American Eagle Outfitters: Large Upside Opportunity

Summary

• Revenues have been substantially increasing in the past 2 years and it seems they will keep maintaining the trend.
• AEO has no financial debt. Though, it still has to face strong contractual obligations.
• The firm's dividend policy seems to be more conservative than in past years. This might help AEO’s free cash flow management.
• Technical analysis converges with DCF results. This is not frequently seen and it really increases probabilities of a stock’s upside movement.
• We found the stock to be highly undervalued by the market, showing a 72% upside opportunity for the next 12-18 months.

American Eagle Outfitters (NYSE: NYSE:AEO) is currently undervalued by the market. The company has really improved its revenue growth and operating efficiency. Nevertheless, it seems that the stock has been driven by momentum and the market hasn’t yet realized the firm's financial improvement. We applied a DCF valuation and a technical analysis to the firm. Both views drove us to the conclusion that AEO is an awesome pick for a portfolio.

Financial Performance

AEO’s financials have shown strong positive results. Revenues have showed an important upward trend and operating expense management has become more efficient. As a consequence, the firm has seen its operating margin increase, alongside with free cash flows expectations.

AEO seems resistant to global economic uncertainty and its inability to respond to consumers' changing preferences in shopping channels. AEO’s revenues fell 1.89% CAGR in the period 2012-2014. For the period 2013-2016, revenues increased 3.22% CAGR. The period 2013-2016 showed a 10% growth. 10% is considered to be a very high level if we take into account the industry’s slow-down expectations for the last 2 years.

The United States led revenues with 87% of sales, leaving the rest to other countries and the firm’s e-commerce business. “Women’s apparel and accessories” drove revenues with a 54% share, followed by “men’s apparel and accessories” with 35% and “Aerie” with 11%. Revenue improvement could be attributable to AEO’s investments in building technologies & digital capabilities in mobile technology, digital marketing, and desktop experiences.

In 2013, gross profit significantly fell due to high increases in the firm’s cost structure (2013 cost structure as a % of sales: ~66%). Since then, the firm’s cost structure fell to a solid 62% improved gross margin. In 2016, the firm’s gross margin was ~38%, very close to its 5Y average (36.75%). Gross profit improvement reflected better merchandise margins as a result of higher product markup levels and a flat cost of markdowns.

The firm has well managed its operating expenses. SG&A expense/Sales margin has had a stable behavior in the last 5 years. However, it showed a little decline for the period 2014-2016. This has positively impacted the firm’s operating earnings. For the period 2012-2014, EBIT had a meaningful decline, which is attributable to higher cost of goods sold. Though, for the period 2014-2016, operating earnings pushed up, leaving 2016 operating margin ~9.18% (just a bit more than its 5Y average ~7.73%). Net and operating margins showed similar levels due to a lack of interest expenses.

(Source: AEO Financial Statements, Author's charts)

For 2016, AEO’s Cash Conversion Cycle showed the lowest level in its past 5 years (2016 CCC: 23.67x vs. 5Y average: 26.27x). DSO was responsible for leading CCC’s improvement. DSO changed from 5.43x (in 2013) to current 4.58x. The company has improved its management in collecting account receivables. Back in 2012, DSO showed a better level when compared to its past 4 years (2012 DIO: 3.4x). Though, TTM’s DSO increased to 7.69x. This tells us that the company might have been starting to lose efficiency when collecting account receivables.

In addition, DIO became worse for 2016. It reflected its highest level in the past 4 years (54x). This means that the company is converting its raw materials into cash at a slower pace. Concerning DPO, AEO has increased its days paying account payables, incurring in larger credits with suppliers. This behavior could affect the firm’s future credits.

It is better for a company to sacrifice its working capital and FCF improvements through DPO, instead of getting larger credits. In the future, this could generate a supplier relationship issue and DPO could reach really low levels, affecting working capital and FCF. For TTM, it is notable how CCC decreases to 30.76x, mainly due to a worse DSO and DIO (7.69x and 56.14x respectively).

(Source: AEO Financial Statements, Author's charts)

AEO’s financial statements do not show financial debt outstanding, neither bank loans nor bonds. This is a positive fact because it gives AEO the needed flexibility to face operational restructuring and strategic changes. Remember that when there is a healthy and growing economy, getting debt is a really good way to raise capital.

But, when things are not so good, you have to keep paying interests. After all, debt is a contractual obligation and it doesn’t distinguish from good or bad times. The company is getting far behind when taking advantage of low interest rates. However, AEO’s flexibility will allow the firm to take advantage of unexpected investment opportunities.

