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It’s true that adverse macro conditions don’t impact all companies equally, but for a company of American Eagle Outfitters, Inc.’s (NYSE:AEO) size, there’s not much it can do to escape an increasingly difficult macro environment. I’ve been impressed with management’s efforts in merchandising in the past, as well as their efforts to optimize inventory and supply chain and store operating costs (including optimizing the footprint). That can still help in an environment of double-digit declines in teen retail spending and a potentially oncoming recession.
It’s been a while since I’ve written on American Eagle, and at the time of my last article, I didn’t like the valuation or risk-reward balance. Down about 50% since then, I’m more positive on the shares from a valuation point of view, but I do still have concerns about the macro environment – even the best house on the block is at risk if the neighborhood is on fire. Mid-single-digit revenue growth and mid-single-digit free cash flow margins can support a long-term annualized return of around 10%, but investors need to be willing to wait out a few more quarters of pressured results.
Fiscal Third Quarter Results – Not Great, But Could Have Been Worse
Q3 earnings top-line results were indeed weak for American Eagle, but better than expected. The company beat expectations by more than 2%, with a 3% year-over-year revenue decline. Brand revenue declined 5%, with comps down 9%, Aerie revenue up 11% (down 3% on a comp basis, the third straight quarter with negative comps), and AE revenue down 11% (down 10% on a comp basis, also the third straight quarter with negative comps). Digital sales weren’t meaningfully different, with reported sales down 5% (versus the reported 4% in-store sales decline).
Gross margin declined 560bp yoy and 780bp qoq to 38.7%. Markdowns continued to weigh on margins (a 400bp headwind after a 750bp impact in fiscal Q2), but not as badly as expected, with the company beating sell-side expectations by around three and a half points. SG&A spending was likewise lower than expected at around 25% of sales (versus expectations closer to 25%).
Operating margin beat by more than three and a half points (operating income declined 44%, with margin down 700bp to 7.5%). AE operating income declined 33%, with margin down seven points to 20.8%, and Aerie operating income rose 8%, with margin down 30bp to 16.2%.
Between markdowns and careful inventory management, American Eagle saw inventory grow 8% year over year (up 7% in units), with inventory turns down 0.12 to 1.02.
Tough Times Won’t Last, But Managements Willing To Make Tough Decisions Will
As confirmed in management’s conference call, not to mention many sell-side reports and a trip to a local mall, this is going to be an aggressively promotional holiday season, as retailers are dealing with high inventory levels and weakening consumer demand. Companies with good merchandising can and will still outperform, but this is going to be a case of relative outperformance – it’s tough out there, and it’s not likely to get easier soon.
U.S. trade data indicates that there has still been strong growth in clothing imports (up 26% in September) even into weakening demand. Bank of America’s retail team examines consumer credit and debit card data to gauge retail trends, and by that analysis clothing demand has been negative since March of 2022, with declines in clothing spending reaching double-digits in October. For teen retailing, which I’d argue is more relevant to American Eagle, clothing spending has been declining at a low-to-mid-teens rate for most of the year.
In that context, then, I’d argue that AEO’s comps (down 9% in FQ3, down 9% in FQ2, and down 5% in FQ1) haven’t been that bad. Moreover, management deserves credit for ongoing efforts to reduce SKUs and run-on leaner inventories – earlier this year the company returned to pre-pandemic sales on 25% less inventory and 40% fewer SKUs. Likewise, I believe management is making the right decision to pull back on capex, tighten up expenses, and pause the dividend.
Aerie Isn’t Done, And Logistics Efforts Can Pay Dividends Over The Long Term
The main driver at American Eagle has been, is, and will continue to be the Aerie business. While comps have turned negative, the business is still growing at a healthy clip and there’s still room for the company to grow relative to Victoria’s Secret (VSCO) and other retailers in the intimate and athletic (or “athleisure”) apparel space. Aerie has continued to exceed my expectations (by about 3% in the last fiscal year), and I’m expecting long-term revenue growth of over 10% from here with improving margins.
I’m also impressed with management’s willingness to think outside the box with the Quiet Logistics and AirTerra acquisitions. Owning logistics assets that can reduce shipping costs, consolidate freight, improve turns, and more efficiently leverage in-store labor seems like a good move, even if there has been some near-term dilution to margins. While merchandising is paramount in retail (if you don’t stock what consumers want to buy, you will fail), the “back office” operations that get that apparel to the stores quickly and cost-effectively are important as well.
The Outlook
I believe calendar 2023 will be a challenging one for retail, but I do think there will be some evidence of improvement toward the end of the year and then into 2024. I’m looking for around 3% growth from FY’22 to FY’25, but longer-term growth more in the neighborhood of 4%.
In the near term, I’m expecting single-digit EBITDA margins through at least the middle of the next fiscal year. Given the good execution on operational costs, I believe American Eagle could exit the next fiscal year with double-digit EBITDA margins, and I think low-teens margins could come back in fiscal 2025/26. As Aerie margins improve over time (scale advantages, et al) and the company needs to spend less on capex to support the AE brand, I expect free cash flow margins to improve back toward the 5%s, driving double-digit FCF growth off of an admittedly low starting point in FY’22.
Discounted cash flow suggests a double-digit total annualized potential return from here. Likewise, using my EBIT margin assumptions for the next 12-18 months and using that to drive EV/revenue and EV/EBITDA, I believe a 0.75x forward revenue multiple and 6.5x forward EBITDA multiple are fair, supporting a fair value around $15.50 to $17.50.
The Bottom Line
Despite the strength of American Eagle’s merchandising and brand value, not to mention the back-office operational execution, the performance of these shares over the last five and 10 years hasn’t been all that impressive. As I’ve written in prior pieces, though, this is a more cyclical stock than commonly believed and one that, when bought right, can still generate attractive returns.
I do think the overall retail environment is going to remain challenging for a few more quarters, but the Street typically anticipates turns in the business and American Eagle could still outperform on margins (and outperform the industry in terms of comps). While I’m not going to claim that there’s no downside risk from here, I do think the upside reward outweighs the downside risk and I think American Eagle Outfitters, Inc. is a name worthy of more due diligence from readers.
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