Apparel stores are generally not a place to put your money given the trends in mall store traffic, how aggressive the competition is, and how fickle the customer base can be. Even the premium names have dealt with diseconomies of scale given the impact of online sales. And even worse, there were a handful of businesses in apparel retail that filed for bankruptcy throughout 2016, and it appears that will be a repeat theme in 2017.
Wowing The Crowds?
American Eagle (NYSE:AEO) however has been doing very well over the last few years. What's the story behind it? In our view, it appears to be the solid execution from the product teams and powerful marketing schemes. American Eagle and Aerie have an exceptional and yet simple store layout, offer the product appeal of the "natural look" (which many consumers identify with), and lastly "provide quality at a reasonable price" as some customers put it. By consequence, sales are up from $2.9 billion in 2011 to $3.6 billion in 2016.
On the other hand, some retailers are simply out of vogue, which is supported by recurring negative year-over-year comps, steep discounting, and store closures. Direct competitors in this category would be Aeropostale (OTCPK:AROPQ) and Abercrombie & Fitch (NYSE:ANF). To a lesser extent, Victoria's Secret (NYSE:LB) has been dealing with comp declines, and management decided to exit select product areas, one of which included swimwear. American Eagle is actively looking to fill these open pockets of customer demand. The average mall is facing mid- to high-single-digit traffic declines, whereas AEO has continued to guide flat even against tough compares. Overall, we think that American Eagle will continue to dominate its niche, and in-store sales growth will no longer be hidden once peer inventory liquidations subside.
What To Expect
LTM gross margins have increased every period since July 2014, which signifies that the business has enjoyed pricing power to some extent. It makes sense the company is executing on its strategy and the customers love the brand. Even though things have been worse than ever for the industry, the company posted a strong translation of free cash flow margin clocking in at 6-7%. The business has been discernibly stealing market share, and it should continue to do so specifically through segment expansions of Aerie and Tailgate. Management confirmed that women's products have really picked up across a variety of categories, and men's are being focused on as an opportunity for the coming quarters.
With management's recent Q4 $0.37-0.39 EPS guide, that's 4 cents below previous year's results of $0.42, which received help from a low tax rate of just 27.9% (~5% lower than its average effective tax rate of 35%). We do think that management could be forecasting conservatively, particularly given that the company has surpassed the Street's consensus eight out of the last 10 quarters.
For our bear-case back-of-the-envelope valuation, we have assumed an exit sales figure of $3.5 billion with a FCF margin of 6% (both slightly below reported LTM numbers), which equates to approximately $210mm in free cash flow.
We believe our second case holds more merit however with a low-single-digit comp growth and nearly flat store base (emphasis has been on re-modeling and e-commerce) with minimal additions. That being said, there has been some third-party discussion that a build-out of Aerie's physical presence in core markets could be a highly accretive strategy. An exit sales target of $3.8 billion, a low-ball ~1.7% CAGR over a three-year period, and 7% FCF margin (albeit near peak) put the annual output close to $266mm. In this case, at a $15.20 price with a net cash position of $1.60, the business is selling for ~9.3x FCF. It's pretty much a base-hit single.
In general terms, we tend to avoid retail as there have been too many value traps. The SPDR S&P Retail ETF (NYSEARCA:XRT) actually has not budged an inch since 2014, talk about a total let down. Going forward, things could get even worse, but it's essentially a zero-sum game, and retail stores are far from dead. Put another way, the quality name brands that are resilient will effectively outperform over time, and we believe American Eagle is one of those operators positioned to do so. Investors will realize immediate capital return with a dividend yield of 3.3% and modest buyback yield. Thank you for reading and please comment below.
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.
Additional disclosure: We will accumulate shares below $15.