AEO - American Eagle Outfitters: Needs A Stronger Track Record

Summary

• Since 2014, the company has grown revenues by 56%, with only one year of revenue decline in 2020.
• Mixed results by AEO have caused its stock performance to lag the S&P 500 by a wide margin over the past five years.
• A DCF analysis estimates that AEO is currently overvalued at its current share price.

Overview

American Eagle Outfitters ( AEO ) is a clothing and accessories retailer that sells a range of fashionable and high-quality products for both men and women. The company operates both American Eagle and Aerie brands.

American Eagle is a U.S.-based brand offering high-quality clothing and accessories, including denim, for both women and men. It was established in 1977 and allows customers to express themselves and feel empowered. American Eagle is also known for offering innovative fabrics in various styles and fits at a value price and aims to build connections with its customers.

Aerie is a lifestyle brand that provides intimate wear, clothing, activewear, and swimwear collections. The company is at the forefront of the #AerieREAL movement, promoting body positivity and empowering women. Aerie is dedicated to encouraging its customers to embrace and love their authentic selves, both internally and externally.

AEO also operates the Todd Snyder New York brand and Unsubscribed brand. Todd Snyder New York is a high-end menswear brand that blends traditional design with contemporary updates, prioritizing comfort and versatility while Unsubscribed is a brand dedicated to producing sustainable slow fashion.

American Eagle Outfitters sells directly to consumers through its retail channel, which includes over 1,300 retail stores worldwide and online stores at www.ae.com and www.aerie.com in the U.S. and internationally. The company has a presence in the US, Canada, Mexico, and Hong Kong and has partnerships with third parties to expand its reach to other regions such as Asia, Europe, India, Latin America, and the Middle East.

Performance

AEO is led by current Executive Chairman and Chief Executive Officer Jay L. Schottenstein. Jay has played a critical role in American Eagle's growth and the establishment of the Aerie brand. He has established a sturdy foundation that has helped AEO maintain its leadership position in the market. Jay came back to AEO as CEO in 2014, a role he previously held from 1992 to 2002. He has been continuously serving as the Chairman of the Board since 1992 and is one of the largest shareholders of the company. Jay's extensive experience in apparel merchandising, operations, retail, real estate, brand development, and team management offers invaluable guidance and direction to the company.

Prior to Jay taking the reigns as CEO in 2014, the company had a few years of poor performance but now the company is establishing a strong track record of revenue growth. Since 2014 the company has grown revenues by 56% with only one year of revenue decline in 2020.

AEO has shown inconsistent free cash flow results over the years. The company has reported four consecutive years of free cash flow declines. This is a cause for concern as free cash flow is a crucial metric for a business. It represents the amount of cash available after accounting for capital expenditures, and negative free cash flow could indicate financial difficulties and a shortage of resources for business growth and meeting obligations.

Additionally, AEO has produced an inconsistent track record of profitability as returns on equity have varied wildly over the years. The company has a current ROE of 8.6% down from over 30% the year before. ROE is important because it shows how effectively a company is using the capital provided by its shareholders to generate profits. A high ROE suggests that the company has a strong financial position, good management, and the ability to generate positive returns for its shareholders while a low ROE may be a signal of poor financial performance.

AEO's balance sheet is somewhat mixed. While the company has taken on a lot of debt over the past three years, its shareholders equity has never been higher. The result is a debt-to-equity ratio of 1.25, this is not terrible but consider in 2018, the company had no debt. On a positive note, the company does have a current ratio of 1.86 , which is relatively high for its industry. This means that the company has enough current assets to cover its current liabilities.

Overall, these mixed results by AEO have caused its stock performance to lag the S&P 500 by a wide margin over the past five years. While the S&P has returned 44.46%, AEO lost -10.58% over the same period, leaving investors to question whether AEO can right the ship.

Outlook

AEO has been following it's "Real Power. Real Growth." strategy in recent years to reach its long-term financial goals. To accomplish this, AEO has two priorities: increasing Aerie's revenue to $2 billion and promoting sustained profitable growth for American Eagle. To hit these milestones, AEG will follow customer-centered strategies, maintain a strong focus on ROI, and rely on the strength of its employees, culture, and mission to achieve success.

