Unlocking American Eagle Outfitters' True Valuation

Background:

The retail industry has been hit hard as investors anticipate a recession. American Eagle’s (AEO) stock is down nearly 50% in the past year and a half. The disappointing negative same store sales figures for the first few months of the year sent the stock tumbling. January same store sales were down 12%, February’s same store sales were down 4%, and in March, they were down 12%. For the first quarter, same store sales declined 6%; net income was down 44% and operating margin declined from 18.9% to 10.1%.

Abercrombie and Fitch (ANF), AE’s main competitor had negative same store sales figures but AE was hit harder then most of its competitors. The disappointing first quarter figures were driven by sales decreases in the girls’ side and a mistake in styling in the denim business, which is AE’s backbone and represents around 20% of sales. This forced AE to take markdowns on denim and girls’ merchandise during the quarter, which negatively affected margins. Insider purchases have been significant over the year. Jay Shottenstein, its founder and chairman, has purchased $24 million in stock over the past year, and his family owns 15% of the stock.

Business:

American Eagle is retailer that sells mid-priced casual clothes targeted to 15-22 year olds through its 942 American Eagle stores in the U.S. and Canada. In 2006, it launched the sub-brand “aerie” which targeted 15-25 year old girls, and has since opened 55 aerie stores. In 2007 a new concept targeting 25-40 year olds called “MARTIN + OSA,” was launched, and currently, there are 21 MARTIN + OSA stores.

American Eagle has been a phenomenal company over the years based on margins, returns on equity and other metrics. Average ROE over the past 10 years has been 28%, with new stores on average producing a return on equity of 65% in 2007. On the average, operating margins have been 16% over the last 10 years, which is one of the best in the entire apparel industry, which averages 4%.

Competition:

American Eagle’s two largest competitors are Abercrombie and Fitch and Aeropostale (ARO). Other competitors include The Buckle (BKE), Gap (GPS), Hot Topic (HOTT), J. Crew (JCG), Limited Brands (LTD), Pacific Sunwear of California (PSUN), Quicksilver (KWK), Talbots (TLB) and Wet Seal (WTSLA). One thing that distinguishes AE from its two largest competitors is price. Abercrombie & Fitch’s merchandise is much more expensive then AE’s with retail price of the average Abercrombie & Fitch unit being $35 as compared to American Eagle’s $20.

On the other hand, Aeorpostale generally is slightly cheaper then AE. I compared jeans, tees and polos from American Eagle to near identical merchandise at Aeropostale, Abercrombie & Fitch and their sub brand Hollister. I found that prices at American Eagle and Hollister were very similar. Prices at Abercrombie and Fitch usually were around 50% more than American Eagle. At Aeropostale, prices were nearly always the cheapest of the four. I also read the latest quarterly and annual reports from Aeropostale and Abercrombie & Fitch. I feel that AE has superior qualities to both of these companies:

First, Abercrombie & Fitch’s prices are much higher then AE’s and both contain very similar merchandise. For example, a pair of jeans at Abercrombie a pair of jeans cost $80-$90, at AE and Hollister they cost $50-$60, while at Aeropostale the cost is $30-$50. The merchandise is nearly the same between these four retailers. Abercrombie relies much more on the intellectual appeal of their brand to convince customers to pay 50% more for very similar merchandise. Therefore, I think Abercrombie is much more susceptible to economic conditions, consumer spending and fashion trends. I personally get all my cloths from AE and fund no reason to spend $90 for a pair of jeans that are very similar to what AE has to offer.

In addition, despite the significantly higher prices at Abercrombie, AE’s margins are very comparable. Over a ten-year period, AE’s average operating margin was 16% compared to 19% at Abercrombie and 10-12% at Aeropostale. However, more recently in the last four years AE’s operating margins were better then Abercrombie’s. Aeropostale’s recent good performance is mainly due to people turning to the cheaper alternative during a consumer spending slowdown.

Finally, insiders at both Abercrombie & Fitch and Aeropostale have been dumping stock recently. At Abercrombie, many insiders have been selling large amounts of stock. These include the chairman, Michael Jeffries who has sold nearly $100 million in stock in the past six months or about half his holdings. Jeffries is scheduled to receive $68 million in equity compensation this year as part of his “career share award.” Insiders have also been dumping stock in Aeropostale as well. However, over the past year, the chairman of American Eagle Jay Shottenstein has purchased over $24 million in stock and many other insiders have been accumulating stock.

Operations:

There are currently 868 AE stores in the U.S., and 75 in Canada. The ultimate goal is to have between 1,000-1,200 AE stores in the U.S. and 80 AE stores in Canada. New AE stores are being opened at the rate of 40-50 per year giving AE 5-8 years of growth of its flagship AE stores. Also sales at AE Direct, American Eagle’s website, are growing at 30%+ per year and Jim O’Donnell American Eagle’s CEO said in a recent investor presentation that AE Direct should achieve sales of $500 million by 2010 up from $200 last year. American Eagle expects to open 40 new stores in 08 and to remodel 40-50 more stores. In 2007, overall, square footage in 2007 grew 12%, and the estimated is that it will grow 10% in 2008.

