AEO - Is It The Time To Buy American Eagle Outfitters?

Summary

• ROE has been deteriorating over the past 5 years, driven by contracting margins and declining asset turnover, partially offset by increasing leverage.
• The net profit margin may start improving in 2023, due to the improving macroeconomic environment; however, the high inventory levels remain concerning and could offset the positive impact.
• The substantial growth in accounts receivable, while sales have remained largely unchanged, could be a warning sign for investors.
• We would like to see sustained positive cash flow from operations, before we would consider investing.
• For now, we maintain our bearish view.

American Eagle Outfitters, Inc. ( AEO ) operates as a specialty retailer that provides clothing, accessories, and personal care products under the American Eagle and Aerie brands.

In 2022 we have published two articles on the firm on Seeking Alpha. In July , we have first rated the company's stock as "hold", then later in September we have downgraded it to " sell ".

The primary reasons for our initial neutral rating were:

• Attractive dividends combined with share repurchase program
• Attractive valuation
• Substantial headwinds due to the cheapening macroeconomic environment

The reasons for our downgrade were:

• The dividend has been paused
• The macroeconomic headwinds have persisted

Today, we will look at AEO's stock from a different point of view. We will be analysing the firm's return on equity and its development over the past years. We will also highlight how the current, changing macroeconomic environment is likely to influence the firm's profitability and efficiency, together with its financial performance in the coming quarters.

Return on Equity

ROE is an important measure of financial performance and it is often used to gauge the corporation's profitability and its efficiency of generating profits. Normally, a stable or improving ROE is preferred. In AEO's case, this measure has been quite volatile, primarily fuelled by the pandemic in 2019 and the challenging macroeconomic environment in 2022. Despite the sharp improvement in 2021, the current ROE reading is significantly below pre-pandemic levels.

Let us now decompose this measure into three parts to understand, which factors have been the main influencers. These parts are the net profit margin, the asset turnover and the equity multiplier.

Net profit margin

During the pandemic, net profit margin has turned negative, but it has been followed by a sharp improvement in 2021, before starting to decline again in 2022. Net profit margin has now fallen below pre-pandemic levels.

The development of the net profit margin appears to have a significant influence on the ROE, and follows generally the same trend.

So what do we expect going forward?

In 2022, the macroeconomic environment has been challenging for many firms in the consumer discretionary sector. Poor consumer confidence has been negatively influencing the demand for discretionary products. The elevated energy prices, combined with high freight costs and other inflationary pressures have put a substantial downward pressure on the margins.

Now, however, the picture looks somewhat more optimistic. The consumer confidence has substantially improved, but still remains at historically low levels. The gasoline prices have also fallen and the dollar index also normalised somewhat. In 2023, we expect these developments to continue. For these reasons, we believe that the firm's margins are likely to start improving in the second half of 2023, which could in turn could have a positive impact on the ROE.

On the other hand, we also have to understand the factors that may keep negative influencing the profit margin. One of these is the inventory levels. AEO's inventories have increased significantly. In order to reduce the excess/obsolete inventories, promotions and discounts may be needed, which could hurt the company's margins.

Asset turnover

The asset turnover ratio (or sometimes called asset utilization) measures the value of a company's sales or revenues relative to the value of its assets. It indicates how effectively the company is using its assets to generate sales. This ratio has dropped significantly in 2019 and 2020, which has been primarily driven by the increase in assets.

While AEO's sales have remained relatively flat over the past 5 years. However, the amount of accounts receivable have quadrupled. This is a development that we find especially concerning. It likely indicates that AEO is selling more and more on credit/ on better credit terms to keep the demand and the sales at the same level. While it might work for a while, it is likely to have a negative impact on the sales figures in the future, as this behaviour is essentially pulling demand forward form future periods. In our opinion, at this point it could be a warning sign for investors.

We would like to see the trend in accounts receivable slow and eventually change, before we would consider investing in AEO's stock.

The following chart depicts the increase in the gross PP&E, which has been the primary driver for the sharp drop in the asset turnover. While the firm has invested significantly in long term assets, it did not have a positive impact one the firm's efficiency so far. We would like to see the efficiency improving or the sales increasing to justify this investment.

Equity multiplier

The last part of the three step decomposition of the ROE is the equity multiplier, which is simply the ratio of assets to shareholder equity. A higher ratio indicates more leverage, meaning that the firm is using a larger amount of debt to finance its assets.

While this measure has increased over the 5-year period, it has been gradually declining in the past 2 years, which we believe is a good sign.

The liquidity of the firm over the 5 years has not substantially deteriorated. The current ratio remaining significantly above 1, which is definitely a positive indication, however we would like to see the quick ratio improving as well. We believe that the quick ratio may be the more important of the two, as it excludes the effect of inventory. The recent increase in the inventory levels has allowed the firm to keep its current ratio more or less constant, but had a negative impact on the quick ratio. As discussed earlier, the firm may need to use significant discounting or promotional activity to get rid of potential excess or obsolete inventory, which would in turn have a negative impact on the liquidity.

To remember

ROE has deteriorated over the past 5 years, driven by the decreasing net profit margin, by the declining asset turnover, partially offset by the increase in leverage.

While margins may be positively impacted by the improving macroeconomic environment, the elevated inventory levels could be concerning.

Despite the investment in PP&E, the firm's efficiency has not improved. While sales have remained largely flat, accounts receivable have increased by about 400%.

Before investing in AEO's stock, we would like to see the profitability and the efficiency improving. Also, we would like to see sustained positive cash flow from operations. We believe, if CFO could remain in the positive territory for several quarters, the firm may consider resuming its dividend payments, which could have a positive impact on the share price.

All in all, at this point, we remain bearish on the stock.

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