While investors may be enticed by the success of American Eagle's (NYSE:AEO) women's intimate brand, Aerie, and the company's depressed multiple, I do not believe the stock is a compelling investment opportunity. American Eagle's legacy brand (84% of FY 2018 sales) is fundamentally positioned such that it is liable to promotional pricing amidst the distressed retail industry. Promotions have consistently damaged historical gross margin, and future gross margin is the largest determinant of American Eagle's intrinsic value, per my DCF model. In addition, American Eagle's management team is focused on growth and market share, not per-share value, which is a dangerous quality for a business operating in an industry marred by excess capacity. The result is that the company's margins, and by extension, earnings, rest on an unstable foundation.
The Company is accelerating Aerie's store footprint, which, despite its popularity, is not immune to promotions itself. After keeping total company store count roughly net stationary between 2014 and 2018 at 1055-1056, American Eagle plans to open 60-70 Aerie locations and increase its overall base of stores by 83 over the near term. This acceleration in store count makes right now a particularly risky time to own the stock as it increases the likelihood of excess inventory, price markdowns, and margin deterioration.
Over the past five years, American Eagle has experienced stellar top-line growth in Aerie and its digital channel. However, these business lines do not operate at a higher margin than the brick and mortar legacy brand. Therefore, as these units account for a greater percentage of American Eagle's business over time, investors should not expect any margin improvement.
Since 2013, the Company's revenue has grown 4% annually, while gross and EBIT margins have ranged from 33.7-37.9% and 5.61-9.76%, respectively. Going forward, allowing for healthy five-year top-line growth of 4-6%, composed of 15-20% growth at Aerie and 2% growth at American Eagle, and an operating margin between 5.0% and 8.5%, American Eagle is worth between $11.35 and $22.30 per share (10% discount rate and 2% terminal growth after 2024). While American Eagle is currently trading towards the low-end of my estimated fair value range, I believe that today's outlook embeds considerable downside risk as Aerie expands. Bullishness in this stock today requires confidence that the Company can sustain margins. The remainder of this write-up will provide evidence for why I believe that present margins are unreliable.
Vulnerable Brand
While Aerie may be less susceptible to markdowns than American Eagle, which I will touch on shortly, the legacy brand still accounts for 84% of the total business and, therefore, has a much larger impact on consolidated gross margin.
There are two specific characteristics of American Eagle's brand that make it vulnerable to promotional activity and pricing markdowns. The first is that it is a self-proclaimed "value brand", meaning that, when competitors markdown prices, American Eagle can ill-afford to sustain its own. Second, American Eagle prides itself on a wide selection of apparel which necessitates hefty on-hand inventory.
Chad Kessler, American Eagle's Global Brand President, speaks to this during the Q2 2019 earnings call, stating that,
"I think we have to make sure we've always been a brand that represents value. We've always been a brand that priced our apparel to … what we think the customer will perceive as a fair ticket. … I think the environment will continue to be competitive and we will continue to be a leader representing value in the space."
Comments of this breed from American Eagle's leadership are consistent and abundant through its earnings calls over the past decade.
Moreover, management concedes that the brand is absent pricing power. Jay Schottenstein, CEO, illuminates the drivers behind an increasing AUR (average unit retail) in Q2 2015,
"We're trying to make sure we are committed to delivering the best value for the customer possible and the most innovation and quality we can in the assortment. And some of that we do take at higher IMU [inventory mark-up] but for the most part, we aren't looking to artificially inflate tickets. That's not how we're getting our AUR."
Schottenstein continues,
"We're really getting [higher] AUR [because] … there is more quality and more innovation in that product than [there] was a year ago."
Any price hikes are attributable to greater "innovation" and are merely commensurate with increased expenditure to accommodate that increase, permitting minimal margin accretion. The impact of the second piece of the brand image, a wide selection of choice, is explained by Chad Kessler in Q4 2018,
"In terms of denim breadth, part of our leadership in jeans is that we offer a jean for everybody. … So it does require an inventory investment to run such a size intensive business, but we … look to make sure that we can satisfy our customer with whatever he or she is looking for."
American Eagle's high inventory strategy increases the probability of markdowns because it is regularly equipped with excess capacity.