Most of the people say that AEO doesn’t have any debt because short-term debt, CPLTD and long-term debt are not visible in the balance sheet. We consider debt as every contractual obligation that requires periodic payments, which are tax deductible and cannot be defaulted. An example of contractual obligations other than financial debt are operating lease commitments. AEO currently maintains this kind of contractual obligation. We capitalized its commitments every year to show you AEO's indebtedness. It is very important to say that the firm’s contractual obligations have been decreasing since 2013 (very positive behavior).

(Source: AEO Financial Statements, Author's charts)

The company’s dividend policy tries to follow two key factors: the firm’s life cycle and earnings. It seems that AEO’s board was too optimistic about future earnings back in 2009 and 2010. For those 2 years, the firm’s board declared its highest dividend levels. It looks like AEO’s management doesn’t make good dividend policy decisions. Even though the firm is changing its dividends paid function to its earnings, the firm’s earnings forecast is not very accurate and DPS has not presented stability.

AEO might not be clear about its current life cycle stage, this is causing its DPS volatility. In addition, it is curious how 2015-2016 EPS has showed same levels as EPS back in 2012. Nevertheless, for 2015 and 2016, DPS levels were not that high. This might tell us that the company is being more conservative in terms of raising dividends paid and it has been improving its dividend policy decisions.

AEO has repurchased stocks in order to benefit stockholders. The firm had repurchased stocks in its best years. 2012 EPS grew considerably when compared to year 2011. Also, for 2015, AEO had an important stock repurchase. You may be asking yourself: why did the company repurchased fewer stock in 2016 than in 2015, while EPS in both years presented almost the same level? This was a result of the firm’s 22.24% decrease in FCFE. Remember that FCFE is what a company can afford to pay in dividends.

AEO has been returning cash to stockholders since 2004. For the period 2012-2016, we can see how the company has been returning non-affordable amounts of cash. Nevertheless, it hasn’t been able to follow a faster upward trend like The Coca-Cola Company (NYSE: KO) or Domino’s Pizza (NYSE: DPZ). AEO has returned more cash to stockholders when its FCFE allows it. It has also decreased total cash returned in years when FCFE has presented low levels. This evidences the firm’s conservativeness in its dividend policies.

(Source: AEO Financial Statements, Author's charts)

With AEO’s dividend policy in mind, it is not a surprise that the firm’s return on equity shows the highest levels during periods of high amounts of buybacks. For 2016, the metric pointed out 20.21%, which tells us that AEO’s returns in equity are higher than the industry’s (Industry’s Average ROE: ~11%). Moreover, return on invested capital has recovered from the period 2013-2014. In those 2 years, ROIC averaged 6.82%, which is considered low when compared to current firm’s ~13% and industry’s average.

It is worth saying that the firm’s ROIC is just at the industry’s levels (~13.27%). This metric became worse for TTM, pointing out ~12.7%. The company’s reinvestment rate has been very volatile, showing a high level of 114% in 2013 due to upward capital expenditures and downward operating earnings. For 2016, the firm’s reinvestment rate was ~12%. For 2017, this rate has high probabilities of increasing due to an Abercrombie & Fitch (NYSE: ANF) possible acquisition.

(Source: AEO Financial Statements, Author's charts)

DCF Valuation

Considering the recent outlook, we decided to apply a 3-stage DCF model to value AEO. We believe that the company will make it through the industry’s issues and it will be a key player in its industry for the following years. In this way, we decided to let the company grow at a 1.39% fundamental growth rate during the growth stage with a transition arriving to 2.35% in the stable stage. We assumed that the company will follow the economy’s pace in the stable stage. In addition, we let the company earn tax benefits. Nevertheless, the effective tax rate will progressively reach the marginal tax rate in the stable stage.

We believe AEO will continue to increase its revenues throughout store openings and inorganic growth. In fact, an acquisition proposal of Abercrombie & Fitch is currently on the table. With this in mind, we decided to use the 5Y reinvestment rate average (~25%), increasing progressively to the industry’s average (~47%). For the stable stage, the firm’s reinvestment rate will be a function of growth. Thus, we computed a 44% reinvestment rate in order to sustain the 2.35% growth in perpetuity.

Return on invested capital will decline gradually from the current ~12% to the firm’s 5.29% cost of capital in the stable stage. We believe the industry is very competitive and even though the firm counts with some competitive advantages, it will not keep playing a leading paper in perpetuity. For this reason, we let the company earn no excess returns in the stable stage.

