AEO - American Eagle Outfitters: Record Performance In Tough Macro

2023-12-25 05:51:31 ET

Summary

• American Eagle posted record TTM net sales and decade-high free cash flow performance.
• Although the business itself is strong, broader industry and economic risks may challenge its operating performance.
• Shares appear fully valued with a balanced risk-reward, and the stock should therefore be avoided.

American Eagle Outfitters, Inc. (AEO) has run higher by nearly 90% since my buy rating in late 2022 , while also significantly outperformed the S&P 500 (SPY) of 26% over the same period. In fact, the last several fiscal quarters have shaped up to be a transformational period for the business after posting record TTM net sales as well as near-record free cash flow ("FCF").

If we adjust for changes in working capital, TTM FCF was $360 million, which is still its best print in over a decade.

The Growth Continues

We can chalk up this performance to strong topline growth in the last three fiscal quarters with total company revenue up 2%, slightly up, and up 3% year-over-year. A significant portion of this growth can be attributed to Aerie, which posted growth of 12%, 2%, and 12% for Q1, Q2, and Q3, respectively.

The company also opened 24 new stores, which translates to about 2% net store expansion, to a total of 1,199 stores worldwide as of last quarter. 1,095 stores are U.S. domestic and 104 stores are international. In my previous article, I outlined that the business has opportunity with its international operations, particularly via expansion into Asia: "Another growth opportunity for AEO is its plan to open two flagship stores in Japan. AEO already has an online presence in Japan, but if this reopening proves successful in these locations, there may be another leg of organic growth for the company." Since then, 3 of those 24 store openings were made in Japan.

American Eagle also made the acquisitions of AirTerra for $3 million and Quiet Logistics for $360 million in 2021, each of which were viewed as strategic targets to improve its operations and supply chain. More specifically, AEO outlines the expected benefits as follows: inventory efficiencies, affordable same-day and next-day delivery options, and other cost-effective in-market fulfillment services via technology and robotics.

Together, AirTerra and Quiet Logistics are known as "Quiet Platforms". Although this business is not broken out directly, it is reported under their "Other" segment along with their Todd Snyder and Unsubscribed brands. Collectively, this segment is another growth engine, albeit smaller relative to its more mature American Eagle and Aerie brands. For the first 9 months ended October 28, 2023, revenue was $329.48 million, or about 4.5% growth. Today, this segment is still unprofitable, although I think it will continue driving growth and reach operating profitability within the next few years. In the long run, the "Other" segment will help to significantly offset the general corporate expenses that total hundreds of millions per year. Simply turning this segment to operating breakeven would likely add at least $30 million in after-tax profits, ~$0.15 EPS, or improve normalized annual EPS by 10+%.

Overall, American Eagle continues to be a category leader in inventory optimization and efficiency among apparel retailers and delivers strong sell-through. Additionally, its capital investments into developing Quiet Platforms may drive a short-term earnings drag, but it will deliver long-term profitable growth. This strategic planning and consistent execution is what shareholders love.

The Challenge Ahead

American Eagle, despite its incredible performance overall, faces a challenging industry environment. According to FRED data, Advance Retail Sales: Clothing and Clothing Accessory Stores for the U.S. was flat in October and only advanced 1.3% in November. Apparel retail sales are yet to be reported for December, but December 2022 reported an approximate 3.27% increase. We can probably expect that December 2023 sales will probably be positive as well, but it's certainly far from a growthy environment.

So far, we've already seen that American Eagle's margins are for the most part capped and creating incremental operating leverage requires material comps growth. Other apparel retailers are testing, developing, and executing marketing strategies, while others appear to be pushing more aggressive promotional activity to obtain foot and digital traffic at any cost. On the one hand, struggling operators like Express (EXPR) is promoting "40% off everything" and Aeropostale is promoting a "clearance event up to 80% off". Alternatively, operators like Abercrombie & Fitch (ANF) has been more successful in driving brand growth and pushing digital marketing. In fact, ANF posted Q3 2023 net sales growth of 20% year-over-year. After being a long-time laggard, ANF is finally hitting its stride and posting higher growth, albeit on a smaller base of $4 billion in annual sales, compared to AEO.

The point is that American Eagle operates in an incredibly competitive space, and there are always other apparel retailers looking to steal away incremental growth with fickle customers.

The last and final factor to consider is that the economy isn't on its strongest footing. The NY Fed's recession prediction model still points to a 51.8% chance of a recession over the next 12 months, as of December 4, 2023. Having the odds of a coin flip is not favorable in owning a cyclical apparel retailer. From a valuation perspective, AEO sells for $4 billion on enterprise value versus TTM FCF of $360 million, or ~11x FCF. Otherwise, it trades at the median of its historical EBITDA at 8.3x. Neither of these valuation lenses are exciting, in my view.

Bottom Line

American Eagle is an exceptional apparel retailer and continues to post growth. If you believe that the economy will continue full steam ahead and AEO will continue posting same-store sales growth accordingly, then that's a fair argument for owning shares at 11x cash flow. However, from a more risk-adjusted perspective, incremental competitive pressures and/or the economy could present a real challenge to its performance. From a conservative standpoint, AEO appears fully valued at its current price and for those reasons I'm going to avoid owning shares today. Thanks for reading and please comment below.

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