Why American Eagle is the Best Bet in Teen Space
Ashish is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Recently, American Eagle (NYSE: AEO) reported 2Q adjusted EPS of $0.21 which was in line with consensus and at the high end of management’s raised guidance. The most encouraging aspect was a 9% same store sales (SSS) growth. Management also indicated that back-to-school season is off to a good start and provided 3Q SSS guidance of mid-single digits with 4Q SSS in the low-single digits. We are encouraged by SSS guidance given difficult comparisons (SSS growth in 3Q11 and 4Q11 was 5% and 10%, as compared to -8% in 1Q11 and 0% in 2Q11). SSS guidance suggests acceleration in two-year trends. Q2 results and guidance back our longer-term view (See: American Eagle: Flying High) that the company is well positioned to continue to report steady sales gains, margin improvement, and profitability expansion. The following are some other key reasons why we remain bullish on this stock.
Denim serving as a strong traffic driver
We believe the company’s "All Blue Jeans $30 and Under" promotion is serving as a strong traffic driver. Conversion has been impressive with customers buying multiple pairs with basic wear-now tops. We believe that despite the competitive promotional environment the company is gaining market share.
Selling 77kids a positive move
Earlier this month, American eagle sold its loss incurring 77kids business to Ezrani 2, a company created by Ezra Dabah, former CEO of The Children’s Place. Although the company will have to face some exit charges getting out of this business, exiting this loss making unit will definitely drive good results in 4Q and thereafter.
Growth Drivers in Outlets and International Markets
With 52 domestic store closures in FY10 and FY11 combined, and 20-30 more closures planned for FY12, the domestic non-outlet market appears to have been saturated. However, outlets and International markets are increasingly becoming important growth drivers. American Eagle outlets currently account for just 7% of net sales whereas its competitors average 15%-20%. Thus, there is a lot of scope to increase penetration of made-for-outlet products. On the international front, management announced plans to enter the Mexican market with 4 company-owned stores and Philippines market with franchise stores in 2013. Going forward, we expect continued international expansion.
Inventory in good shape
The company’s ability to manage inventory levels is important to the health of margins and earnings. Though the company saw elevated inventory levels in 1Q12 (up 14%) and 4Q11 (up 24%), at the end of 2Q12 inventories were clean; up 3% on a cost per square foot basis as compared to 9% same store sales growth. 3Q ending inventory is planned to be down in mid-single digits as compared to expected SSS growth of mid-single digit. Thus, we believe significantly lower inventory should set the stage for meaningful gross margin gains over time.
Competitor Urban Outfitters (NASDAQ: URBN) also posted strong second quarter results with year over year revenue growth of 11% and EPS growth of 20%. It appears that the teen and young adult industry is improving as a whole and the growth outlook for Urban Outfitters and American eagle looks bright. American eagle is the clear standout in the teen landscape, and is likely to build on its momentum for BTS as it takes share from Abercrombie and Fitch (NYSE: ANF) and Aeropostale (NYSE: ARO). While many fear that Abercrombie & Fitch and Aeropostale may pressure American eagle’s gross margins in the second half, we believe it is important to note that American eagle has always planned to manage inventory units down, putting them in a position to take advantage of the margin opportunity in H2. Moreover, both Abercrombie & Fitch and Aeropostale are looking to be more conservative in terms of their unit buys for H2.
To conclude, we are encouraged by American Eagle’s positive promotional tempo, improved merchandising, denim positioning, incremental product flows, premium cost-cutting opportunity, controlled inventory, aerie growth vehicles and international openings. We remain further encouraged by management's conservative macro view and ongoing planned store event calendar. Moreover, strong balance sheet and shareholder friendly activities limit significant downside risk. Thus, we recommend it a buy.
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