Description

American Eagle Outfitters (AEO) $14.87

American Eagle presents investors the opportunity to purchase one of the bright spots in specialty retail at a discounted valuation of sub 5x EBITDA and sub 11x earnings.  The elevator pitch boils down to:

• AEO is the beneficiary of the declining prospects of teen apparel competitors ANF and ARO

• Recent market reaction to AEO’s pre-announcement creates an attractive entry point

• Capital allocation is responsible with Jay Schottenstein at the helm as CEO and largest shareholder. Jay has been buying in size personally, AEO has an 18mm share buyback authorized with $1.3bn purchased over the last decade, and AEO pays a 3.3% dividend ($0.50).  Rational capital allocation in specialty retail is a rare quality

• Operating margins have rebounded from  6% to 9.5% with management committed to a target of 10-12% in line with its 10 year average of 11.8%, yet far below is “over-earning” years of 20%.

• After a decade of tinkering, AEO’s aerie intimates concept is working well under new leadership and could provide a meaningful growth engine going forward

• Internet/mobile sales have grown from 11% to 20% of total sales in the last 5 years leveraging their existing store base omni-channel investments

Business basics

American Eagle operates two primary brands consisting of American Eagle Outfitters with 948 stores targeting 15-25 year old men and woman predominantly across North America. The brand’s aesthetic leans toward preppy and basics with an emphasis on denim which hedges some of the fashion risk.  AEO also operates 92 aerie stand-alone stores focused on woman’s intimates.  The aerie brand is also sold at American Eagle stores, sometimes with a “shop in shop” type feel.  

Competition

The teen apparel landscape has always been a hypercompetitive environment.  Besides the usual historical suspects of Aeropostale and Abercrombie, the last decade has given us fast fashion chains H&M, Forever 21, Zara.  The last few years has also introduced the “athleisure trend” of Nike, Under Armour, and Lululemon clothing becoming acceptable attire outside of the gym.  The result has precipitated stagnant store growth and operating income in the last 10 years.  However, it appears that Eagle is capturing the market share of it historical rivals.  In the last 3 years, Abercrombie’s sales have declined 22%, while Aeropostale’s sales are off 37%.  Eagle’s sales are flat over the same period.   ARO’s $0.25 stock price and financial leverage against negative EBITDA support a continued destruction of the brand.  Besides ANF’s ugly sales trend, CEO and COB Mike Jeffries was forcefully terminated.  While he had his share of critics and some very eccentric behavior, canning the visionary creator of a brand leads to bumpiness before repair.  Given ANF’s brand problems and risky premium AUR’s in a fast fashion world, return to growth is unlikely in the near term.  AEO should continue to take share.

aerie

After a number of false starts in its quest to best Victoria’s Secret Pink sub-brand, new management appears to have the right formula with the brand posting a 19% comp in 2015 and a 6% comp in 2014. New global brand president (chief aerie merchant since 2010) Jen Foyle has driven impressive growth with seven consecutive quarters of positive comps and earnings growth. After testing smaller footprint aerie stores in 2015, AEO will be rolling out new stand-alone aerie units for first time since 2011.  This is a marked change after years of negative comps and taking stores from 158 to 92 today.  The smaller remodels are seeing a 60% improvement of productivity versus legacy stores.  2016 plans include opening 10 new stand-alone units and 25 side-by-side stores. At approximately $310mm in 2015 revenue, aerie represents 9% of AEO’s sales and management thinks they can double aerie over the next few years. With L Brands (Victoria’s Secret) on every sell side analyst’s top pick list trading at 23x earnings and its all-time high stock price, we have a growing, undervalued competitor inside of AEO.

