After Some Preening, American Eagle Could Fly Again

By Stephen D. Simpson, CFA | May 23, 2013 AAA

A retailer's work is never done. Even if a company has the store footprint it needs and has its brand identity/merchandising dialed in, there's often the need to refresh the stores, upgrade logistics systems, and so on. While all of that goes on, there's still the matter of weather, fashion, and competition-related volatility in comp store growth to consider.

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American Eagle (NYSE:AEO) looks like it has a little more work to do before really getting going again. The company is in better shape than just a couple of years ago (when the stock traded in the low teens and “Can AEO ever be relevant again?” stories were more prevalent), but sizable cash investments and some sluggishness in sales could leave the stocky chopping around a bit before resuming a more positive trajectory.

Not A Quarter To Brag About
The first quarter wasn't a disaster for American Eagle, but it also wasn't exactly a strong start to the fiscal year. What's more, management guidance suggests that investors won't have a big rebound to look forward to in the next quarter.

Revenue fell 4% this quarter, with a 5% comp store decline. Sales were pressured by adverse weather this quarter, and a challenging year-ago comp certainly did the company no favors either. The core AE stores saw a 6% comp decline, aerie was up 4% and the company's online sales grew 24%.

Margins were also a bit disappointing. Gross margin improved 40 basis points, but came in a little short of expectations on higher markdowns. Between the sales decline and a 1% rise in operating expenses, American Eagle saw operating income decline 11%, with a 70bp decline in operating margin.

SEE: Understanding The Income Statement

Reinvesting In The Business
While American Eagle has largely outgrown its period of rapid store expansion (at least in the U.S.), that doesn't mean that the company can just harvest cash flow indefinitely. Management is pushing initiatives like a new point-of-sale (POS) system, a new merchandising system, new planning tools, and some store refreshes.

All of these require cash, and that will impact free cash flow margins for the next year or two. These moves are also not risk-free. If there are any stumbles in implementing the new systems, investors are going to see it show up in in the comp store and operating expense numbers.

What Fuels The Next Leg Of Growth?
Apart from the aerie concept, American Eagle has struggled to develop additional successful retailing concepts. That puts significant pressure on management to maintain the quality of the AE brand. That doesn't look like a problem now, but investors only need look at the history of other retailers like Abercrombie & Fitch (NYSE:ANF), Urban Outfitters (Nasdaq:URBN), Pacific Sunwear (Nasdaq:PSUN), or Aeropostale (NYSE:ARO) to see that shoppers can be quite fickle.

There are at least two avenues that American Eagle management can attempt to exploit above and beyond better comp growth in the core store base. First, management has clearly made online sales a priority, and the company is getting solid results here. Rivals like ASOS (OTC:ASOMY) shouldn't be underestimated, but this should be a high-margin revenue growth driver.

The second, and less certain, avenue is international sales – AE is looking to build stores (and its brand) in markets like Asia-Pacific. While the potential in markets like China is enormous, every retailer on the planet knows this too. International retailers like Fast Retailing (OTC:FRCOY), Inditex (OTC:IDEXY), H&M (OTC:HNNMY), as well as a host of American retailers, are all looking to compete for this business and some have definite cost advantages on American Eagle at this point.

The Bottom Line
With management guiding to flat comps in the second quarter and continuing to reinvest capital into the company's back-office systems and stores, the next couple of quarters could see the stock going nowhere fast without a positive surprise. That would argue for investors moving to the sidelines if it weren't for a pretty undemanding valuation.

SEE: 5 Must-Have Metrics For Value Investors

I believe that American Eagle can grow its free cash flow at a compound annual rate of almost 5% for the long term (well below the 13% growth of the past decade), and even that relatively low bar points to a fair value in the mid-$20s. Although I would not rush to establish a full position in the stock, I do believe that these shares offer some long-term capital appreciation upside at today's price.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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