It Is Too Early To Bet On A Turnaround At American Eagle Outfitters

| About: American Eagle (AEO)
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Teen-oriented retailer American Eagle Outfitters posted improved profitability in its latest fiscal quarter, thanks to a solid uptick in its gross margin.

Unfortunately, the company continues to struggle to deal with falling sales, an unfavorable trend that may limit its ability to generate sustainable profit growth in the future.

Investors should probably wait for confirmation of an upward trend in operating profitability prior to betting on this turnaround story.

Shareholders in teen-oriented retailer American Eagle Outfitters (NASDAQ: AEO) are probably not too happy with the company's stock price trajectory in 2014, down roughly 10%. American Eagle Outfitters has anecdotally been hurt by the continuation of a promotional selling environment in the retail sector that has cut into its adjusted operating profitability, culminating in a 30.5% decline in operating income in FY2014.

On the upside, though, management is aggressively trying to improve the company's future prospects by closing under-performing stores and focusing on its product selling margins, a mindset that helped to produce better operating profitability in its latest fiscal quarter, up roughly 160 basis points. So, after a negative return to-date in 2014, is American Eagle Outfitters a good bet for investors?

What's the value?

American Eagle Outfitters is a major player in the teen-oriented segment of the retailing sector, operating a network of more than 1,000 stores around the country, complemented by a subset of franchised stores in select international markets. Unfortunately, the teen retailing space has not been a great place to find profit growth lately, due in part to a customer base that seems to have become more cost-conscious and selective in their purchasing decisions. The net result for American Eagle Outfitters has been generally declining operating profitability over the past five fiscal years, a performance that has led to a poor stock price return during that time period.

In its latest fiscal year, it was an unambiguously poor showing for American Eagle Outfitters, evidenced by a 64.2% decline in its operating income. During the period, the company was hurt by weak per-store sales productivity, with its comparable store sales down 6%, a trend that motivated it to utilize more discounting activity in order to help move merchandise, culminating in a roughly 630 basis point drop in its gross margin. Not surprisingly, American Eagle Outfitters' cash flow also declined sharply, a situation that showed the importance of the aforementioned restructuring program.

Looking into the crystal ball

The question for investors is whether American Eagle Outfitters can find its way to profit growth in the future, thereby providing a foundation for a higher market valuation. The good news is that there is some optimism on that front, judging by the company's 21.5% increase in its adjusted operating income in its latest fiscal quarter. American Eagle Outfitters benefited during the period from an improvement in its gross margin, up roughly 200 basis points, a performance that management attributed to reduced inventory markdowns. On the downside, though, the company continues to deal with falling per-store productivity and lower overall sales, which may make profit growth a difficult goal to achieve over the long term.

Of course, American Eagle Outfitters isn't the only teen-oriented retailer struggling with declining sales momentum in the current selling environment. Competitor Abercrombie & Fitch's (NASDAQ: ANF) recent results paint a similar picture, evidenced by an 11.8% top-line decline in FY2014 that has been a function of lower sales across its major brands. Like American Eagle Outfitters, Abercrombie & Fitch has been utilizing product discounting in an attempt to get more customers through its doors, a strategy that led to a 200 basis point drop in gross margin during the period. The net result for the company was a 6.7% decline in its adjusted operating income, a performance that has culminated in downside pressure for its stock price in 2014.

The bottom line

American Eagle Outfitters is a little cheaper than it was at the start of the year, after a moderately negative stock price return to-date in 2014. That being said, with a forward P/E multiple of roughly 17, the company isn't exactly cheap, given its operating profit decline in FY2014. While American Eagle Outfitters' uptick in profitability in its latest fiscal quarter was a positive data point, investors should probably wait for confirmation of a sustainable upward trend from another quarterly report prior to betting on this potential turnaround story.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.