Profit Margins Key to American Eagle’s Growth

American Eagle Outfitters (NYSE: AEO) is a specialty retailer that designs, markets and sells its own brand of trendy, high-quality clothing, accessories and personal care products at affordable prices, targeting the 15-25-year-old demographic. Close competitors in the youth apparel market include Abercrombie & Fitch (NYSE: ANF) and Aeropostale (NYSE: ARO). The American Eagle Outfitters (AEO) stores division contributes 49% of the $26 Trefis price estimate for American Eagle’s stock.

American Eagle’s profit margins have plunged  in recent years, mostly due to markdowns and promotions during the recession. We believe that margins will recover significantly during the forecast period, driven by aggressive cost-cutting and rising consumer demand. In a scenario where margins fail to recover from last year’s trough level, our estimate would drop by about 13%, to $22.15.

American Eagle’s Expenses Have Been Increasing

AEO relies heavily on advertising and promotions to generate sales for its American Eagle stores, and this has significantly impacted its margins in recent years. Between 2006 and 2008, the Trefis estimate for American Eagle stores’ EBITDA margin fell from 24% to 13%. This was primarily driven by decreasing merchandise margins, mostly due to markdowns and promotions, and increasing marketing & advertising expenses.

During this period, merchandise margins decreased at an annual rate of nearly 10% while marketing & advertising costs grew at an annual rate of 12%. Although the company reduced its advertising expenses in 2009, its EBITDA margin further declined to 12%, mostly driven by additional markdowns and promotions during the economic slowdown.

American Eagle Looks To Aggressively Cut Costs

In a bid to improve its operational efficiency, AEO has been aggressively cutting expenses, particularly advertising and supply costs. The company’s efforts bore fruit with a 6% merchandise margin boost in the last quarter of 2009, followed by a 2% improvement in the first quarter of fiscal 2010. As the economic environment improves, we expect that merchandise margins will continue to expand.

We expect EBITDA margins for American Eagle stores to recover to around 17-18% by 2016. You can modify our forecast for American Eagle stores’ EBITDA margin to see its impact on the $25.70 Trefis price estimate for American Eagle’s stock.

You can see the complete $25.70 Trefis Price estimate for American Eagle Outfitters’s stock here.