Fly Like an American Eagle--or Not
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Gotta go back in time to 2007-2008 when distressed denim was in its prime but getting ready to die. There were whole industries specializing in taking perfectly good denim and shredding and fading it. Distressed denim was selling for $200, $300, $400 a pair for jeans. They were ripped, wrinkled, stained and sequined. Companies like Aeropostale(NYSE: ARO) and American Eagle(NYSE: AEO) were doing big business in jeans at a discount and for far less than True Religion and 7 for all mankind.
In retrospect, both Aeropostale and American Eagle may have stayed at the party a little too long and they spent the next 3 years looking for the next big trend. In 2007-2008, plaid and stripes were big, graphics featured company names and logos and denim was wrinkled, faded and belled. While it still sold, it did not sell with the same fervor and by 2011, same store sales for both ARO and AEO began to slide and margins crumpled, as markdowns and promotional sales pricing were the only ways to move the inventory.
In 2007, AEO revenue reached historic highs and margins were at their peak,but same store sales were beginning to lag. It’s hard to comp well at all time highs. From there, it was all downhill.
I left it in 2008 as AEO looked pretty much corpsified and did not stop back to see how the body was doing until a few weeks ago. There are changes. The one I was most interested in was the change at the top as James O’Donnell left and Robert Hanson took over. The change-over will be expensive. O'Donnell made $9 million in compensation in 2010 and this compares to the nearly $13 million Robert Hanson will get for 2012.
O’Donnell has a generous severance package that includes a lump sum payment of his highest compensation in a 7-year span. That could approach $5 million. In addition, he gets a year’s salary plus bonus, retirement benefit accrued ($3.6 million), outstanding options (value unknown) and restricted stock ($8.3 million). Total severance is estimated at around $15 million. The expense has already started to be felt on the P&L in Q4.
Cash expense for Mr. Hanson was the $3 million signing bonus and $1.03 million salary plus various expenses and perks that start in 2012. There is $5 million in options and restricted stock due to him this year. The expense coming off the P&L won’t be a deal breaker, but investors have to hope the new guy is bringing his A game. There was $6 million in Q4 related to executive transition fees.
Also of note is the new merchandise worlds away from the rips and tears of distressed denim and the plaid and jail-striped shirts and outerwear. The clothes look good for spring. And same store sales are back in the plus column, but is it time to buy? The stock has already recovered nearly 70% from the 52-week low.
Numbers can paint of a picture of the business almost better than words and maybe some numbers will shed light on the state of the corpse at the end of 2011. The Q1 results will be out in May and until then all we have last year.
Paint by numbers
Growth at the top? Great but what about the rest:
Revenue was up a little but far from the glory days back in 2006. Still, positive growth is good. Gross profit growth was negative and much worse than 2010. It indicates two things: American Eagle is still having to discount heavily and the costs (mainly cotton) are high and can’t be passed along to the consumer. It’s a position of weakness. SG&A included $6 million in executive transition costs and account for part of the negative growth in operating income. Other SG&A costs were not leveraged effectively over the upstream declining gross even though as a percent of revenue they looked reasonable. Markdowns and high materials costs are still killing growth and margins.
Margins? Need a defibrillator:
See above—markdowns, high cost fabrics and fixed costs are a continuing problem and AEO is not done with them yet.
Same store sales, sales per square foot? Faint signs of life:
Of course it’s great to see revenue grow and same store sales increasing, but what happens after revenue and same store sales is more important at this point. Downstream results are not good and do not paint a pretty picture of a beautiful business. With degradation of growth in gross and operating income and shrinking margins, the revenue increase and same store sales lose their luster.
Inventory turns? Mixed signals:
Increases in inventory at the end of the highly promotional Christmas season is not a good sign. The shelves should be cleared. Turns and DIO are reasonable.
Growth? Revenue recovering:
Q4 is still troubled by shrinking gross profit and increasing costs not dispersed over a store base running efficiently. Poorly performing stores will be executed over the next year if they continue to underperform.
Part of the operating income decrease can be blamed on a non-cash impairment of stores—mostly aerie. Bad news for the concept is it is not living up to cash flow estimates, requiring a write off. I hate concept expansion for the most part. Martin + Osa was one of Eagle’s they had to close entirely in 2010 for failure to perform.
Margins? Lowest of 2011 for gross:
Q4 saw gross margins at the bottom for the past four quarters. Pricing power is non-existent.
Same store sales? Off the critical list:
But higher same store sales that can’t be leveraged into better margins are only halfway helpful.
Inventory increases are outpacing revenue and leaving us to wonder if the store is running at such high inventory levels that they will need more discounting to get it lean. Comments in the Q4 conference call are affirmative--more markdowns.
The numbers paint a picture of American Eagle still mired in inventory issues and marking down clothes to move them off the shelves. There is evidence of recovery with revenue increasing and inventory turns picking up. It does not show us a picture of a great investment. AEO has already recovered over 70% off lows and those small improvements in same store sales and revenue increases seem to be priced in today.
There is something that can move this Eagle a lot higher after the earnings are released in May – beating guidance. Guidance for 2012 is decidedly down beat. I have been here before with Aeropostale and two quarters of big earnings surprises to the upside pushed shares up over 100%. AEO's new CEO is estimating modest sales increases and margin improvement this year. He does expect to get back to double-digit operating margins at some point, but not in 2012. I believe that costs are going to moderate in the second half—that’s been a theme across retail guidance.
From the filing:
However, the company’s outlook remains cautious with spring breaks and Easter still ahead. First quarter EPS guidance of $0.08 to $0.10 per diluted share assumes continued margin pressure from product costs, higher markdowns and the potential for increased promotions.
AEO intends to continue to sell down inventory to get it to respectable levels. Promotional/discount pricing may keep EPS to 8¢ to 10¢, but an earnings beat on such low guidance is not complete lunacy. AEO did 15¢ in Q1 of 2011.
It’s risky to buy on the hope of a positive earnings surprise. You can take that cash you were going to put on Double Zero Black at the roulette table if you feel lucky.
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