This strategy has fared well for AEO as it was able to hit it's 2023 operating income and margin goals in 2021, two years ahead of schedule. However, 2022 was a struggle for AEO. The company hasn't reported full year results yet, but net income was down 81% through the 3rd quarter. Macroeconomic difficulties and inflationary pressures were the major factors attributing to these poor results. Both influenced consumer spending, leading to lower revenue and pressure on margins to clear surplus inventory. AEG is taking steps to enhance financial performance by implementing more substantial cuts in expenses and capital expenditures.

Where AEG is investing is it's omni-channel and digital capabilities. AEG offers its merchandise for sale through digital platforms such as www.ae.com and www.aerie.com. The company's digital channels enhance the brand's image and are meant to complement the in-store shopping experience. AEG has invested in advancing its technology and digital presence over the past few years, with a focus on mobile technology, digital marketing, and enhancing the digital customer experience.

AEG has also has recently acquired AirTerra and Quiet Logistics recently, as both acquisitions closed in 2021. These purchases will enable AEG to operate more efficiently and will allow the company to create a supply chain platform. The company will call the platform "Quiet Platforms." AEG expects significant long-term growth from these acquisitions.

A final consideration for investors on AEG's capital allocation is that the company has recently announced that due to ongoing external uncertainties, it will temporarily suspend its quarterly cash dividends to increase financial flexibility. It's never a good sign when a company decides to cut its dividends. A dividend cut can signal to investors that the company's financial performance may be weaker than previously thought, which can lead to a decrease in the company's stock price.

Valuation

To estimate AEO's intrinsic value, a comparative and discounted cash flow ("DCF") analyses will be used. The comparative analysis will consist of taking the highest, lowest, and median price-to-earnings ratios the market has paid for AEO over the past five years and multiplying them by AEO's consensus 2024 EPS estimate of $ 1.16 per share. As a bonus, the current sector median valuation of 14.86 will also be applied to AEO's consensus 2024 EPS estimate for an additional scenario.

On a comparative analysis, AEO has a wide range of scenarios that can play out. Investors could realize an excellent 275.82% return if the market were bullish and applied the 52.42 multiple, seen in 2021, to next year's average analyst earnings estimate, should those estimates materialize. On the downside, investors could realize a significant -56.92% loss if the market were to value AEO at the 5-year low multiple seen in April 2020.

The most likely scenario is the base case which is based on the 5-year median P/E ratio. This base case scenario would result in a -2.64% loss for investors. The final scenario which is based on the sector median multiple also results in a small 6.54% loss. Altogether, this comparative analysis indicates that is AEO stock is currently at fair value and investors may only experience a significant profit or loss if an extreme scenario were to play out.

Turning to the discounted cash flow analysis, the starting point will be the average of the last five years of free cash flows, which is $168 million. Then a 5% growth rate will be applied to the free cash flows for the next ten years. This growth rate is based on rule 72 which states a 5% growth rate will take just over ten years to double the original value. This is a reasonable amount of time for AEO to double its free cash flows based on a combination of the company's past performance and future growth opportunities.

Following the 10th year, a 2.5% growth rate will be used into perpetuity to determine the terminal value. A discount rate of 10% will be used, representing my personal required rate of return. With these inputs, the DCF analysis estimates AEO's intrinsic value is $13.34, representing a downside of -17.37% from the company's current share price.

Therefore, this DCF analysis indicates that AEO is overvalued at its current share price. However, if you are more bullish on AEO, then the company would need to achieve an 8% growth rate over the next ten years for its current share price to be considered fair value.

Takeaway

AEO has established itself as a popular clothing and accessories retailer that sells a range of fashionable and high-quality products for both men and women. The resurgence of Jay L. Schottenstein as the AEO's CEO has helped the company return to revenue growth. However, the company has a mixed record on other key performance metrics, including free cash flow growth and return on equity. Macroeconomic difficulties and inflationary pressures are attributed to the company's poor performance.

I expect the company to rebound when macroeconomic conditions improve, but I need a stronger track record or future growth opportunities for me to invest in this business. If you disagree, please let me know in the comments section below.

Thank you for reading!

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