You probably won't find a bigger bear on mall retail than I - I shorted a number of mall retailers into their Q3 reports - but even I can't understand the market's treatment of American Eagle Outfitters (NYSE:AEO). All of the concerns I have about the space - How can a company drive consistent sales growth amid declining traffic? What happens if denim fades again or the economy weakens? - seem to be consistently raised and consistently priced in (at least), relative to AEO. Yet the market happily bids up turnaround plays facing the same headwinds like Gap Inc. (NYSE:GPS) and Abercrombie & Fitch (NYSE:ANF), even though neither company has shown any ability of late to compete on the same level as American Eagle.
Obviously, if Gap, A&F and other mall retailers have more low-hanging fruits to capture, there reasonably should be more optimism towards those stocks, at least relative to near-term performance. But the divergence between the endless hope that seems to greet AEO's peers (Express (NYSE:EXPR) was another great example heading into its Q3 report) and the skepticism that AEO (and its Aerie concept) consistently faces belies the execution gap in the space. Bear in mind that Tilly's (NYSE:TLYS) guided for 0-2% comps in its Q4 - and the stock soared over 40%. AEO gave similar guidance for the same quarter - and declined double-digits. Obviously, there are myriad differences between the two situations, but the bar seems set so high for AEO as to be nearly unfair.
All told, AEO's Q3 - and the market's reaction - seemed a microcosm of the unfair treatment of the stock over the last year-plus. Most retailers are targeting the kind of performance American Eagle continues to post and few have any opportunities even close to that in front of the Aerie concept. Yet at ~13x 2016 EPS, AEO is trading at a discount to a number of peers and at a multiple that implies basically zero growth over the long term. After a quarter that looked solid at first glance - and even better in context of the space as a whole - that's simply too conservative.
As far as Q3 itself went, the report looked pretty solid. The headline numbers matched expectations, and behind those numbers it looked like a solid performance from a steady, if mature, retailer. Same-store sales were up 2% against a difficult comparison (9% growth the year before); most of that gain came from Aerie, where comps increased 21% against a 0.4% print for American Eagle brand. Gross margin increased 20 bps, with higher markups offset by modest increase in markdowns. SG&A expenses were down on an absolute basis, and deleveraged 60 bps despite an increasing advertising spend. EPS increased 17% year-over-year, though almost half of that gain came from a lower share count (buybacks reduced the float by over 6% year-over-year).
It's the type of quarter investors should expect from American Eagle: CEO Jay Schottenstein pointed out on the Q3 conference call that it was the ninth straight quarter in which AEO posted YOY earnings growth. Growth is far from spectacular, though YTD comps of 4% are rather impressive in the mall space and AEO is growing against a solid FY15 (fiscal years end the following January). Bear in mind that American Eagle grew adjusted EPS 62% last year (excluding one-time gains in Q4); at the midpoint of Q4 FY16 guidance, EPS will increase another 21% this year. Share buybacks have helped this year, but AEO still is driving double-digit net income and free cash flow growth while being priced as if it will barely grow at all. While I understand some of the reasons for concern going forward, I still don't think they support such a compressed multiple.
The Reasons For Concern
1. Q4 guidance wasn't very good.
AEO has recaptured close to half of its post-earnings losses; a strong broad market this week has helped for sure, but I would wager there's also been a slow understanding that Q4 guidance was stronger than a YOY EPS decline suggested. AEO management might not have helped on that front. While it called out a gain on sale and tax help in the Q3 FY16 release, it was less emphatic in the Q4 FY15 release, not even excluding those benefits to report non-GAAP adjusted figures a year ago.
To be sure, the Q4 guidance isn't great, regardless: net income is guided basically flat excluding the benefit to EPS. But it is another tough comparison: American Eagle posted 4% same-store sales growth off lower promotions in Q4 last year and net income more than doubled. It's still terribly unclear exactly what this year's holiday season will look like: the responses to Q3 results in the mall space have been notably divergent (to name a few retailers which have reported recently, TLYS, FRAN and ASNA have soared; AEO, EXPR and GES have plunged). A double-digit sell-off based on Q4 guidance which wasn't that bad to begin with strikes me as an overreaction - and the market may be coming around to that interpretation.
2. Aerie is due to stall out.
Undoubtedly, one of these quarters, Aerie is going to struggle to lap its comparisons. But it hasn't happened yet: Aerie's same-stores sales grew 20% in FY15, and have increased another 25% YTD.
I can somewhat understand the skepticism toward Aerie. The concept actually disappointed after first being rolled out: AEO cut Aerie's store count by 40%+ in the beginning years of this decade. And it seems clear that many investors and analysts see recent strength as being driven by bralettes, a potential fad: two analysts asked a version of "so is this bralette thing going to last?" question on the Q3 call, and it was not the first time the subject has come on an AEO post-earnings call.
