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 MarginsAnd 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.

Related Articles
  1. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  2. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  3. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  5. Stock Analysis

    Analyzing Porter's Five Forces on Under Armour (UA)

    Learn about Under Armour and how it differentiates itself in the competitive athletic apparel industry in light of the Porter's Five Forces Model.
  6. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  7. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  8. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  9. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  10. Mutual Funds & ETFs

    3 Vanguard Equity Fund Underperformers

    Discover three funds from Vanguard Group that consistently underperform their indexes. Learn how consistent most Vanguard low-fee funds are at matching their indexes.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center