we believe the company's management is setting realistic goals, and analysis of the data supports their ambitious objectives. The company appears to be positioned well to reach high EBIT CAGR goals. Below is a snapshot of TTM EBIT margin for the past decade. The company is at its lowest of EBIT margin over the period. Combining marginal EBIT expansion from its current position along with revenue growth should reach the stated EBIT growth goals.

AEO EBIT Margin (<a href=

AEO EBIT Margin (TTM) data by YCharts

How can AEO management change the EBIT margin? Let's review the income statement for the TTM (we pasted the prior period as well):

Nov 2013 TTM

Nov 2012 TTM

Rev

3381.148

3387.191

COGS

-2113.414

-2094.282

GP

1267.734

1292.909

SG&A

-829.565

-793.421

EBITDA

438.169

499.488

Impairment

-53.743

-19.62

D&A

-127.387

-130.24

EBIT

257.039

349.628

Other income

2.433

6.324

EBT

259.472

355.952

Taxes

-92.223

-126.265

EP

167.249

229.687

Loss from disc. Ops

0

-41.071

NI

167.249

188.616

Shares O/S

192.73

196.177

EPS

0.87

0.96

Above the line of EBIT the first charge we see against revenue is COGS. It is a recognized issue for the apparel industry that costs related to Asian producers (from where AEO sources all its product) are spiraling due to increased employee power. Wage increases, skilled worker shortages, inflationary pressures, better working conditions, increasing energy prices feeding production and shipping are all increasing the costs of goods sold. The company recognizes opportunities are nil in this space to make great efficiency gains, and its competitors are subject to the same negative forces.

However, management does see opportunity in reducing SG&A significantly. Much of this is being driven by the move of distribution to Kansas and CapEx spending to upgrade technology systems that support omni-channel sales, increasing operational efficiencies across the business. It is a stated goal of management to realize significant SG&A reductions - we believe this is very possible with the proper infrastructure investments. There are immeasurable and uncertain but possible costs of damaging future operations through reduced SG&A, such as lower discretionary compensation causing employees to leave, but due to these descriptors it would not be prudent to attempt to factor such effects into the valuation.

AEO SG&A to Revenue (<a href=

AEO SG&A to Revenue (TTM) data by YCharts

Finally, the $53 million impairment charge should come down significantly in 2014 and forward. The bulk of the charge is related to shutting down a distribution center in Pennsylvania. The company expects an additional $15 million in charges over 2014 and 2015, but we expect overall impairments in each of those years to be under $10 million.

In the avoidance of going on too long (if we haven't already), I will just say that ROIC is well within the company's realized performance and industry expectations (from the same Damodaran data source pasted above). A fundamental of accounting is that Invested Capital (Debt + Equity - Cash) must equal Net Operating Assets. YCharts doesn't have the ROC (or ROIC) metric, but it does have return on net operating assets, so with some faith we will use this chart:

AEO Return on Net Operating Assets (<a href=

AEO Return on Net Operating Assets (TTM) data by YCharts

Sound Financial Position to Support Strategic Turnaround

To the second point of the investment thesis, AEO has substantial resources to weather a down period for the company and re-engineer operations for future growth. The company is and remains cash flow positive, with ample funds for reinvestment and to support the current dividend (in fact, the company has increased the dividend from $0.11 cents per quarter in 2012 to $0.125 cents per quarter since June 2013). At the end of 2012, the company paid a special dividend of $1.61. With $350 million in cash, positive FCF, and no long-term debt (more about this in a moment), there is little chance of a default and ample funds to pursue the stated $250M in CapEx over the next 12-months as the focus shifts to omni-channel retailing backed by the efficient Kansas distribution center.

The insightful ones should be saying "what about contractual obligations." Please see the table below:

Lease obligations from balance sheet (with some modification to spread out summarized 1-3 and 3-5 year periods)

Lease Commitments

Current Year

257.5

1

154.6

2

154.6

3

154.6

4

186.6

5

186.6

6 and beyond

570.4

Calculations to convert leases to debt:

Converting Operating Leases into debt

Year

Commitment

Present Value

1

154.6

149.0

2

154.6

143.6

3

154.6

138.4

4

186.6

161.1

5

186.6

155.2

6 and beyond

190.1

441.0

Debt Value of leases =

1,188.4

Converting the operating leases to debt (aka "capitalizing) increases EBIT by about $100 million as the operating expense is added back and deducted using straight-line depreciation of the entire capitalized asset of ($1,188.4 / 5). That is, original lease operating expense of $257.5 is added back to SG&A or COGS, and replaced with 1/5 of the PV of lease obligations, $148.55, resulting in a $109M net adjustment gain to EBIT.

A cursory view of the AEO balance sheet shows strength, there are no immediate risks on the horizon of cash shortages, and positive free cash flow provides opportunity for investment into strategic goals.

