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American Eagle Outfitters, Inc. (New York stock market :AEO) is far from recession proof, in fact, it is very economically sensitive. Clothing is consumer discretionary, one of the first categories to be cut when people cut back on spending, and in general consumers are fickle with brands. With the economy no sounding too sound, these are the main risk considerations when investing in AEO. That said, the management is, in my opinion, among the most talented in the clothing retail industry. They executed their growth strategy, maintained efficient operations and inventory management to support margins. It is very easy for a retailer to overstock merchandise that may require significant markdowns to restock shelves with the correct SKUs. Without clearing inventory fast enough and at the right price, stores become unprofitable and, if protracted, require closure depending on other factors such as leases.
Overall, however, AEO has done quite well in this regard with limited store closures and significantly increasing its store footprint from 1,047 locations in FY17 to 1,133 in FY17. fiscal year 21 and 1,141 in the second quarter of 2022. , and now a looming recession as consumer sentiment slumps to multi-decade lows:
Despite the efficiency of American Eagle’s stocks relative to the competition, it is not immune to broader economic pressures. In September, the company said it was actively eliminating inventory, cutting capital spending and eliminating its dividend. This is strategically sound given that the company’s margins and cash flow were under pressure, especially as cash and equivalents fell to a new low.
Fortunately, the company remains profitable and its cash flow is positive, which eliminates any liquidity risk. Although consolidated revenues were essentially flat or slightly up year-over-year, operating profit compressed in all three segments due to markdowns, higher transportation costs and the minor loss of Quiet Platforms.
In 2021, AEO completed two supply chain related acquisitions including Quiet Platforms and AirTerra to form its “Supply Chain Platform”. Management explained that these decisions were driven by the goal of achieving scale and greater efficiency to compete with large retailers. For example, AEO sought to improve customer service by offering same-day and next-day delivery like Amazon (AMZN). Although some net losses have been incurred so far, management has already relayed lower shipping costs, fewer shipments per order and faster delivery times. Given AEO’s already strong inventory management capabilities, such integrations should result in improved sales, operating margins and cash efficiency over the long term.
In the near term, management indicated that gross margins will fall to the low of 30 in the fourth quarter of 2022, which will be the lowest mark since the COVID pandemic.
However, I believe that once the business gets through this excess inventory cycle, gross margins will normalize and cost savings will bring operating margins back to their historical average. My estimate is that operating margins should return to an average range of 7-10%, similar to the trend seen in recent non-COVID years.
Another growth opportunity for AEO is its plans to open two flagship stores in Japan. AEO already has an online presence in Japan, but if this reopening is successful in those places, there could be another stage of organic growth for the company.
I think AEO’s sales will eventually top $6 billion or more, but it’s certainly possible that growth will falter for a while around its $5 billion TTM revenue. If we combine this estimate of revenue and operating margin, AEO can generate $350 million in bottom-end operating profit. Factoring in its total interest expense of $16 million and an effective tax rate of 25% generates about $250 million of net income or about $1.39 of EPS. This equals 8 times the winnings. If we take the blue sky scenario of $6 billion in sales and an operating margin of 10%, that’s a much better EPS of $2.43, or 4.5 times earnings. Arguably, a cyclical retailer shouldn’t trade more than 8x earnings, except AEO is not your typical retailer. Again, AEO demonstrates a fairly consistent ability to generate organic revenue growth, particularly by always having a lead with Aerie, and further optimizing its supply chain. It also has limited financial leverage.
Taking these factors together, I think there’s a strong case for AEO to be revalued toward a total enterprise value of $3 billion, or about $16 per share. This price target equates to almost 50% upside from current prices.
Downside concerns
The main downside risk considerations are that the economy and/or consumer confidence could remain much weaker than expected, which would negatively impact sales and margins. Also note that when sales and margins tend to fall, the market tends to overreact and valuation multiples could drop further.
Second, but less relevant, AEO suspended its dividend. While I believe this decision is in the best interests of shareholders to preserve the balance sheet, some investors are invariably disappointed. This is the second suspension in recent years, so it can be frustrating to own this stock for income. However, I think it is far better to own a stock whose management fundamentally cares about the financial health of the company than to appease a certain class of shareholders. In other words, if management cares about the shareholders, it will care about the company first. Regardless, I believe that once this large excess inventory is absorbed and/or the economy stabilizes, management will have more clarity and eventually reinstate the dividend.
Conclusion
I generally caution against bottom-picking, which is very difficult. Investors should be cautious about holding positions given fourth quarter inventory and gross margin forecasts. Performance might get uglier before it gets better. Management still seems cautious about the apparel industry and the economy in general. Although I expect some volatility and lower prices over the next few quarters, I fall into the bullish camp at today’s prices. AEO’s management team will continue to execute its growth strategy and further improve operational efficiencies through its supply chain acquisitions. The company’s valuation, which is trending towards multi-year lows, is another attractive factor, which I believe will lead to a long-term upside. How do you think AEO will work? Let me know in the comments section below. As always, thanks for reading.
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