Description

American Eagle (AEO) shares have traded down because the company has missed the fashion cycle in women’s jeans for the last year and its CMO just resigned. The current price implies that AEO will be unable to fix its merchandise until 2015, and that virtually every dollar of FCF that exceeds the dividend until then is worthless. There is a reason to believe that management will get merchandise back on track within the next few years and if they can, EPS will recover to $2.00, which at the median comp’s P/E of 13x, would imply a value of $26 per share.

 

Description

 

Price                             13.24

(x) Shares                     208.1

Market Value               2,755

 

(+) Debt                        75

(-) Cash                     (338)

(-) Discounted ARS        (209)

Enterprise Value          2,283

 

 

⁽¹⁾       Retail sales divided by the average of beginning and ending gross square footage, this metric ignores “other” sales such as ecommerce

 

AE operates 869 AE, 76 AE Canada, 63 aerie, and 22 MARTIN + OSA stores. They plan to launch a new concept called 77kids with a website in 2008 and stores in 2010. The company owns its HQ as well as its two US distribution centers in Pennsylvania and Kansas. AE leases its Canadian distribution center.

 

Sales by customer type are 60% women, 35% men, and 5% footwear. Roughly 20% of sales are jeans. I estimate sales by channel are 71% Domestic AE Stores, 10% AE ecommerce, 10% AE Canada, 7% aerie, and 2% MARTIN + OSA.

 

PUBLIC COMPS (Street 2009E)

 

	EV/EBITDA	P/E	EBITDA%	Sales Growth
URBN	10.6x	21x	22%	19%
ZUMZ	5.8x	14x	14%	18%
JCG	7.4x	16x	16%	12%
ARO	6.9x	14x	15%	11%
BKE	6.0x	13x	22%	12%
APP	5.0x	14x	17%	19%
GPS	5.0x	12x	13%	2%
ANF	4.7x	10x	24%	12%
AEO	3.2x	7x	20%	8%
PSUN	3.2x	11x	12%	2%
Median	5.5x	13x	17%	12%

 

It is easy to understand why faster growing retailers like Urban Outfitters (URBN), Zumiez (ZUMZ), and J. Crew (JCG) trade at much higher multiples, but the discount being placed on companies with less short-term visibility defies most financial math. For example, while JCG is expected to grow at 12% in 2009, the company’s growth rate in 2010 is expected to decline to only 8% (equal to AEO’s in 2009E) while the company’s EBITDA margin in that year is expected to be around 17% (lower than AEO’s in 2009E) yet JCG trades at 7.0x its estimated 2010 EBITDA versus only 3.2x for AEO’s estimated 2009 EBITDA. AEO also appears undervalued when compared to peers who have worse growth rates such as Gap (GPS) and Pacific Sunwear (PSUN).

 

 

⁽¹⁾       Rent is for GPS as a whole rather than just Gap North America

⁽²⁾       My very rough estimate

 

FINANCIALS (FY ends in January)

 

Here are the current street numbers:

 

Street Estimates	2008E	2009E
Average Sqft (MM)	6.1	6.6
(x) Sales / Sqft	$536	$538
Sales	3,272	3,549
(x) Margin	19%	20%
EBITDA	624	703
(-) D&A	(125)	(140)
EBIT	499	563
(+) Interest	25	30
EBT	524	593
(x) Tax  Rate	38%	38%
(-) Taxes	(199)	(225)
Income	325	368
(/) Shares	208.1	208.1
EPS	$1.56	$1.77
P/E	8x	7x
Cash-Adjusted	7x	6x
(+) D&A	125	140
(-) Capex	(260)(1)	(170)
FCF	190	338

 

⁽¹⁾       Includes $160MM for store expansion and $60MM for a distribution center upgrade

 

SCENARIOS (2009+)

 

