Description

All managers are self-interested, but some are more self-interested than others. Jay Schottenstein, American Eagle Outfitters, Inc.’s Chairman, is a consummate opportunist, and his actions nearly always signal share price movements and reward security analysis.  Schottenstein purchased 1 million shares of American Eagle, beginning the day after second quarter earnings were announced, at an average price of $24.06 (he owns over 6% of the company and family members own another 7.5%).  It is among the largest insider purchases in the retail industry in memory.

American Eagle is a mall-based apparel retailer, targeting 15-25 year-old women and men, but skewing younger. Denim is the business’ backbone, comprising approximately 20% of the company’s $3 billion in revenues. Its 800 stores average 5,700 gross square feet, a portion of which typically includes offerings from its new “aerie” concept, which sells underwear, sleepwear and dormwear to 15-25 year-old women and competes with Victoria’s Secret’s Pink.  The company has begun opening stand-alone, 3,000 square-foot aerie stores, and management believes it will open 60 stores in 2008 and that the brand can achieve $1 billion in revenues within five years. A third concept, Martin + Osa, which targets 28-40 year-old women and men under-served by department stores with a “refined casual” look (J. Crew meets Banana Republic), was launched in 2007 and is not yet profitable.  Although the American Eagle store concept is relatively mature in the U.S., international expansion remains and the aerie concept achieves returns on capital similar to American Eagle in a smaller store format (3,000 square feet).  Company-wide square footage is projected to increase over 10% in 2008.

The company is valued at only 6.2x 2007 EBIT and 9.5x 2007 earnings, net of the company’s $3.50 in cash per share. Furthermore, if one assumes that Martin + Osa will be closed if it is not value enhancing and its $0.16 per share loss is eliminated, then the company is being valued at only 5.7x 2007 EBIT and 8.8x earnings.  American Eagle has a repurchase authorization for over 10% of its shares.  Since the beginning of 2005, the company has repurchased approximately 25 million shares, representing more than 10% of the current shares outstanding, with almost one-half of the dollar amount being done during the last six months.  American Eagle could repurchase almost 15% of its shares with its remaining cash on hand.

American Eagle enjoys extraordinary margins, relatively low working capital requirements and high returns on capital.  Operating margins have averaged 20% over the last four years. Stores cost $730,000 to open, including $100,000 of inventory and all pre-opening costs, and return $525,000 in “four-wall” profits (which exclude allocated costs such as headquarters and distribution) or 72% in the first year before taxes.  Vendor financing increases first year returns to approximately 78%, before landlord incentives, gift cards and other zero-cost financing are considered.  Moreover, four-wall profit increases 17% per annum to $970,000 four years after opening.  These high returns on incremental capital at the store level are mirrored at the corporate level. Company-wide after-tax returns on average tangible capital exceeded 100% during the last two fiscal years.

American Eagle competes primarily against Abercrombie & Fitch Co. and Aeropostale, Inc., and while their merchandise is similar in style if not in quality, each employs very different pricing and promotion strategies and their stores offer markedly different customer experiences. It is widely believed that Abercrombie is the fashion leader and that American Eagle and Aeropostale follow.  However, all three companies design their merchandise based on European trends and place orders with suppliers at the same time.  What distinguishes Abercrombie, instead, is their typical price point, or “average unit retail” (AUR), which is approximately $35.  This AUR is substantially above American Eagle’s at $20, which is higher than Aeropostale’s undisclosed AUR.  Although merchandise may appear superficially similar at the three concepts, the AUR differential can be explained by differences in fabric weight and detailing. Abercrombie is also distinguished by its “club” store experience—it does not use its store windows for display, but instead covers them with blinds to distinguish between those who are “in” and those who are “out”, lights are dim and, semi-clad, live models greet customers at the entrance.  The American Eagle brand relies on a similar “club” association with its customers, and management believes this is critical to avoid price-based competition. Aeropostale, by contrast, is a “price point business,” meaning that merchandise is displayed on tables or racks with a particular price point—“$14.99”—displayed on signage that is intended to draw traffic into the store and stimulate purchases.  In addition, Aeropostale drives traffic with markdowns, frequently offering 50% off on entire categories such as hoodies or sweatpants or both.

American Eagle, like any large apparel retailer, may be sensitive to an economic downturn. In what has been a difficult retailing environment this year, comparable store sales have increased approximately 4%.  However, its Southern California and Florida stores are underperforming the rest of the store base, probably reflecting relatively worse housing price deflation. It could be argued that American Eagle’s lower AUR makes it less susceptible to margin pressure than Abercrombie, although this remains to be seen.  Management argues they expect to sustain margins, even during the current unsettled economic environment, as a result of lower transportation costs from increased sea shipping and better markdown performance from software that bases merchandise orders on size profiles by location and, when sales are less than expected, optimizes markdowns by considering regional differences in inventory.  In addition, management has shown an ability to control costs, with SG&A expenses as a percentage of sales declining over the last several years.

Catalyst