American Eagle: Time To Accumulate

Summary

• The correction on American Eagle is a solid opportunity.
• Aerie is the usual suspect in AEO's brilliant results.
• American Eagle isn't like L Brands; pricing is backed by fundamentals. Maintain Buy.

I had a minimum target of $19.18 on American Eagle (NYSE:AEO) at the beginning of this year. The stock crushed that target within months, but after the correction yesterday, I think it is back to being attractive again.

Not much has changed so far as my assumptions are concerned. But since I did not anticipate a 12% growth in sales in the fourth quarter, my base for projection inched higher. I am persisting with my buy rating with a slightly enhanced target of $20.7 by December-end.

Q4 Review and Commentary

Net sales increased 12% to $1.23 billion. Aerie continued to be the usual suspect in American Eagle's record-breaking fourth quarter. As I had written in my previous piece as well, Aerie's usage of cotton, association with body positivity and affordable prices are making it a hit with millennials. And the brand posted an industry-leading 34% increase in comps to show for this imaging and execution.

The company also offered an interesting nugget of information on Aerie's brand potential:

I believe in the next two years, we can achieve over $1 billion. And when I look at Aerie, I look at the American Eagle and I see the progress that's being made in Aerie. And with the experience we have, I think this could become in the next few years a $2 billion, $3 billion brand. (Transcript)

The "next few years" phrase is confusing, so I simply halved the growth rate over the next three years. If we were to assume a 2% CAGR for rest of the company, total revenues would still have a CAGR of 6%. Therefore my assumption of a 6%-3% revenue growth taper could well be conservative.

Rest of AEO (mn $)	3295	3361	3428	3497	3567	3638
Growth		2%	2%	2%	2%	2%
Aerie (mn $)	500	700	1000	1200	1440	1728
Growth		40%	43%	20%	20%	20%
Total AEO (mn $)	3795	4061	4428	4697	5007	5366

Click to enlarge

Note: $3.795 bn is the sales figure for the year ending Feb. 2018

The company's market share focus ensured that the company hooked people on discounts in order to use that momentum in the upcoming quarters which are likely to be less promotional. Gross margins were off as a consequence. But an increase in sales base should allow the firm to drive leverage on the SG&A side. I have, therefore, increased my operating margin assumption by 50 bps in the 7.5-8.5% range by 2023. Other assumptions for my $20.7 target include a tax rate of 25% and capex at 4-5% of sales.

Conclusion

The retail sector has seen some rerating after the last quarter of 2017. L Brands (LB), a key competitor of Aerie, is a prominent ticker I remember being pessimistic on. When the stock surged along with other retail names, I was criticized, but the fundamentals were just not there. The stock has now tumbled back to levels in September. American Eagle, on the other hand, has fundamentals backing its pricing. I, therefore, think if there is panic selling on the ticker below, investors should look to have a skin in this game.

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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.