Taking a Flyer on American Eagle
We believe American Eagle Outfitters (AEO; $25) is one of the most compelling investments in the youth apparel retailer space, given the leading brand positioning of its American Eagle brand with the youth demographic.
The American Eagle brand is considered among the "coolest" brands (second only to Nike (NKE)), according to Teen Research Unlimited in spring 2007. We believe the company's focus on its core 15- to 25-year-old customer, along with improved merchandise, store upgrades, and a differentiated marketing strategy that reaches its target audience, drives its success.
Over the last three fiscal years, the company's EBIT (earnings before interest and taxes) margin expanded 1,190 basis points to 21% for fiscal 2007 (ended January). Same-store sales rose at annual double-digit rates during the same period.
Although we see the American Eagle brand approaching maturity within the next three years in terms of store expansion, we expect further opportunity as the company enlarges assortments, develops its Sunbelt merchandising, and grows its accessories lines—strategies that potentially add up to +$1 billion in revenues over the next five years. We have a 5-STARS (strong buy) recommendation on the shares.
Company Background and Strategy
American Eagle Outfitters is one of the largest specialty retailers targeting the teen/young adult demographic, offering all-American casual apparel, accessories, and footwear. The first American Eagle Outfitters store opened in the U.S. in 1977, and the brand expanded into Canada in 2001. Through its e-commerce operation, ae.com, the company offers additional sizes, colors, and styles of key items and ships to 41 countries worldwide.
During fiscal 2007, the company launched its new intimates sub-brand, aerie by American Eagle, a collection of dorm-wear and intimates, including bras, undies, camis, hoodies, robes, boxers, and sweats; and Martin + Osa, a new sportswear concept targeting 25- to 40-year-old women and men, which encompasses apparel, accessories, and footwear, using denim and sport as inspiration.
As the American Eagle chain offers limited expansion potential, given its 840 domestic locations, we are pleased with the success of the aerie launch, which generated about $100 million in revenues in its first year, as well as margins at the corporate rate. We believe momentum will grow for the aerie brand as its geographic reach expands given its unique positioning and the lack of competition we see in the young women's intimates specialty format. The company sees aerie as a $1 billion opportunity.
More Work for M+O
To put this in perspective, the bra and panty market is an approximately $4 billion annual business and the inclusion of dorm-wear doubles the potential market size, in our view. In fiscal 2008, the company intends to open 40 (up from 14 at the beginning of fiscal 2008) new stand-alone aerie stores, with 34 (down from 45) new AE stores—56 AE remodels are also planned for this year.
The development of Martin + Osa (M+O) has required more fine tuning, in our view. A new M+O president, Laura Dubin Wander, joined in April, 2007, and is working with the company's president and chief merchandising officer, Susan McGalla. We believe M+O's merchandise is very active-lifestyle-inspired and a little too low-key in the color palette department.
The store ambiance is modern, the service levels superior, and the dressing rooms exceptional, in our opinion. Over the next 12 months, we expect to see merchandise improvement before a more aggressive store rollout is begun in fiscal 2009. AEO plans to open 14 M+O store locations in fiscal 2008.
We note that multiple specialty retail operators are targeting the underserved 25- to 40-year-old demographic, and we anticipate rising competition from both specialty retail operators as well as mall-based department stores.
Plans for Expansion
In addition to developing new retail brands, we see underdeveloped product categories such as handbags, jewelry, and shoes as areas of opportunity for AEO. We think these accessory categories could generate an incremental $500 million a year in sales as they are developed. In addition, the company plans to launch aeriefit, an active lifestyle component to aerie, in stores by the 2007 holidays.
As of July, 2007, there were 840 AE and nine M+O stores in the U.S., as well as 74 AE stores in Canada. AEO has upgraded its real estate portfolio with about 300 store renovations, relocations, and expansions in the past few years; at the start of fiscal 2008, about 12% (100 domestic stores) were in the old store format, with plans to upgrade 56 this year. Most stores are located in regional malls and urban and lifestyle centers. Total new store openings and remodels are expected to increase square footage 10% in fiscal 2008.
Remodeled stores generally pay back in 16 months with an average 33% sales lift, a 46% profit boost, and a 40% increase in average square footage to 6,000 sq. ft.
Sales per average gross square foot were $524 in fiscal 2007, up 11%. Mature stores generate $3 million in sales, a 33% operating margin, and $550 in sales per square foot in a 5,250 sq. ft. box. New stores (in their first 12 months of operation) see $2.4 million in sales, a 22% profit margin, and $390 in sales per square foot in a 6,300 sq. ft. box, with a one-year ROI (return on investment) of 88%.