(Source: Author's valuation model)

We discounted cash flows with a cost of capital based on a 60%-40% capital structure. You might be asking yourself “How is that possible? The firm doesn’t have any debt outstanding.” Well, remember what we discussed previously about contractual obligations. Cost of equity was computed in order to reflect risk for local and out of state presence, apparel business and US currency. Bloomberg terminal doesn’t have a credit rating for AEO.

Thus, a synthetic rating couldn’t be computed due to a lack of financial debt to use the firm’s coverage ratio. We decided to use the industry’s cost of debt in order to reflect AEO’s cost of debt. In this way, we arrived at a 7.78% cost of equity, a 2.91% after tax cost of debt and a 5.83% cost of capital. Moreover, we let the cost of capital remain equal during the growth stage but showing a transition to 5.29% in the stable stage, in order to reflect the firm’s full matureness in perpetuity.

We sensitized exceed returns and fundamental growth at the stable and growth stages respectively in order to increase our confidence in the results. Thereby, we arrived at a worst-case scenario where AEO will not be able to increase its operating earnings. Instead, we decided that the worst that could happen is for the firm to decrease operating earnings at 1% and earn no excess returns.

This scenario tries to reflect a slowdown in the global economy and the industry’s demand deterioration. For an optimistic scenario, we decided the company will increase its current fundamental growth (1.69%) and earn 1% excess returns, assuming it will maintain competitive advantages over the industry and a market share improvement due to acquisitions.

(Source: Author's valuation model)

Technical Analysis

It is important to mention that we don’t mix investment approaches. We use technical analysis for our short-term positions and also to find an entry point for long-term investments. We do not recommend to use technical and fundamental analysis at the same time, since it might decrease your confidence in your long-term view of the stock price behavior.

However, it is worth to show our technical analysis view because it increases probabilities of a stock’s price upside move. AEO's stock is currently in an uptrend since its IPO. The resistance marked by the uptrend seems to be very strong. Every time the stock reaches the resistance of the uptrend, it significantly bounces. The first bounce in 1997 caused the stock to surge from $0.5 to $11. For 2000, the stock went back to the trend and bounced again significantly.

Again in 2002, after the stock bounced at the uptrend, it increased to its high in 2007 (~32$) and went back to the trend with the 2008 financial crisis. For the after-crisis period, we see the stock reaching higher levels than before the crisis, but it hasn’t reached 2007 levels. In addition, the stock has found a resistance level at ~$11 and every time the price reaches it, the stock starts an important up move.

Currently, the stock is trading at $11.70 and has already bounced from a convergence between the historical uptrend and the $11 resistance level. Technically speaking, we expect a stock’s up move in the next 12-18 months, reaching ~$20 per share. MACD divergence indicates that the last down move of the stock has lost strength and price could be ready to reach higher levels.

(Source: Trading View Chart, Author's analysis)

Conclusions

• Even though the apparel industry is facing pressure from a slowdown in the global economy, AEO has been able to increase its revenues, operating margin and FCF in the last 2 years. This behavior is attributable to the firm’s investments in building technologies and digital capabilities in mobile technology, digital marketing, and desktop experiences. Improvement of merchandise margins from higher product markup levels and flat cost of markdowns has also impacted the firm’s financials in a positive way. In order to stay competitive in the future, AEO needs to anticipate consumer preference trends by innovating its apparel offer. The firm needs to grow its e-commerce business and omni-channel retailing and improve its supply chain efficiency.
• AEO’s efficiency turning cash into sales and back into cash has been compromised. Its cash cycle conversion has increased due to a DPO and DIO deterioration. However, for TTM, the firm has shown improvements in its account receivables collection.
• The company doesn’t have any financial debt outstanding but it has a lot of operating leases commitments, which are also contractual obligations. Operating lease debt was reflected in the firm’s capital structure and in equity value of common stocks. It is important to include in debt all contractual obligations, even the ones that are not accounted in the balance sheet.
• Our technical view of the stock matches the DCF valuation results. Technically speaking, we are expecting a stock’s up move to $20. This movement is very probable to happen since the stock’s current level is at a convergence between $11 resistance level and the historical up trend resistance (including MACD divergence). It is not frequent to see 2 different investment approaches conclude with the same results. Thereby, we do not recommend mixing a technical and fundamental view.
• In our DCF valuation, we found the company to be undervalued by the market. We establish a strong buy recommendation based on a 71.77% upside opportunity for a 20.10 $/share target price and a fair range price between 16.44 $/share–23.06 $/share. We see the stock reaching our target price in the next 12-18 months.

Source: All data comes from the firm's financial statements. Charts are creations of the author.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.