American Eagle Outfitters (Stock: AEO) is a clothing retail brand focused on 15 yr to 25 yr old demographics. They have 3 different retail channels that includes American Eagle stores, their outlet stores and aerie lingerie and apparel. The brand is going through a growth phase as they restructure their business model and look to open up new owned stores. The company has gone through a rough phase due to recession and the the change in spending habits of the demographics. As is normally the case, there are often good valued to be found when a business undergoes any sort of transformation.
Thoughts on AEO Restructuring Process
The company has tried to gain and hold on to their market share by competing on price. While the rest of the competition is also suffering through the current reduced discretionary spending in this demographic, a few companies like Gap have gained market share.
Chad Kesseler is taking over the role of Chief Merchandising and Design Officer replacing Fred Grover who is retiring. Chad has worked at Urban Outfitters and brings knowledge in Global luxury and multi-channel merchandising and design and should be a help in expanding and growing AEO’s online and mobile sales. The company has set up a new distribution center closer in Pennsylvania to increase their capacity and be able to deliver online orders in a day to the east coast.
The company is planning to open 26 new outlet stores in 2014 as they are able to generate better margins in this channel supplying the lower end market.
In the previous quarter, the company also started 3 new franchised stores in Central America and Thailand. The company has converted their franchised stores in China and Hong Kong to company owned.
In reviewing all the recent company initiatives and focus areas to restore growth, it appears to me that the company is doing everything it can without the benefit of a well thought out strategy to aid them. As such I expect the business to continue to flounder for a while until they figure out a rational way forward. Despite my misgivings about the business strategy, it is useful to look at the valuation of the stock, as even a mediocre business can be a great investment at a sufficiently low price.
AEO Balance Sheet Analysis
In reviewing the Q3 2013 financials, the first thing that shows up is that the inventory levels have risen by 8% while the revenues in the comparable 9 month period were flat with more stores. Sales in the stores already open have actually declined 6%. There is still a disconnect between the demand for their products and what they are supplying.
The market value of AEO is $2.7 Billion while their book value is $1.2 Billion including $44 million in intangibles and $14 million in goodwill (What is book value?). Price to Tangible Book Value (P/TBV) is 2.36. In comparison, Gap (GPS) sports a P/TBV of 6.72 and Urban Outfitters (URBN) has P/TBV of 3.34. This shows that on a relative basis AEO stock is better valued than its competitors. The stock trades at 16.7 times earnings compared to 13.73 for GPS and 19.27 for Urban Outfitters which indicates that the expectations for AEO are high.
The liquidation value after adjustments comes out to $4.47/share or ($817 million). The adjustments include discounts to the inventory value (15%), PPE (25%), 10% for other assets. Cash and Liabilities have been taken at the face value. The company turns inventory at 4.56 times a year so its assets are leveraged to generate additional revenues, therefore a P/TBV multiple of 2.36 and Price to Liquidation Value of 3.17 is justifiable.
AEO Income Statement Review
By our calculations, the company has to generate $2.85 B per year to stay profitable. Their current revenue is $3.4 B (ttm) so a 16% decline in revenues will make the company unprofitable (with the current cost structure). The company has been able to maintain their overall revenues over the last few years and has actually improved on their margins so the likelihood of the company becoming unprofitable (and destroying the value in its franchise) is little.
We calculated the present value of the cash flows (DCF) under 3 different scenarios
Scenario 1: 10% decline in sales in year 1, 5% decline in year 2, 2.5% increase in year 3, 3% increase in year 4, 3.5% increase in year 5 and thereafter a 2% increase every year for perpetuity. This scenario assumes that the company will lose sales and market share before its efforts start to bear fruit.
In this scenario, the present value of the future cash flows is $1.6 B or $8.32/share.
Scenario 2: Gross margin goes down to 32.86% for yr 1, 33.86% in yr 2, 35.86% in yr 3 and stays at this level. The revenues are constant at the current level of $3.4 Billion.
In this scenario, the present value of the future cash flows is $1.87 B or $9.58/share.
Scenario 3: This is a combination of Scenarios 1 and 2. We have both the revenues and gross margins levels change.
In this scenario the present value of the future cash flows is $1.5 B or $7.75/share.
While the company looks attractive on the basis of their strong balance sheet, the earnings power is weak and there is no coherent strategy to grow and raise their margins. In terms of a moat, the company has a strong enough brand but in a demographic that is known to be fickle and tend to grow up fast. Personally I would wait for the stock to decline another 50% (~$7/share) or so before considering a purchase. This of course is in contrast to John Buckingham of Alfrank Asset Management, but we are looking at a stock that has no margin of safety at the current levels and it should be avoided. There are better valued alternatives.
Credit: Research and analysis by Erwin Hessing, reviewed by me.