Valuation with Scenarios:

To summarize, AEO has sold off and we believe there is a good risk/reward opportunity presented for investors who believe the company's management knows how to turn around recent poor performance in an attractive retail environment. This requires managing the transition to omni-channel and leveraging online retailing, which management has stated as their focus, along with expanding factory stores, since these are showing higher rates of return of the flagships (management expects to open 151 factory stores in 2014 versus closing around 15 under-performing flagship).

Using the TTM and capitalizing leases, we put together a valuation based on EBIT growth. The base assumption is the company has an additional -5% EBIT growth in 2014, increasing linearly to 11% by 2017, and terminal growth of 2%. We then ran two sensitivity tables - one with different starting and ending EBIT CAGR and another with different starting EBIT CAGR and terminal values:

Base valuation (3% EBIT CAGR 2014, 12% EBIT CAGR 2017, 2% terminal growth, capitalized operating leases):

WACC calculation:

Cost of Equity =

11.67%

Equity/(Debt+Equity ) =

70.69%

After-tax Cost of debt =

2.33%

Debt/(Debt +Equity) =

29.31%

Cost of Capital =

8.93%

DCF calculation:

2014

2015

2015

2016

2016

2017

2017

Current

1

2

3

4

5

6

7

Terminal Year

Expected Growth Rate

3.00%

5%

6%

8%

9%

11%

12.000%

Cumulated Growth

103.00%

107.64%

114.09%

122.65%

133.69%

147.73%

165.45%

Reinvestment Rate

97.95%

97.95%

97.95%

86.00%

62.09%

38.19%

14.29%

EBIT

$366

$377

$394

$418

$449

$489

$541

$606

Tax rate (for cash flow)

35.50%

35.86%

36.21%

36.57%

36.93%

37.29%

37.64%

38.00%

38.00%

EBIT * (1 - tax rate)

$236

$242

$251

$265

$283

$307

$337

$375

$383

- (CapEx-Depreciation)

$232

$231

$237

$247

$227

$169

$101

$19

$50

-Chg. Working Capital

($0)

$6

$9

$13

$17

$22

$28

$35

$5

Free Cash flow to Firm

$5

$5

$5

$5

$40

$116

$208

$322

$328

Cost of Capital

8.93%

8.93%

8.93%

8.58%

7.86%

7.15%

6.43%

Cumulated Cost of Capital

1.0893

1.1866

1.2926

1.4035

1.5138

1.6220

1.7263

Present Value

$5

$4

$4

$28

$77

$128

$186

Valuation from DCF:

Present Value of FCFF in high growth phase =

$433.10

Present Value of Terminal Value of Firm =

$4,290.15

Value of operating assets of the firm =

$4,723.26

Less: expected charges for shutting down distribution center

$15.00

Value of Cash, Marketable Securities & Non-operating assets =

$357.21

Value of Firm =

$5,065.47

Market Value of outstanding debt =

$1,189.38

Minority Interests

$0.00

Market Value of Equity =

$3,876.09

Value of Equity in Options =

$8.20

Value of Equity in Common Stock =

$3,867.89

Market Value of Equity/share =

$20.07

Scenario tables:

Sensitivity to different 2014 and 2017 EBIT CAGR with straight line change over 7 years from start to end:

2014 STARTING EBIT CAGR

14.84

$20.07

-3%

0%

3%

6%

10%

2017 EBIT CAGR

0%

10.93

11.07

12.26

14.03

16.63

3%

11.0

12.1

13.9

15.9

18.7

6%

12.04

13.85

15.81

17.93

21.03

9%

13.74

15.71

17.86

20.18

23.56

12%

15.57

17.73

20.07

22.60

26.29

15%

17.55

19.91

22.45

25.21

29.23

Sensitivity to 2014 and terminal (2018 forward) EBIT CAGR with 2017 CAGR fixed at 12%, using straight line EBIT CAGR change over 7 years:

2014 STARTING EBIT CAGR (2017 @ 12%)

$20.07

-3%

0%

3%

6%

10%

TERMINAL GROWTH RATE

0.50%

10.78

12.42

14.20

16.12

18.92

1%

12.08

13.86

15.79

17.88

20.93

1.50%

13.65

15.60

17.71

20.00

23.34

2%

15.57

17.73

20.07

22.60

26.29

2.50%

17.98

20.40

23.02

25.86

30.00

Summary:

Management must stay focused on identifying under-performing assets such as negative growth flagship locations and replacing them with high-performers, such as factory storefronts and direct. Smart CapEx spending on technology and infrastructure to support a highly functional omni-channel customer service and logistics system will please customers, build brand appeal, and drive additional customer traffic. As long as margins can be maintained, macro-economic forces will drive revenue expansion and cause the rapid supplier price increases to plateau. Opportunity exists for margin expansion from flattening COGS and management's ability to control spend through SG&A.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.