Management and capital allocation

On the creative side, Roger Markfield has been the driving force behind AEO since the 90s with a few retirements in between.  With Chad Kessler promoted to Eagle brand president and Jen Foyle promoted to aerie brand president, a succession plan for Markfield’s next retirement is in place.  Jay Schottenstein, a Columbus, OH retail icon has been back at the helm as CEO since January 2014.  He has been COB since 1992 and remains Eagles largest shareholder.  Jay has been the Chairman/CEO of DSW, Retail Ventures, American Eagle, and a number of private family office vehicles.  It’s fair to say that Jay thinks like an investor more than a retailer, which is to say he understands the beneficial math behind share repurchases at the right price over new store growth.  In the past 10 years AEO has repurchased 13% of its stock for approximately $1.3bn.  Eagle currently has an 18.4mm share repurchase authorization outstanding, good for 9% of the outstanding shares and should have a net cash balance of $500mm at 1/31/16.  Beyond the buybacks, Eagle has returned an additional $1.3bn to shareholders by way of dividends. Jay eats his own cooking as the largest holder of Eagle with approximately 15mm shares (7.6%).  Followers know that he tends to be a shrewd purchaser of share for himself.  Shares were up 15% in one year (47% in 2 years) following a Jan 2014 purchase of 500K shares.  Shares were up 115% in one year following a 1mm share purchase in Sep 2011.  If the past is prologue, it’s a good data point that Jay purchased 164K shares last week at $13.22 after purchasing 500K shares at $15.74 on 9/14/15.  

Recent financial performance

Ahead of the ICR retail conference on 1/8/16, AEO preannounced a QTD same store sales comp of 4% and fourth quarter EPS guidance of $0.40-$0.42 representing a 14% increase over the prior year implying 70% increase of 2015 vs. 2014. Despite the pre announced numbers falling squarely within AEO’s guidance given one month prior, and  despite a very challenging and promotional holiday season that left a multitude of retailers comping down hard, Mr. Market punished AEO 16% to a one year low.  Perhaps the sell side had gotten a little “over its skis” in forecasting 5-8% comps and, as is often the case with retailers, the punishment didn’t fit the crime.    

Stepping back to the bigger picture, Eagle’s 2015 operating margins should be 9.4%, representing a large improvement from its historical low point in 2014 of 6.3%, yet still below its 10 year average of 11.8%.  Management thinks they can get back 12%.  At its current valuation simply maintaining its current margin should prove beneficial for the stock.  The current financial picture is a far less risky than the 20% peak margins Eagle was overearning in the 2003-2006 timeframe.  

Mall traffic

It’s no secret that mall traffic has been declining for years.  The offset to bricks and mortar declines has been embracing the shift toward online and mobile which has increased from 10% to 20% of total sales in the last 5 years.  Eagle has spent $210mm over the last 6 years building out its omni-channel platform to have one inventory channel pulling from both DCs and in stores, allowing customers the ability to ship from the DC, from the stores or to order online/pickup in store.  Like many retailers, Eagle is also addressing the trend by rationalizing its store base and expects to close approximately 150 more stores by the end of 2016.  Eagle also leverages its size with mall operators to negotiate shorter terms on its leases to create more flexibility.  Declining mall traffic is not a positive, but it’s a factor they have tackled directly.    

Valuation

At 4.6x 2016E EBITDA and 10.6x 2016E earnings (ex cash) AEO is too cheap for a retailer without negative comps, good management, respectable capital allocation, and optionality for growth in aerie.  An appropriate valuation range is 7x EBITDA and 15x earnings while giving credit to the net cash, putting AEOs fair value over $20.  Such a valuation is significantly below other growing retailers like LB and LULU at mid 20x earnings and 10x+ EBITDA but a premium to declining competitors like ANF.  Should aerie continue to perform and Eagle grow its operating margins into the double digits there is certainly upside in the form of multiple expansion.

Risks

• Declining mall traffic, unexpected margin decline, more than a slight negative comp in 2016

• Competition from fast fashion intensifies more than expected

• Amazon grows so fast that every brick and mortar retailer disintegrates
• AUR declines accross the retail landscape due to economic conditions and delfation from cotton price declines
• Mr. Market decides the consumer is dead an punishes the sector

Catalyst

Catalysts

• Continued margin expansion

• Continued declines in ARO and ANF

• Death of the athleisure trend at some point….maybe…hopefully

• Multiple expansion (for those that consider it a catalyst)