Despite a still-challenging environment for more traditional hybrid youth retailers (hybrid in this case meaning significant physical store and digital presences), American Eagle Outfitters (NYSE:AEO) has done alright since my last update, with better-than-expected sales and margin improvement.
That performance hasn’t been fully reflected in the shares, though, as the 25% gain since my last article has been outpaced by the resurgent Abercrombie & Fitch (ANF), as well as Urban Outfitters (URBN), though AEO has outperformed Levi Strauss (LEVI) and Buckle (BKE).
Already a top player in denim, and with growth at Aerie slowing, it’s fair to ask whether American Eagle can grow the business fast enough to satisfy the Street, particularly with a lot of recent upside driven by gross margin and with ongoing challenges in hitting SG&A targets. I’m still bullish on management, but with upside to mid-$20’s without more reason to get more bullish on the financials, this is a borderline call in my book.
Comps Are Getting Tougher
American Eagle’s recent performance depends a lot on how you frame the comparisons. Next to the broader “softlines” retail category, AEO’s 7% same-store growth in the last quarter is quite good (versus around 4%), likewise next to Urban Outfitters (up less than 5%) or Buckle (down 9%), but it certainly pales in comparison to the 21% growth at Abercrombie & Fitch.
What’s more, while the core American Eagle brand is doing well (up 7%), and digital continues to grow nicely (up 12%), Aerie has been slowing. Granted, the last quarter comps for Aerie (+6%) were compromised by weather-related shortfalls in swimwear (underlying ex-swim up 11%), but the business has still slowed to a low double-digit growth rate faster than I’d expected, and management’s longer-term targets now suggest high single-digit growth as the high end of expectations.
Near-term comparisons are also going to get more challenging. Fiscal Q3 sales were up 2% at AE and 12% at Aerie last year, while Q4 sales were up 6% and 13% respectively. In a slowing economy where consumers are starting to be more careful with discretionary spending, that’s a risk. So too with gross margin – those year-ago quarters saw three-point improvements in gross margin on product costs, inventory management, and clearance management changes that may be tough to replicate.
How Discretionary Is SG&A Spending?
American Eagle’s SG&A spending is going to remain a front-and-center topic, as it seems to be one of the biggest areas of concern with more bearish analysts.
Since my last update, SG&A spending has risen from a low-20%’s percentage of revenue to the high-20%’s. Management doesn’t break down all of the components here, but ad spending growth did outstrip revenue growth last year by 125bp, and I’m concerned that drivers like labor costs and store operating costs are going to be fairly stubborn. Some of this, too, is being driven by higher depreciation costs tied to recent store remodeling efforts (the store base is now about 12 years old on average and management is looking to renovate around 100 a year, or a little less than 10%).
AEO has been missing sell-side expectations for SG&A spending pretty consistently, and I’m worried that this is going to be an ongoing issue (higher SG&A levels, that is, not misses versus the Street). There’s not much that management can do about higher D&A expenses other than to stop remodeling, and likewise, I don’t think there’s much room to drive store-level costs down all that much. That leaves advertising as a possible option, but I don’t think cutting ad spending is going to be a particularly good solution.
Can Aerie Still Drive Upside?
As I said before, the slowdown in Aerie sales is a concern. The business should be far from saturation, with management talking about a $75B addressable market across intimates, softs, swimwear, and activewear, and annualizing the last quarter’s sales suggests only about 2% share of that large opportunity.
Still, growth has slowed and Aerie missed my sales expectations in both of the last years, and now management’s longer-term guidance is calling for “mid-to-high single-digit” growth from this business. Perhaps this is just conservatism on the part of management. Lululemon (LULU) is almost six times larger and still growing at a 7% comp rate while generating nearly 20% operating margin (versus a little over 16% at Aerie).
On the other hand, since FQ3’23 (the last quarter before my last article), there have only been 15 net Aerie store openings. I’m not sure if weaker sales are leading to lower capex plans or not, and it is possible that online is becoming a larger part of the business faster than the company expected, but it is interesting to me that management seems to be taking a conservative approach with what was once seen as the major growth driver for the business.
I don’t think Aerie is “broken” by any means; adjusted comps were up 11% in the last quarter, 13% in the quarter before that (FQ4’24) and 12% in FQ3’24. And perhaps setting beatable expectations makes sense in the context of how Wall Street operates. Still, I would like to see the company reinvest a little more here and reaccelerate the square footage growth for Aerie.
The Outlook
I do have some concerns over the outlook for consumer discretionary spending over the next six to 12 months, but spending on youth retail categories tends to be somewhat more resilient, so I may be too bearish there. Still, comps are getting more challenging and that could be a headwind to sentiment.
Modeling AEO, I’m looking for long-term revenue growth of around 3% to 4%, and my estimates further out are more impacted by the lower guidance for Aerie growth, as my long-term Aerie growth rate moves from a little over 10% to a little over 7%.
AEO has done better on margins than I’d expected, largely due to the gross margin line, and I’m looking for ongoing improvement over the next three years. I think the 10% operating margin target could be challenging to hit, but I think they’ll at least be comfortably in the 9%’s in FY’27. For EBITDA margin, I’m expecting around 12.5% this year, 13% next year, and 13.25% the year after. There’s definitely room to exceed that, particularly if SG&A spending improves.
For cash flow, I expect AEO to move from the lower end of the mid-single-digits to the higher end, with a long-term average of around 6% and adjusted FCF growth in the 7% to 8% range.
Discounted back, those cash flows support a fair value in the mid-$20’s. For retailers like AEO, there is often a tight relationship between margin and multiples like EV/revenue. An 8% operating margin this year (which should be conservative; I think 8.5% is possible), supports a fair value of over $24; 8.5% would take the fair value to over $25.50, and management’s target of 10% would support a 1.2x revenue multiple, or $29 on this year’s revenue.
The Bottom Line
As I said in the open, this is a borderline call. I’m concerned about the long-term growth trajectory for Aerie, but I think it can be improved. I’ve been impressed with margin improvement so far, but I’d like to see more of it coming from SG&A discipline/control. I like the momentum in the business, but I’m worried about a softer economy and tougher upcoming comps.
All told, the shares do look undervalued below the mid-$20s, and I like management. That keeps me positive, but I won’t be shocked if there’s a chance to buy these shares closer to $15 before another move up.
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