Web Site Redesign
A strong denim assortment incorporating a tiered pricing strategy supported the company's annual double-digit same-store sales gains for the past three fiscal years (12%, 16%, and 21% for fiscal 2007, fiscal 2006, and fiscal 2005, respectively). In fiscal 2008, despite negative mall traffic, the company has achieved 7% comparable store sales growth for the 22-week year-to-date period ended July 7, as improvements in conversion rates have driven increased transactions per store and units per transaction have risen as well. We see a 5% comparable-store increase for fiscal 2008 and fiscal 2009, as the company benefits from new product categories at aerie, expanded assortments including women's accessories, and an improved knit assortment for women.
We are impressed with American Eagle's innovation and unique marketing targeted at 15- to 25-year-olds, a demographic whose rejection of traditional advertising has affected multiple consumer industries. Kathy Savitt joined the company as chief marketing officer in the summer of 2006 from Amazon.com, and we have been impressed with her efforts since her arrival. The company's Web site has been redesigned with all key tasks on the home page. The conversion has improved, and traffic growth is leading the industry.
Tapping into the appeal of MTV and reality TV to AE's consumers, the company created It's A Mall World, a series of 12 five-minute episodes airing on MTV and ae.com beginning Aug. 1, just in time for back-to-school shopping. The series showcases the lives of sales associates in the mall who wear AE clothing (a soap opera for Gen-Yers). On the Web, the functionality allows you to click on the merchandise and be directed to the e-commerce site, to purchase items. AE's consumers "live" on the Net; 60% of its retail store shoppers arrive having pre-shopped on the Web, and the multi-channel AE shopper spends three times as much as the single-channel shopper.
Tiered Marketing Approach
AE recently sponsored the AE Fit Challenge from July 10 to July 24, whereby denim purchasers voted for their favorite fit. On Aug. 28, the winning fit (based on total units purchased) will be announced, entitling participants to either a free pair of jeans (if they chose the winner) or a $10 coupon. This is an important event, in our view. AE has the leading back-to-school denim market share among specialty stores for 15- to 25-year-olds, according to NPD Group's consumer tracking service.
The company participates in the specialty apparel retail market targeted at youths spanning the "tween" to young adult demographic, an age group that includes 7- to 24-year-olds. With its American Eagle brand, AEO targets the 15- to 25-year-old, though the halo effect reaches up to the 40-year-old Gen-X customer (more on this later).
While the U.S. apparel market is considered mature, with demand mirroring population growth and somewhat related to fashion, the youth marketplace is generally considered attractive based on its spending clout, as their money is discretionary and the "right" fashion accessory is a non-negotiable. According to NPD consumer estimated data, collectively, this group accounts for approximately 35% of total apparel spending, with the sweet spot being teenagers (18%).
Despite AE's positioning as a youth or teen brand, we have seen more than a smattering of 30-plus-year-olds sporting AE denim with a wink and a nod. While we do not believe the company is cultivating this demographic, we believe the lifestyle positioning of the brand as cool, hip, and youthful along with the topping out of the premium denim market ($100+ a pair) has attracted youthful and fit thirtysomethings. We think the benefits of lifestyle, mindset, or "psychographic" brand positioning is even more apparent for aerie, given the dearth of choices for intimates in the mall.
For fiscal 2008, we foresee 16% sales growth, to $3.24 billion, driven by 10% selling square footage growth, a mid-single-digit same-store sales gain, and a 25% gain in e-commerce sales. We expect a 30-basis point (bps) decrease in the gross margin in fiscal 2008, to 47.7%, following 970 bps of expansion over the past three years, and a modest decrease in the SG&A (selling, general, and administrative) expense ratio despite investments in M+O. We see a flat operating margin for fiscal 2008 at 21%. Our fiscal 2008 operating EPS (earnings per share) estimate is $1.97.
For fiscal 2009, we estimate 12% sales growth and operating margin expansion of 50 bps, driven by leveraging of SG&A expenses and reduced losses at M+O. Our fiscal 2008 EPS estimate is $2.25.
To arrive at our 12-month target price, we applied the average price-to-earnings multiple for the company's peers in the youth apparel business of 15 to its estimated fiscal 2009 earnings per share of $2.25, and then added the $3 cash per share American Eagle currently has on its books. That gave us the target of $37. The shares recently traded at a 20%+ discount to peers based on fiscal 2008 and fiscal 2009 EPS estimates. On a p-e-to-growth (PEG) ratio metric, the stock trades at 0.86 times, a 25% discount to peers. We anticipate that the rollout of aerie and further success with the Martin + Osa concept will support multiple expansion.
In general, we view the company's corporate governance favorably. Several of the practices we view positively include the separation of the chairman and chief executive officer positions, that the majority of the board is controlled by independent outsiders, a board-approved CEO succession plan is in place, and there have been no related party transactions involving officers, directors, or the CEO.
We note that a former CEO serves on the board as chairman and is thus considered an affiliated outsider, but we do not consider this a negative. However, we do think the board's ability to increase or decrease its size without shareholder approval is not in the best interests of shareholders.
Risks to our recommendation and target price include fashion, inventory and markdown risk, declines in consumer spending, as well as the success of new business initiatives. A slowdown in store-level productivity could also adversely affect the shares.