American Eagle Outfitters: Thriving In The Retail Apocalypse

Summary

• American Eagle stock is 24% below its May 2019 price despite 17 consecutive quarters of growth.
• The company's Aerie brand continues to move from strength to strength.
• AEO has announced it will start selling CBD-infused products.
• The company has no debt and generates a significant amount of cash flow that is returned to shareholders via dividend and its buyback program.

One of my favorite strategies is looking at unloved sectors that the market has ignored and look for solid companies at a discount (even better if the company pays a dividend so you get paid to wait!). American Eagle Outfitters (NYSE:AEO) is one such company.

AEO is a multi-brand clothing and accessories retailer with over 1,200 retail stores. As a retailer in the age of online shopping/death of malls, the company has managed not only to survive but to thrive through a combination of significant digital presence to complement its brick and mortars stores as well as the proper brand messaging. I believe the market is undervaluing AEO due to trends in the overall retail sector.

Retail Apocalypse Or Retail Evolution?

The retail industry has vastly underperformed the market this past year. As the S&P 500 (led by the technology sector) quickly recovered from the December 2018 lows, retail stocks, as evidenced by the SPDR S&P Retail ETF (XRT), have barely budged off their lows. The issues facing the retail industry are largely structural and mainly caused by a confluence of factors namely the growth of online shopping, oversupply of malls and shifting consumer habits with analysts predicting more retail outlets and shop closures in the years to come.

Source: Tradingview.com (registration required)

What does a “retail apocalypse” look like? If the predictions are correct, about 145 Malls of America.

That’s how many combined stores are projected to close between now and 2026 — 75,000, according to Coresight Research. The advisory firm counts 5,994 announced shutterings just in 2019 so far, beating all of 2018.

That much retail real estate, if equated to the Mall of America’s 2.5 million square feet of 520 stores, translates to more than 700 million square feet, or 25 square miles — larger than the city of Manhattan.

Source: Forbes

Now it is easy to look at this environment and judge that the entire retail sector is doomed and will be eaten up by Amazon (AMZN) and all shopping henceforth will be done online, however, that is not really the case. What is happening is a shift in the way consumers interact with physical brick and mortar stores and the digital component. Despite the massive growth of e-commerce, retail sales are still largely being done offline. The latest data for 2019 shows that e-commerce in consumer spending as a percentage of total retail sales is at 10.2% (excluding motor vehicles, gasoline and groceries this figure jumps to around 20%).

Source: Statista

What is becoming obviously true though, is that retails cannot simply sit on their laurels and provide a cookie-cutter customer experience. In order to succeed in this tough retail environment, there must be a focus on melding both the digital and physical marketing experience. AEO has managed such a feat by investing in omnichannel capabilities to better serve customers i.e. connecting physical stores directly to the digital store. These investments don’t necessarily have to be at the “cutting edge” of technology to be effective. Even simple things can greatly enhance the customer experience like being able to seamlessly return product via any physical store or online regardless of where it was originally purchased, or offering a reserve online, pick up in store service. Due to the company’s efforts, AEO’s digital sales were strong in Q4 2018 and for the full year, digital sales were $1.1 billion and represented 28% of total sales.

More importantly, AEO’s brand and digital presence have been resonating well with Teens as evidenced by the fact that in Piper Jaffray's latest Taking Stock with Teens survey, American Eagle was ranked as the second-favorite clothing brand after Nike and 4th Top shopping website. Now while teens can be a relatively fickle market, AEO has shown remarkable resiliency with comparable sales increase of 8% marked four straight years and 17 consecutive quarters of positive growth as of the last fiscal year. As long as AEO can avoid any major missteps and stay current on the trends, I see no reason for this changing in the future.

Source: Piper Jaffray

Dual Growth engine – Aerie + CBD products

Aerie is AEO’s lingerie and activewear brand and has been a major growth vehicle for the company in recent years. The brand has emerged as one of retail's most influential and rapidly growing brands by focusing on a message of body positivity and female empowerment. Its main competitor, Victoria’s Secret (LB), was once a brand practically synonymous with lingerie yet has recently found itself on the wrong messaging side this past few years. Simply put Victoria Secret’s Photoshop supermodels and racy runway shows no longer resonate with the modern customer. In the first quarter of 2019, Aerie's trend continued as the brand had a 14% increase in same-store sales.

Currently, Aerie represents 16% of AEO’s last fiscal year’s $4.0 billion in revenue (putting its revenue at about $640 million). Assuming the company can grow the brand to $2.0 billion in revenue, at a net margin of 5% (AEO’s net margin currently stands at 6.5%) this would translate to an additional 65 million in Net Income (or 0.37 additional EPS). This target should be attainable in the next few years as the company expects to continue to achieve double-digit growth for the brand this year and to open a total of 60 to 75 new locations (currently the company has 115 locations). For reference, Victoria’s Secret has revenue of about $7 billion. With Aerie’s stronger marketing and brand position, I feel confident that it can steal more market share from Victoria’s Secret.

AEO has also recently partnered with Green Growth Brands (CSE:GGB)(OTC:GGBXF) to sell hemp-derived cannabidiol (CBD) infused personal care products. The products, which were exclusively developed for American Eagle, include a wide assortment of CBD-infused personal care items such as lotions, muscle balms, and aromatherapy. Sales of the product are expected to begin in October 2019. This could potentially be a huge revenue boost for the company as the CBD market is forecasted to reach $20 billion by 2020.

Although retail peers Abercrombie & Fitch (ANF) and Designer Brands (DBI) are also entering the CBD business, AEO has an advantage in the sense that its Omnichannel presence (digital and storefront) are better geared toward marketing this sort of product. Based on the survey discussed earlier, AEO's website is popular among teens, therefore, the company has an advantage over its competitors in terms of branding and digital presence.

The products will appeal directly to American Eagle’s mainly millennial audience as they view CBD as the next big trend in lifestyle focused on health, analysts told Reuters.

CBD is a non-psychoactive chemical found in cannabis plants that is known to ease anxiety and other ills without causing a high.

“American Eagle’s image is about positive messaging and wellness, so it’s not shocking that they would have CBD-infused products,” Jane Hali & Associates analyst Jessica Ramirez said.

“The products complement their brand and customers.”

Source: Reuters

Valuation

In terms of valuation, AEO is trading at a pretty steep discount. At its current price of 18.31, the stock is 24% below its May 2019 high of 24 and currently trading at a P/E of 12.36. The company also has a relatively healthy dividend yield of 3.28% which would reward patient investors who wait in the wings. This dividend is fairly secured as the company generated $456 million of cash flow from operating activities in the last fiscal year (taking out the company forecasted $200 million to $215 million in Capital Expenditures leaves the company with $256 million worth of free cash flow).

The company also carries no debt which adds even more security to this dividend. Furthermore, AEO management has recently announced an additional share buyback program as they plan to purchase 30 million shares through Feb 3, 2024. Given the current undervaluation of AEO stock, this will only improve shareholder returns in the future. Consensus forecast on AEO is at $1.58 EPS at a P/E ratio of 14 (which I feel is conservative as Levi's (LEVI) has a P/E of 20) would imply a price target of 22.12 resulting in a 20% upside. If it takes a while to achieve that target you can always enjoy your 3.16% dividend yield.

The main risk to achieving this upside target is that AEO needs to keep up with the current trends (especially with regard to the Aerie brand) and keep its customer engagement high. I am confident that AEO can continue to do so as evidenced by its track record of 17 quarters of consecutive growth. Given the company's multiple avenues for continued growth, cheap valuation and steady cash situation make this an easy buy.

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.