Investors hoping for a rapid turnaround in American Eagle Outfitters (NYSE:AEO) should be a little concerned. Although the company is reporting better results, it seems that much of that is a byproduct of easier comps, as opposed to truly improving performance. Moreover, while American Eagle has been one of the very few to consistently post attractive returns on capital and earn real economic profits in the brutally-competitive no-moat retailing world, competition makes this very nearly a zero-sum game. There is still value in these shares, but investors need to understand that the company has to sell Wall Street on its turnaround plan before the shares are likely to match that value.
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An OK Third Quarter
American Eagle had preannounced top-line results, so there were few surprises there. Revenue rose almost 11% on a 5% comp-store increase. Keep in mind, though, that the comp-store growth was just 1% in the prior quarter, so a rebound was to be expected. Direct sales continue to be a growth opportunity (up 21% this quarter), while traditional store sales growth is more modest.
American Eagle's profitability left a mess on the bottom of the cage. Gross margin fell more than four points from last year, with merchandise margins down almost five points. Granted, higher cotton and freight prices certainly played a role, but this will do nothing to quell worries that the company has to get very promotional to move merchandise. Operating results weren't any better - operating income fell 11% from last year. (To know more about income statement, read: Understanding The Income Statement.)
Mind the Inventory
One area of worry for the company will be the inventory position. Inventory rose almost 40% this quarter, or 35% per square foot and 20% on a unit per square foot basis. That's a sizable bet on a healthy holiday shopping season, and while management was positive on Black Friday results (bumping up guidance for the fourth quarter by a few pennies), it's a big risk to future margins if they cannot move all of that merchandise.
By the same token, American Eagle is hardly alone. Other retailers in this space like Abercrombie & Fitch (NYSE:ANF), Buckle (NYSE:BKE) and Urban Outfitters (Nasdaq:URBN) have been laying in the inventory as well. If holiday sales disappoint, there will be some fierce bargains to be had in January.
Where's the Saturation Point?
The teen retailing world is pretty remarkable when you go to the mall and look at the sheer number of retailers out there, and how similar the products look to the non-teen eye. Now, to be completely honest, trusting my fashion sense is tantamount to sending your children to daycare run by dingos, but the fact remains that the mall is looking awfully crowded these days. Relative newcomers to the U.S. market like Forever 21 and Hennes & Mauritz (OTCBB:HNNMY) have seen good acceptance and a full U.S. rollout of Japan's Fast Retailing (OTCBB:FRCOY) would only make matters worse.
American Eagle is in a tight spot. On the top line, they have to fight companies like Aeropostale (NYSE:ARO), Abercrombie, Rue21 (Nasdaq:RUE) and Urban Outfitters to get folks in the store and carrying out their products. But at the same time, the company really needs to lower its cost structure, and sometimes what's good for the top line makes things harder on the bottom line (and vice versa). For instance, higher inventory turns would really help margins, but the company's efforts to lower production lead times to be more trend-sensitive (good for sales) may make it hard to reduce those costs.
The Bottom Line
If American Eagle can grow at all anymore and preserve its cash flow margin, the stock is too cheap. Unfortunately, American Eagle's same-store sales trends have not been all that strong recently, and regaining momentum in teen retailing is a difficult job for the best of managements. Still, even the bearish analysts seemed to grudgingly acknowledge that the company isn't apt to disappear, so there could be real value here. The trick is going to be in the timing. Bold investors can buy now and hope that strong holiday seasons mark the turning point in this name, but another disappointing holiday is going to keep this stock cooped up a while longer. (For additional reading, check out: Analyzing Retail Stock.)
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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.