In our view, American Eagle Outfitters (NYSE:AEO) still is a solid investment pick. Growth in Aerie continues to run at full speed, with management’s target of reaching $1B in sales not too far. Its legacy brand, AE, although not a growth driver, continues to provide stability with its important market share in jeans. Currently, the company is launching OFFLINE, a new activewear brand, leveraging on the success of Aerie. Management noted that women’s active apparel is a $16B market opportunity. Since Aerie and OFFLINE can share the same assets, we believe incremental revenues from the new activewear line could be highly accretive to EPS down the line.
The company reported solid second-quarter results, and after listening to the conference call, we like where the company is headed. As a result of the pandemic, management is rethinking its brick-and-mortar strategy with plans to exit underperforming stores once leases expire. At the same time, the company is strengthening its digital channel in response to demand shifting towards e-commerce.
The market is pricing AEO at a forward earnings multiple of 12x while competitors The Gap (NYSE:GPS), Abercrombie & Fitch (NYSE:ANF), Guess’ (NYSE:GES), and Levi Strauss (NYSE:LEVI) trade a forward earnings multiples of 15x, 18x, 9x, and 15x, respectively, or an average of 14x.
We don’t believe AEO should trade at a discount to peers. The company has clear growth drivers ahead supported by a strong balance sheet. If we apply a 14x multiple to expected EPS of $1.09, we get a fair value estimate for AEO of $15.2 per share. We continue to be bullish on AEO
Solid quarter supported by continued growth in Aerie
AEO reported second-quarter sales of $883M, down 15% compared to its prior-year period, but beating analysts’ expectations by $39M. The company also reported non-GAAP EPS of minus $0.03, ahead of the consensus by $0.13.
Store closures during the quarter impacted AEO’s consolidated top line. Store sales declined 43% compared to last year as the company had the equivalent of 32% fewer selling days, while reopened stores on average were running at 85% of sales productivity compared to the previous year, however, increasing to 95% in May and June. The sequential improvement in sales productivity came to a halt in July, which saw a decrease as the back-to-school season was delayed due to states still determining the appropriate way to reopen schools.
By brand, AE’s results were impacted by store closures and a decline in mall traffic, with revenues decreasing by 26% compared to last year. A delayed back-to-school season also affected AE’s top line, as back-to-school is a main sales and volume driver for the end of Q2 and the beginning of Q3 due to the increasing demand for denim. That said, the brand saw decent digital demand growth (as measured by ordered sales) of 21%.
The highlight of the quarter definitely came from Aerie. The brand reported record sales and margins and continues to see strong momentum. Revenues at Aerie rose 32% during the second quarter despite store closures. Approximately 70% of sales came from its online channel while total new customers increased by 22% during the quarter. Aerie’s digital demand increased by 113% compared to its prior-year period. Management still considers a brick-and-mortar strategy for Aerie as important due to the fact that it gives customers more ways to interact and shop while increasing brand awareness. As a result, management is planning the opening of 25 new Aerie locations this year while targeting a digital penetration of more than 50%.
The company is well-positioned to tackle its second half
During the second quarter, the company cleared excess inventory and has significantly cut back on inventory receipts. In total, AEO finished the quarter with a decline of 21% in inventory levels compared to last year and has a clean position going into the fall season.
With a clean inventory slate, we expect AEO to have better control of its promotional environment. Also, as the company runs a more narrowed product assortment, we believe it could benefit from efficiencies in its supply chain as less SKUs simplify the ordering process. The benefit should reflect in better AURs and margins moving forward.
The company is also on track to complete its supply chain transformation. AEO is opening regional hubs in L.A., Boston, Chicago, and Florida this month, which should improve delivery performance while adding capacity to handle digital demand in the second half. The company is also working with additional logistic partners to provide better customer satisfaction.
New activewear brand OFFLINE is an interesting growth driver
We believe the new activewear brand OFFLINE creates an interesting opportunity for AEO moving forward. Management noted that the total addressable market for OFFLINE is approximately $16B, with players like Lululemon (NASDAQ:LULU) dominating the space.
Activewear clothing is currently on-demand, which bodes well for OFFLINE in the short term. Many retailers are reporting strength in their activewear and outdoor categories as consumers seek comfort at home. While the market might become crowded as other retailers try to catch the wave, we believe OFFLINE has some nice upstart advantages.
For one, OFFLINE can leverage the popularity and momentum of Aerie as its sister brand. In fact, 1/3 of store space in Aerie is dedicated to OFFLINE.
We believe the introduction of OFFLINE to the market via Aerie stores is an interesting strategy. For example, the company can use the data gathered from Aerie customers to introduce new product lines within OFFLINE. The company can also leverage the marketing spend in Aerie to support growth in OFFLINE, as customers coming through its brick-and-mortar stores or online would also get exposure to the new brand.
AEO is also testing out two standalone OFFLINE stores this year. If it sees good momentum, then it would be reasonable to assume the continued expansion of OFFLINE’s retail footprint, offsetting the planned reduction of AE’s brick-and-mortar stores.
We also believe OFFLINE could become an interesting catalyst for the market to re-rate AEO higher once the brand starts capturing market share. For example, Athleta, Gap’s athletic brand, was recently valued by Citi at $3.6B. Athleta’s revenue has been estimated at less than $1B in 2019, implying a sales multiple of 3.6x for the athletic brand. Depending on how much share OFFLINE can take, it could become a potential way to unlock shareholder value along with Aerie.
The Bottom line
AEO has a solid balance sheet, so the risk of insolvency is out of the picture. We also like how management is seriously considering rightsizing the business, starting with the possibility of reducing AE’s retail store footprint:
We are actively evaluating our fleet and plan to increase closures over the next several years and reduce the fixed costs associated with our stores.. We have at the same time, our real estate team reviewing our market studies again for post-COVID expectations, store by store, market by market – Q2 call
At the end of this year, the company expects to close around 40 to 50 locations specifically chosen based on lease tenure, mall profile, and customer engagement levels. AEO has 250 leases expiring this year and another 250 expiring in 2021. Its average lease term is 3.5 years. We believe this gives management a lot of flexibility to exit unprofitable locations while reinvesting the capital towards strengthening its e-commerce channel and distribution capabilities.
Although the outlook still looks murky, we find comfort in Aerie and are interested in the evolution of OFFLINE. At a forward earnings multiple of 12x, we believe the market is underappreciating the growth potential of these “new” brands, and in our opinion, AEO shouldn’t trade at a discount to its peer group, which trades at an average forward PE multiple of 14x.
We believe the market still offers investors a good opportunity to acquire AEO at a cheap multiple coupled with strong growth opportunities. We remain bullish AEO.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.