During Fiscal 2006, American Eagle launched its new girls intimates brand; “aerie” targeting girls aged 15-25. “The aerie collection is available in aerie stores, predominantly all American Eagle stores and at aerie.com. The collection includes bras, undies, camis, hoodies, robes, boxers, sweats, leggings, fitness apparel, and personal care for the AE girl. Designed to be sweetly sexy, comfortable and cozy, the aerie brand offers AE customers a new way to express their personal style everyday, from the dorm room to the coffee shop to the classroom” (2007 10-K). The aerie stores have been very successful so far with 55 aerie stores already opened and 80 more planned for 2008.

aerie seems like a natural extension of the girls section of the American Eagle stores given the synergies and brand recognition already established. Despite the fact that AE stores get 60% of their sales from girls, the addition of an aerie store in proximity to an AE store doesn’t cannibalize sales away from the original store’s sales. Many other retailers have opened stand-alone girls intimate stores targeted to the teenage girl. Abercrombie is starting the new concept Gilly Hicks targeted to teenage girls. Victoria’s Secret started the sub-brand Pink in 2004 and last year Pink achieved sales of $900 million. American Eagle’s CEO said that he thinks aerie will eventually achieve sales of $1 billion with over 500 stores possible.

The company also introduced MARTIN + OSA during Fiscal 2006, a concept targeting 28 to 40 year-old women and men, which offers refined casual clothing and accessories. At first M + O appeared to be struggling badly and in 2007 Jim O’ Donnell said he was optimistic but he would close the stores if it didn’t return to profitability. More recently, the stores have improved with same store sales increasing over 50% but the brand is still losing money, about 15-17 cents in annual earnings per year.

For the first quarter, the CEO said he is pleased by the performance of the new concept. During the conference call, the CEO said that the brand is doing better and that store traffic is increasing. In addition, the brand has specific goals it has to make otherwise they will consider closing the stores. The CEO expects M + O to be profitable by the 4th quarter this year. Either way it will be good for shareholders because if the stores are closed the $0.15-$0.17 in losses per year are eliminated or if the brand becomes successful, it will be a new avenue for growth. Currently, there are 21 MARTIN + OSA stores, with 15 more planned for 2008.

Last year, AE announced a new concept, 77 Kids, which will sell apparel for kids aged 0-10. The new concept is currently being developed with the website set to go up this year and stores are planned for 2010. Although it's hard to forecast what will happen, it appears as though this one of the CEO's pet projects. Prior to his arrival at AE, Jim O'Donnell helped start Gap kids and in six years, turned it into a $400 million business.

Valuation:

• American Eagle is down over 50% in the last year and a half. With a market capitalization of $3.3 billion, American Eagle’s is trading at eight times last year’s earnings.
• With $338 million in cash and $367 in investments, enterprise value divided by EBITDA is an appropriate way to value American Eagle. Cash and investments are equal to $3.50 per share.
• Earnings for 2008 will come in lower then 2007 but, when the retail environment improves in a few years, American Eagle will be worth much more then what it’s trading for currently.
• The company has repurchase plan with up to 41 million shares available for repurchase. With the cash on hand, 22 million shares, or over 10% of the stock could be repurchased. The share count has decreased by 23 million shares since 2007.
• Options issuances continue to be large as they are in this industry, with about 12 million shares available for issuance. On average, option dilution has been about 1% - 1.5% per year.
• Either MARTIN + OSA will return to profitability, or the stores are closed. The loss from M + O held earnings down by about $0.16 cents or $36 million last year, or almost 10% of net income.
• With a market capitalization of $3.3 billion net of $370 million in cash and short-term investments and $75 million in notes, American Eagle is trading for an enterprise value of $3 billion.
• Based on 2007 figures American Eagle is trading for an enterprise value/ EBITDA ratio of 4.2. Looking at any valuation metric, AE is significantly cheaper then its competitors.
• Cash flow from operations has been strong with $480.4, $749.3 and $464.3 million generated in '05, '06 and '07, respectively. With capital expenditures north of $200 million a year, free cash flow generation has been $398.9, $523.3 and $213.9 for '05, '06 and '07, respectively.

I think AE is worth twice what it’s trading for, and the value will be unlocked once the retail environment improves, share repurchases boost EPS and aerie and MARTIN + OSA begin to make meaningful additions to AE results.

Disclosure:  None

Comments

[2old2care]

Well done young man!
The question is when will:
"and the value will be unlocked once the retail environment improves"
this occur?
Nice analysis.

[MFoxBCguy]

From a qualitative standpoint, do you think ANF and AEO will adjust their product line to the changes in fashion? From my perspective (college senior) the companies haven't changed their look in the past 4 to 5 years. Their target market is fickle- if kids think something isn't "cool" anymore, it's taboo.

[depression2008to2012]

Why was the word "then" used so often instead of the word "than"?