Scenario	Really Bad	Bad	Good
Average Sqft (MM)	6.6	6.6	6.6
(x) Sales / Sqft	$360	$450	$550
Sales	2,376	2,970	3,630
(x) Margin	12%	13%	23%
EBITDA	285	386	835
(-) D&A	(140)	(140)	(140)
EBIT	145	246	695
(+) Interest	30	30	30
EBT	175	276	725
(x) Tax  Rate	38%	38%	38%
(-) Taxes	(67)	(105)	(275)
Income	109	171	450
(/) Shares	208.1	208.1	208.1
EPS	$0.52	$0.82	$2.16
P/E	25x	16x	6x
Cash-Adjusted	24x	14x	5x
(+) D&A	140	140	140
(-) Capex	(170)	(170)	(170)
FCF	79	141	420

 

Really Bad: AEO is the single worst teen retailer in the mall. Sales of $360/sqft are equivalent to the ten-year low AEO experienced in 2003 ($395/sqft adjusted for 2% inflation) and worse than Gap’s North American business. AEO’s 10-year low in EBITDA was the 14% it posted in 2003, but the company now has more scale, owns its own HQ as well as both US distribution centers, and has significantly enhanced its IT infrastructure. The company will invest capex well above maintenance costs in a perennially doomed attempt to establish a new growth concept.

 

Bad: AEO is one of the worst teen retailers in the mall. Sales per square foot fall back to 1999/2000 levels and margins, despite advantages of scale, come in at the low end of peer group. The company still burns money trying to find something new that works.

 

Good: AEO gets merchandising right. Sales per square foot comes in modestly below 2006 and 2007 with an average margin below that achieved in the last four years. As a gut check, street 2008E in Q3 2007 was universally $850MM EBITDA on $3.6B of sales on a smaller base of stores.

 

LONG-TERM VIEW

 

There is a good chance that AEO does not get its fashion back on track this year and that the macro environment deteriorates a lot further. The long-term scenario might look like the following:

 

1. AEO has non-stop “really bad” years
2. When a “good” year does come, the stock trades at a cash-adjusted P/E of 11x = $23.77/share
3. Even in the “really bad” years, FCF should be enough to maintain the current dividend of $0.10/quarter, and I assume that this is maintained until the “good” year occurs = $0.40/share per year
4. Its unlikely that AEO would keep trying to grow throughout this period, but let’s just assume that they continue to spend $30MM a year of Capex > D&A on new concepts that end up worthless and that all new stores operate at EBITDA breakeven until the company has a “good” year again
5. The auction rate securities are eventually liquidated for par = $1.76/share
6. Excess net cash is returned to investors = $1.26/share

 

Under these assumptions, here is what AEO’s stock would return to shareholders assuming that the “really bad” scenario exists until a “good” year occurs. (Example: if AEO’s next three years are “really bad” but the fourth is “Good” the stock would deliver an IRR of 21%)

 

 

The worst recession in the US in the last 150 years lasted five years while the average lasted a little less than a year and a half. If I assume that a return of 12% a year represents “fair value” in the capital market, then the current price of $13.24 implies that AEO will not have a “good” year until 2015 and that results will be “really bad” until that time. Furthermore, the price also implies that the company will continue to invest capex well above a “maintenance” capex level in new concepts that all have to be fully written off.

 

While things can go horribly wrong in the short-run, I believe that these long-term assumptions above are relatively conservative for a few reasons. First, it’s unlikely that AEO is not able to generate FCF > dividends. Currently tempered street estimates would put this above $1.00 in additional FCF per year. Second, given management’s ownership and track record, it’s unlikely that management destroys all excess cash flow and it would be more reasonable to assume that excess cash is used to buyback shares. Finally, upon seeing some light at the end of a major consumer downturn, its possible the market values the stock at a higher multiple than 11x , perhaps as much as 14x, given AEO’s average five-year multiple of 18x trailing earnings.

 

FASHION MISSTEPS

 

AEO’s stores have average price points of $20 which is less than Abercrombie (ANF) but more than Aeropostale (ARO). The consumer has been trading down and ARO, with its much better brand perception for “budget” product, has benefited. AEO has shifted its strategy to focusing on a value proposition in attempt to regain some lost share. While this explains a portion of the underperformance, AEO still gets ranked as the #1 or #2 brand by most teenagers. When you look closer at what has driven same-store-sales over the last few months, the reason for the underperformance becomes clear.

