American Eagle Outfitters: Don't Let The Historical Stock Performance Fool You

| About: American Eagle (AEO)
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Summary

American Eagle Outfitters' stock performance has been disappointing.

The company has a healthy balance sheet with no debt to speak of, and is nicely poised to keep returning value to its shareholders.

The Aerie brand can prove to be the biggest catalyst for American Eagle Outfitters.

The 1-year target price range for the stock is $19.71-23.68, which implies considerable upside from current levels.

American Eagle Outfitters (NYSE:AEO) demonstrated robust financial performance in 2015 despite macro headwinds and a rather difficult retail environment. The stock performance, however, hasn't lived up to the billing. If you'd invested $100 in AEO in January 2011 and had regularly reinvested the dividends, your collective returns on AEO stock would have been disappointing compared to that from the S&P Midcap 400 and the Dynamic Retail Intellidex.

(Source: Company's latest 10-K filing)

So, does that mean AEO is not a compelling investment opportunity? Are there any factors that could drive the stock upward in 2016 and beyond? And finally, do shares possess any significant upside potential? I shall try to answer these questions here.

While AEO stock performance may have disappointed its shareholders, the company has managed to achieve impressive earnings growth in recent quarters driven by positive comps at both AE and Aerie. It has a healthy balance sheet with no debt to speak of, and ended fiscal 2015 with $260 million in cash. As a matter of fact, AEO generates $5.29 FCF for every $100 in sales, and this has allowed the company to return over $1.6 billion to shareholders in the last 5 years. All this is well and good, but this isn't exactly why I am getting excited about AEO right now.

The Aerie brand can prove to be the biggest catalyst for AEO, and 2015 was, in many ways, a historic year for this brand. In Q4 2015, Aerie's comp sales grew by a massive 26%, and this was the seventh quarter in which the brand delivered positive comps. This is an amazing achievement considering how tricky it is to succeed in the lingerie business, which has traditionally been dominated by household names like Victoria's Secret (NYSE:LB). Much of the credit goes to the company's well-thought out and innovative marketing campaigns that are helping Aerie establish its presence in the lingerie and swimwear market against the odds.

The Aerie Real campaign is all about promoting the idea that young women ought to love their bodies, and sexiness has a lot to do with originality. This is a very powerful message that has undoubtedly attracted a large number of teens to Aerie, as evidenced by the 12% growth in active customer base last year. Although Aerie's sales, at present, are not even one-twelfth of the sales of Victoria's Secret, I strongly believe this brand has a lot of potential and can steal customers away from the big names. AEO, as part of its selective store growth strategy, is planning to open 10 new standalone Aerie stores this year in North America, which will lead to brand expansion. Furthermore, Aerie is not only sold in the company's brand stores, but is also sold online, implying that as AEO broadens its online offering, more customers can be easily drawn towards the brand.

At 13.6x forward earnings, AEO doesn't look too expensive. In fact, the company's current P/E multiple is sitting roughly 43% below the 5-year average. However, based on the price-to-sales and price-to-FCF ratios, AEO is still trading at a premium to its direct rivals, including Abercrombie & Fitch (NYSE:ANF), Gap (NYSE:GPS) and Aeropostale (NYSE:ARO).

To calculate the fair value of AEO stock, I use a 5-year DCF model, modeling for 2% terminal FCF growth rate. My model uses WACC, calculated using the CAPM, as the discount rate.

By the end of 2020, AEO can achieve ~$594 million in EBITDA, driven by 3.1% and 2.8% revenue growth in 2016 and 2017, respectively, and 2.0% per year thereafter. These revenue growth assumptions are in line with analysts' consensus estimates.

In fiscal 2015, the company's EBITDA grew at a faster rate than revenue because of a softer increase in SG&A and cost of goods sold. This was a consequence of fewer promotional activities and lower rent expenses. In coming years, I believe AEO can demonstrate even better expense management and can benefit from store consolidation, owing to which I project the company's EBITDA margin for fiscal 2016 and beyond to be higher than the historical average.

As far as other assumptions are concerned, for the period starting from fiscal 2016 until fiscal 2020, I project capital expenditures to be 4.3% of revenues. This figure is the median of capex to revenue for fiscal 2011-15. Depreciation and amortization is assumed to be 4.2% of revenue, consistent with the 5-year mean. Net working capital is assumed to be 1.9% of revenue, consistent with the 5-year mean. The tax rate is assumed to 38%, consistent with the 5-year mean.

Key Assumptions

Terminal FCF Growth Rate

WACC

Fair Value

Low

2.0%

8.7%

$19.71

Mid

2.0%

7.5%

$23.68

High

2.0%

6.6%

$28.02

Projections

Fiscal Years Ending

Jan-16

Jan-17

Jan-18

Jan-19

Jan-20

Jan-21

($ in Millions)

Revenue

3,522

3,630

3,730

3,805

3,881

3,958

% Growth

7.3%

3.1%

2.8%

2.0%

2.0%

2.0%

EBITDA

469

545

560

571

582

594

% of Revenue

13.3%

15.0%

15.0%

15.0%

15.0%

15.0%

Calculation of FCF

Projected Unlevered Cash Flow

Jan-17

Jan-18

Jan-19

Jan-20

Jan-21

Terminal

EBITDA

545

560

571

582

594

594

D&A

(153)

(157)

(160)

(163)

(167)

(161)

EBIT

392

402

410

419

427

432

Pro forma Taxes

(149)

(153)

(156)

(159)

(162)

(164)

NOPAT

243

250

254

260

265

268

Capital Expenditures

(156)

(160)

(163)

(167)

(170)

(170)

NWC Investment

(69)

(2)

(1)

(1)

(1)

0

(+) D&A

153

157

160

163

167

161

Free Cash Flow

171

245

250

255

260

260

% Growth

43%

2%

2%

2%

Calculation of Equity Value

Model

Low

Mid

High

Market

Enterprise Value

3,608

4,387

5,239

2,999

(+) Cash & Equivalents

260

260

260

260

(+) Investments & Other

0

0

0

0

(-) Debt

0

0

0

0

(-) Minority Interest & Other

0

0

0

0

(-) Preferred Stock

0

0

0

0

(-) Other

0

0

0

0

Value of Common Equity

3,868

4,647

5,499

3,259

Diluted Shares Outstanding

196

196

196

196

Implied Stock Price

19.71

23.68

28.02

16.61

Upside / (Downside)

18.7%

42.6%

68.7%

According to the calculations shown above, we get AEO's market value of equity equal to ~$4.65 billion in the "mid" scenario by subtracting the market value of debt and adding back cash and investments to enterprise value. Dividing this figure by the diluted shares outstanding, we get a fair value of $23.68, representing an upside of ~44% from the closing price on April 4, 2016.

My 1-year target price range for AEO is $19.71-23.68, which implies considerable upside from current levels.

Conclusion

All in all, I am optimistic about AEO's prospects. Even though there are concerns regarding mall traffic which could impact its comps, and competition in the teen apparel retail market could stiffen in the future, I think the company has the potential to keep growing. I have high hopes for AEO's Aerie brand, which has boundless opportunities to become the real deal in the lingerie market. As it stands, AEO is a buy because its shares possess significant upside potential and downside risk looks minimum.

Disclosure: I am/we are long AEO.

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.