Does Aerie share similar qualities? The brand, which mostly sells lingerie and swimwear, is pillared on a positive body image. Since 2014, Aerie has grown its top-line 25% annually. The brand resonance and accompanying revenue growth suggest Aerie may be capable of withstanding industry-wide price markdowns. The following quote from Jen Foyle, Global Brand President of Aerie, however, implies that, while Aerie may be able to weather promotional environments, it is not exempt from pricing pressures. Foyle touches on Aerie's increasing prices and gross margin improvement in Q3 2019,
"We definitely were less promotional. We're definitely getting paid for all the labor we're putting into our garments and we've really focused on pulling back on promotions and be[ing] more strategic with our promotions."
While it gleans positively that Aerie had success pulling back on markdowns in this particular period, the quote also reveals that Aerie has participated in promotions in the past that have damaged margins. Therefore, as Aerie is set to expand dramatically in store count (capacity) going forward, markdowns are a real risk.
In addition, management has shared that Aerie runs at a similar margin to American Eagle. This makes me question Aerie's true franchise value, as a key signal of a brand's economic value is pricing power that translates to above-average margins. American Eagle certainly does not possess pricing power, and if Aerie operates with comparable economics, it may not be a particularly valuable brand either.
Growth-Hungry Management
Here are some quotes demonstrating American Eagle's explicit focus on market share, brand leadership, and growth instead of per-share value maximization.
Jay Schottenstein, CEO, Q4 2018 earnings call,
"as we look forward, our focus is squarely on … fueling growth and gaining market share."
"It's our goal to be the number one denim brand in the US … we have to be a leader. We can't be a follower. We have to be the leader in that category and we have to be the authority for that category."
Schottenstein, Q2 2016,
"Our stores really for us have a few jobs as we evaluate them. Number one, they need to [be] market accretive; number two, they need to be able to meet our referral rate in terms of four wall operating profit".
(Notice "market accretive" before profitable.)
Schottenstein, Q4 2016,
"… we can go out and aggressively gain market share and that's really our plan … with some of the increased promotions. … I think that we can pay with some new targeted strategic promotions … and take advantage of our position and strength and drive as much market share gains as we can … and that's really our intention."
Jen Foyle, Aerie Global Brand President, Q1 2019,
"we're opening up stores as fast as we can. We're talking about 70 this year. I think if I did any more, my team might keel over Adrienne." … "…that's why we're moving fast and furiously into next year with 60-70 stores."
This is a management team with overt priorities on moving "fast and furiously" to gain market share and who uses promotions to achieve the goal. In a commoditized industry, market share is going to be inversely correlated to margins. It seems clear, which is the goal for American Eagle.
Omni-channel
American Eagle's modern strategy is "omni-channel". The Company reports that online sales, which are now ~30% of revenue, tend to increase in a certain location when a physical store is erected in that area. One implication of this is that online sales are unlikely to be accompanied by growing margins because additional stores, with their associated rent expenses, have been erected to facilitate the online business. In sum, Management states that the online business runs at an equivalent margin to brick and mortar, and the health of the two channels is likely to be positively correlated going forward such that potential brick and mortar weakness will not be offset by digital strengths.
Insolvent Competitors
Widespread retail distress has been well-documented and is a primary driver of the industry's promotional pricing tactics. However, when one of American Eagle's competitors wholly liquidates or reorganizes, the effects are punctuated. Chad Kessler offers color on what happened to American Eagle's business when Aeropostale reorganized in Q3 and Q4 2016,
"So, in the fourth quarter, in particular, we were definitely negatively impacted by what was going on within Aero … what we found was we had a significant negative comp … where they were very aggressive with their inventory liquidation. It had about a 4-comp point impact on us in November…".
2019's retail insolvencies were headlined by Forever 21 and Diesel. Future peer group liquidations are an imminent risk of disrupting American Eagle's margins at any time.
Conclusion
While American Eagle looks cheap and boasts impressive same store sales, I do not feel comfortable partnering with this management team, in this industry, stewarding this brand. Per my DCF, expectations embedded in this stock are pretty grim vis-à-vis margins. As such, I would expect American Eagle to appreciate in the short to medium term if it maintains 8%+ operating margins. However, and importantly, I do not believe that American Eagle will consistently compound intrinsic value over a long period of time. Significant growth is likely to be met with excess inventory and subsequent price markdowns, which imposes a structural constraint on the business's ability to profitably expand over time.