 

 

AEO’s men’s business has been positive but the women’s business has been horrible. Specifically, tops are up, accessories are down and jeans have been absolutely destroyed. Simply put, AEO got women’s jeans wrong. This caused an inventory oversupply and management decided to take their medicine up front by aggressively clearing slow moving merchandise at a loss in Q1. At the start of Q2, inventory was down significantly and appeared to be aligned if not conservative for the current environment. AEO’s new denim offering will hit stores in the second week in July and will be launched with a “major” marketing initiative. Management has tested the product with teenagers and said that they feel “really good” about the assortment. While you can be sure they also felt “really good” about last season’s women jeans assortment, the new jeans line-up recently became viewable online and it is materially more comparable to the women’s jeans being offered at Hollister, Buckle, and Aeropostale than previously.

 

CMO DEPARTURE

 

Last week AEO announced that the company’s President and Chief Merchandising Officer (CMO), Susan McGalla, will be leaving the company at the end of the year. Susan originally joined AEO as a buyer in the women’s division and had worked her way to general merchandise manager of the women’s division. She was promoted to EVP of Merchandise in 2002 and then to CMO in 2003. Susan was being paid around $5MM a year in total compensation, making her one of the higher paid, non-CEO executives in retail. She owns about $1.4MM in stock and has another 500k in options that are likely mostly under water at the current stock price.

 

The street interpreted her departure as a sign that the fall merchandise line up is a mess and the stock fell 15%. It’s likely that management knew about her situation around March because that’s when her contract was usually renewed. In Q1, CEO O’Donnell began a thorough review of the business in order to get performance back on track. Keep in mind that McGalla was managing merchandise for the entire company as the women’s jeans business missed the mark and MARTIN + OSA struggled to resonate with consumers. While its possible that McGalla resigned because it’s the end of the line for AEO, its equally possible that she realized that she would not be up for the CEO position when O’Donnell steps down in a few years, and decided to pursue her CEO post elsewhere.

 

I was able to speak with investor relations briefly and was told that while they are looking for a new CMO, they are not looking for a new President, because they want someone solely focused on merchandise. Whoever joins will have some fairly large shoes to fill and will likely be someone with considerable industry expertise.

 

RESOLUTION OF MARTIN + OSA

 

This concept targets 25 to 40 year-olds and was launched in fall 2006. The start-up costs hit AEO’s EPS by $0.12 in 2006 and $0.15 in 2007. Stores have recently had some traction with new products at lower-price points but management has told investors that either MARTIN + OSA proves its viability by generating at least $350 sales/sqft this year or they will shut it down in Q1 2009. While either resolution would create upside to current estimates, the recent departure of the company’s CMO makes a full shutdown more likely.

 

AUCTION RATE SECURITIES

 

Company has returned slightly less than $1B in cash through buybacks and dividends over the last three years. When a number of auctions in the ARS market failed, the company froze its buyback to make sure it had more than enough capital to continue growing in an uncertain macro environment. The company has since secured a $175MM credit line of which only $75MM is currently drawn.

 

 

AEO’s ARS are government backed and likely to ultimately recover close to fair value but in the present environment it is fair to apply a discount. Auctions on $286MM of these securities have failed and thus the company will likely hold them at an average yield of 6% for the next few quarters. AEO had to reclassify its investment in ARS investments from short-term to long-term investments and thus it is effectively ignored by the street. If and when the ARS market clears, this excess cash will likely be used to buyback shares. AEO bought back $172MM, $154MM, and $451MM worth of stock in 2005, 2006, and 2007 and the company still has an additional 41.3MM shares authorized through 2010

 

AEO’s chairman, Jay Schottenstein, owns 7.5% of the company and his relatives own another 7.5%. He bought a million shares for around $24/share in Q3 2007.

Catalyst

Reception to new merchandise to be released second week of July, analyst day on July 15th, new CMO announced by end of year, reinstated buyback (hopefully by the end of the year), resolution of MARTIN + OSA (end of the year), monetization of investment in ARS.