To me, the biggest question coming out of American Eagle's (NYSE:AEO) poor second quarter and weak guidance is whether or not there's an overall traffic problem at the malls. If traffic is down across the board (and there's some evidence that that may be the case), this is just another one of those bad stretches that every apparel retailer has to deal with now and then. If the traffic patterns are more inconsistent, though, and some really outperform, it sets up a whole new round of questions about merchandising, brand value, and long-term margins. A Terrible Second Quarter …This was a rotten quarter for American Eagle, as management had warned the Street a couple of weeks ago. Revenue fell 2% as the store saw comps plunge 7% against an original Street expectation for scant growth (0.2%). Sales were worst in the core AE brand (down 8%), with aerie down 2% and online sales up 11%. Comps for women's clothing were worse (down 9%) than men's (down 4%), but neither were good. Traffic (as measured in transactions) declined 3%, and sharp discounting led to a 4% decline in ticket. With weak sales and heavy discounting, margins were soundly thrashed. Gross margin declined more than three and a half points from last year and about five and a half points sequentially. Operating income plunged 56% as the operating margin was more than cut in half. If there was any good news, it was that inventory per square foot declined 1%, suggesting that the company's markdowns were at least effective in clearing merchandise.SEE: Analyzing Operating Margins … And It's Getting WorseWhen management warned about the second quarter numbers in early August, they suggested that heavy markdowns had cleared out inventory and left the start of the fall selling season relatively “clean”. Unfortunately, very weak July results haven't improved all that much, and management lowered guidance once again. AEO management took third quarter EPS guidance down by more than 50% ($0.14 to $0.16 per share versus a prior average Street estimate of $0.35), and projected a comp sales decline of “mid to high single digits”. General Malaise Or Merchandising Mistakes?Sell-side analysts routinely come out with seasonal pieces containing their opinions on who has the best merchandise assortments and the best prospects for sales performance in a given quarter. Not surprisingly, adults in the 30-50 age bracket aren't all that good at accurately predicting the tastes of teenagers on a consistent basis. So while many analysts had tried to use American Eagle's earlier warning as “confirmation” of their calls regarding retailers like Aeropostale (NYSE:ARO) having better assortments than American Eagle, Aeropostale's subsequent warning pretty much took care of that notion. Moreover, in a call peppered with references to disappointing and unacceptable performance, American Eagle's management addressed a point that I have worried about for some time now – very aggressive promotional activities from rivals. Several of American Eagle's rivals have been pursuing pricing/promotion policies that aren't sustainable on a long-term basis, but serve to seriously mess up the results at retailers like American Eagle. All told, that tells me that traffic is pretty poor right now, and it doesn't like the back-to-school season is offering any respite. Likewise, larger, less teen-oriented like retailers like Wal-Mart (NYSE:WMT), Target (NYSE:TGT), and Kohl's (NYSE:KSS) have all reported pretty challenging conditions in the apparel market.SEE: Analyzing Retail Stocks The Bottom LineOver the long term, I still believe that American Eagle more than holds its own with the likes of Aeropostale, Urban Outfitters (Nasdaq:URBN), Abercrombie & Fitch (NYSE:ANF) and so on. I think the company's efforts to shorten lead times, improve merchandise planning, and accelerate international and online sales will pay dividends, and I think management has the skill and credibility to lead the company out of this disappointing stretch. Valuation is a tricky discussion, as it's hard to encourage anybody to invest in a company when the current conditions are looking this tough. Still, I don't believe my long-term assumptions of 4% revenue and free cash flow growth are all that aggressive, and I believe these shares are undervalued today. It's likely going to take some time for the retailing environment to improve, though, and aggressive promotions from other teen retailers could poison the well for a couple of quarters. Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.
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