But I'd argue that Aerie, at this point, is not a potential catalyst to the downside when growth inevitably slows, but rather a substantially underappreciated part of the AEO story. Aerie only drove 9% of total sales in FY15, per the 10-K, a figure that should rise to ~11% this year. But I still believe, as I argued earlier this year, that the concept easily could be valued at 2-3x revenue, or in the range of $1 billion. (It's difficult to drive a comparable valuation, which is kind of the point: there simply aren't opportunities like Aerie in the current U.S. retail environment.) Given AEO's ~$3 billion enterprise value, that implies a valuation for AE brand of around 10x EPS (assuming operating margins are roughly equivalent, which I don't believe is the case).
While bralettes do pose a risk of a slowdown, I still see the branding at Aerie as a huge advantage and significant white space for the brand. Relative to the latter point, Aerie has done a far better job of 'omnichannel' retailing than most legacy brick-and-mortar retailers (and AE brand's performance hasn't been shabby either) and Aerie itself only has locations in 11 states.
Meanwhile, Aerie has dominated L Brands' (NYSE:LB) Victoria Secret in bralettes and I still see plenty of room to take share. The AerieREAL campaign is a huge hit and simply from a 'feel' standpoint seems absolutely perfectly suited for the times. In a time where 'fat-shaming' and 'authenticity' are buzzwords, Victoria's Secret distributes catalogs full of airbrushed photos of nearly physically impossible women; Abercrombie & Fitch based its brand on shirtless teens with "rock-hard abs" and hasn't found a better way. Aerie's campaigns have explicitly challenged the perceptions underlying those brands - and customer opinion is trending in its direction.
There seems a sense that Aerie is some lucky strike on a new category that has led to unsustainable growth. There may be some truth to that assessment. But, as a brand, Aerie also seems to have made a substantial number of prescient moves that position it well going forward. The attitude toward Aerie - focusing on the risks, ignoring the execution - seems to mirror that of the market's attitude toward AEO as a whole. And in both cases, I think it's far too pessimistic.
3. Mall retailing is in secular decline.
I agree with this concern; there are few mall retailers left that I haven't shorted at some point in the last few years. But AEO is one of them, because I don't think it makes sense to bet against good management and because of the classic "there are a lot better short options out there" argument.
Yes, there are significant risks simply from the business model: CFO Bob Madore said on the Q3 call that traffic declines ranged from low single-digits in 'Class A' malls to mid- to high-single-digits at Class B and C properties. But if investors are so concerned, why is GPS getting bid to $30? Why has ANF received chance after chance? Why is TLYS (admittedly not a mall pure-play) trading at 40x FY16 EPS?
From my standpoint, anyone citing a secular decline in the mall is preaching to the choir director, let alone the choir. But those risks can be teased out with a pairs trade, and simply from a sentiment standpoint, it's unclear why any gains at AEO seem thwarted by these concerns while they're ignored at peers posting far weaker performance. Either mall retailers get a discount or they don't. The market's consistent discounting of one of the best performers (from an execution/fundamental standpoint) and similarly consistent optimism toward a "turnaround" from secularly challenged brands like Banana Republic and Abercrombie & Fitch is a contradiction that I still don't quite understand.
From here, I still think AEO deserves to trade above $20, a level the stock has consistently failed to hold since the financial crisis. A consolidated mid-teen multiple to 2016 EPS plus cash supports that figure; so does a rough estimate of 12-13x (essentially, zero growth) AE brand EPS plus a 2.5x revenue multiple for Aerie (again, adding net cash).
As bearish as I am on retail, any long position for me in AEO would serve as a partial hedge against short positions and I do think a pairs trade makes some sense. Either GPS, ANF, or LB could be used as the short; the latter stock, trading at 20x EPS, in particular seems like a potentially attractive option. I don't think Victoria's Secret is well-positioned looking forward (nor is Bath & Body Works all that impressive), and I do think both AE brand and Aerie can take share from their larger, better-known peer.
And I do think at some point, AEO will break through its high-teen resistance and upside from there could potentially be significant. If sentiment toward Aerie changes from "waiting for the bottom to fall out" to "wait, this is a legitimate long-term growth driver," there's room for the multiple to rerate in combination with bottom-line growth. The holiday season will be challenging; I've been surprised to see some of the trading strength in retail as a whole, and if that reverses, AEO may offer a better entry point. But below $18, I still think AEO looks too cheap, both on its own and, especially, relative to its peers.
Disclosure: I am/we are short TLYS, GPS.
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.