American Eagle Outfitters (NYSE:AEO) reported quarterly earnings this week, which sent shares higher. The big picture is that the company's sales were not that great, and the spring and summer assortments were not as good as the company had hoped, but the company did a great job clearing this inventory and is in good shape going into the back-to-school season (which to date has been better than last year). More importantly, because of average unit cost "AUC" reductions, the company was able to post strong merchandise margins, and more importantly, provide very strong gross margin commentary for the back half of the year (instead of AUC reductions, this will be driven by reduced markdowns). Overall, though sales were light and the guidance for sales wasn't that great, the guidance for gross margins was very good. This, combined with very low expectations for the company, sent shares much higher since the call.
Real Estate Update
The company gave some very interesting unit economics for its store base on the last call which I think will help investors:
"Now I'd like to provide more details on our fleet repositioning. The majority of our AE store fleet is healthy and generating four wall profitability on a trailing 12 months basis. For the American Eagle stores, the average sales productivity of the fleet is over $400 per growth square foot with double digit per growth profitability.
That said, we continue to look at the entire strong portfolio evaluating sales trends to identify potential closures. Last quarter we outlined our plans to close 100 AE and 50 Aerie stores over the next three years.
These stores underperformed the fleet with average sales productivity of $250 per square foot. Of the closures most are in B and C malls and geographically dispersed throughout North America.
Our investments in factory in Aerie side by side stores are generating more return. Factory store productivity is over $600 a foot and four-wall profitability is over 25% well above the chain average."
Note: The company also has another 200 stores that have leases expiring over the next three years, so these closure targets could increase.
The company's decision to close stand-alone Aerie locations and create side-by-side stores next to AE locations seems to be paying off. After the relocation, the average productivity lift at Aerie is 30%, and the company is also seeing a lift in the AE stores from the move.
The company will continue to expand internationally. They are now moving into the UK and will be opening more stores in Mexico and China this year.
Overall, most of the company's stores are profitable, even in this current environment (though I will note, last call they said every store was profitable). The company has many real estate levers it can pull, but will also be spending money to move internationally.
Commentary on Sales
For the 2nd quarter, revenues decreased 2% to $711 million from $727 million last year. The comp was negative 7%, which broke out as -8% at AE and +7% at Aerie, and unit growth was 5%. Something important to highlight from the call, it seems like the Aerie business has bottomed - the company's side-by-side strategy is working and bring more business back. This is an item that I think is going overlooked, but is very important to the long-term sustainability of the business.
The company also had muted sales guidance for the back half - management is looking for mid-single-digit comp declines in the back half, even though they are comping up against the very weak results in the back half of 2013 (remember, sales basically fell off a cliff starting in July/August of 2013)
This guidance doesn't really jive with commentary on back-to-school, which to date has been fairly strong. Overall, I'm disappointed by the sales guidance.
Also, factory stores are seeing comp decline, which is something to worry about. Management noted that now that the honeymoon period is over, sales are normalizing. This creates a situation where the $600/sq. ft might be unsustainable, but I will note to offset this, with store rationalization, the $400/sq. ft productivity of AE should increase.
Commentary on Margins
As I noted above, the company was able to post strong merchandise margins, driven by AUC reductions. For the back half on the year, the company is looking for gross margins in the 37-38% range, which was the biggest positive from the call. On the SG&A side, while the company has talked about looking for cost savings, they will continue to invest in the business, and I don't see much leverage coming out of this line unless we get a sales lift. Any savings the company finds will be pushed into ad spend or investment for growth and e-commerce.
Commentary on Denim
Currently, AEO holds a 30% market share of teen denim, which is quite a remarkable statistic and another reason why they will be one of the winners in this space. On the last call, the company has the are managing down their inventory in denim, but plan to maintain share as they are really excited by the new assortment coming out for the fall. The company now has more of a fast-fashion "chase" model, so if they need to bring in more denim they can. I thought that this was an important item to note because of the fantastic market share, but also because of the plan-down in inventory.
Loyalty Customer Commentary
After the last quarter, AEO has 30MM rewards members, which is up double digits year-over-year. Again, loyalty card members are more likely to shop at a "feeder" location or online when stores are closed, helping maintain sales levels while reducing SG&A in a store rationalization strategy. It's good to see this part of the business trending upward.
Capital Expenditures Commentary
On the latest call, we received confirmation that capex would indeed decline next year to $150MM, from guidance of about $230MM for this year. This is a positive for the company, but I believe there was hope that this capex could be reduced even further in the future. When asked on the call, management noted that historical capex has been in the $100-$150MM range, and the company continues to invest in the business for the long-run (something the noted several times on the call) so we should be expecting the $150MM number to be a run rate for the next several years.
Share Buybacks do not seem to be in Play
One would think the announcement to reduce capex next year, combined with the company's stock price, might lead to share repurchases. After being asked this on the call, I get the sense that this will not happen. The company noted they need a $200-250MM cash cushion on the balance sheet (currently at $263MM with no debt), so there isn't much wiggle room. The company will produce minimal free cash flow this year, which should improve next year as capex is reduced by $80MM and we get a slight improvement in the business. But, the company's dividend (~4% yield) costs just under $100MM annually. I do not see a risk to the dividend at this point, but next year's free cash flow improvement will go towards the dividend, so I don't see buybacks coming.
After reviewing the call, I am maintain the long-term valuation I provided in my previous article. I see downside at $10, and still believe that as the company improves that it can get back to the $25 level. In the intermediate term, I still see a business under pressures, so I don't expect $25 anytime soon. But, I think this will be one of the teen retailers that survives, which means there will be share to gain in the future.
Even though the sales were weak, and the fact that I was underwhelmed by the guidance for sales in the back half of the year, the tone of the call was overall bullish and you could tell that the analysts were pleased with the results. If the company can continue to reduce markdowns, that would be a big plus. The big tone from the call was that the company is still going to be investing heavily for growth.
As I have said before, I think when the dust settles, AEO will make it out of this teen retailing storm and will eventually command a valuation much higher than it does today.
Disclosure: The author is long AEO.
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