Half a year ago, I was relatively positive on the turnaround prospects for American Eagle Outfitters (NYSE:AEO), as I thought Wall Street gave the company virtually no credit for the improvements it had undertaken. The stock is up 50% since then, which is not a bad return for a half-year turnaround story. The question for investors now, though, is whether the company has anything else left in the tank - can the company leverage its mature store base into sustained growth, and/or can the company develop a new growth strategy?
Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.
Second Quarter Numbers Beat Again
American Eagle is still at a point where it is leveraging pessimism and skepticism into earnings beats. Revenue rose 11% this quarter, on the back of a 9% comp (management had previously guided to mid-single-digit comp growth). The flagship AE brand saw a 7% improvement, while aerie grew 13% and online sales rose 28%. Management continues to drive improved margins. Gross margin improved more than two points from last year as the company continues to benefit from decreased product costs, lower markdowns and improved fixed cost leverage. At the same time, tight expense control led to 76% growth in adjusted operating income and a three and a half point improvement in operating margin.
SEE: Analyzing Retail Stocks
A Winning Formula, but for How Long?
American Eagle management is delivering pretty much the results that it said it would a few quarters ago. Better merchandising and inventory management has reduced the need for markdowns and kept customers coming into the stores. At the same time, a focus on better expense control is allowing for the company to better leverage those costs. The real question is how much more the company can squeeze out of this process. Inventory management is a tricky thing - carry too little and the stores go out of stock, leading customers to leave disappointed (and some don't come back). Carry too much inventory (and too much of the wrong stuff) and markdowns wreck gross margins. It sounds simple, but keeping a fresh line-up and strong brand image has troubled almost every retailer at some point, including Abercrombie & Fitch (NYSE:ANF), Express (NYSE:EXPR) and Hot Topic (Nasdaq:HOTT).
SEE: The 4 R's Of Investing In Retail
If at First You Don't Succeed
Expect investors to have more than casual interest in what management has planned to drive future growth for the company. The flagship AE brand has pretty much saturated its potential store base, with outlet stores remaining the only probable square footage expansion opportunity. Aerie likely still has more expansion potential, but the company's desire to co-locate with existing AE stores could make that a long-term process.
More recently, the company sold its struggling 77kids concept, as it simply was not showing the growth or profits necessary to continue committing resources to it. The question is whether management will (or should) try again. With all of the competing concepts out there, it would seem that building another chain wouldn't be so hard, but very few retailers find much success doing it on their own. Perhaps some of it is a matter of patience - even concepts that people still think of as "new" like Forever 21 or rue21 (Nasdaq:RUE) have been around for more than 20 years, and Wall Street just doesn't have that sort of long-term vision.
SEE: Do You Belong In Retail?
The Bottom Line
Absent a new growth driver, it's difficult to see how American Eagle Outfitters will deliver long-term revenue growth beyond the mid-single-digits, as current results are helped in part by easier recovery comps. On a more positive note, there is definitely more leverage to be had from the existing store base and solid free cash flow conversion potential. Mid-single-digit free cash flow growth suggests a fair value in the low-to-mid $20s, and that's not a compelling enough potential return to offset the near-certainty that the company will again see a slowdown in sales at some point. Better cash flow generation would boost that fair value into the higher $20s, but it looks like the easy money is in hand with American Eagle Outfitters.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.