American Eagle Outfitters Falls On Bleak Guidance, But Shows Some Bright Spots

American Eagle Outfitters‘ (NYSE:AEO) shares have been down almost 10% since it reported its Q3 fiscal 2014 earnings and provided a bleak guidance for the fourth quarter. In anticipation of weak sales during the holiday season, and due to high restructuring charges and asset write-downs, the retailer expects its Q4 earnings per share to be around $0.30-$0.33.  Analysts expected the figure to be around $0.35. ^[1] American Eagle’s sales during the third quarter were hit by weak foot traffic, which resulted from low demand for basic products, a customer shift to the online channel and persistent weakness in consumer spending.

However, a closer analysis of the company’s results suggests that its performance was not all bad. The retailer’s comparable sales including online sales declined by only 5%, better than the declines of  10% and 7% posted in the first two quarters of the year. American Eagle went easy on promotional activities during the quarter, which produced a high-single digit increase in average unit retail sales. Even units per transaction  increased in mid-single digits, though a decline in the number of transactions (which reflects weak mall traffic) overshadowed these improvements.

Our price estimate for American Eagle Outfitters stands at $13.45, which is just below the current market price. However, we are in the process of updating our model in light of the recent earnings release.

See our complete analysis for American Eagle Outfitters

With fewer-than-expected markdowns, American Eagle’s gross margins improved by an impressive 200 basis points. Amid a highly competitive and promotional retail environment, an improvement in gross margins has been a rare occurrence in the industry. While several apparel companies have struggled to even match their last year’s levels, American Eagle has recorded a significant increase. The improvement in the retailer’s margins was driven by better merchandise selection and stronger inventory control. Shoppers seemed to notice the improvement.  They are still shopping at the retailer’s stores, even with fewer discounts, provided that they have access to a larger variety of fashion relevant merchandise. In a press release last month, Interim CEO, Jay Schottenstein, stated that the design team has made significant progress on merchandise improvement, but they aren’t planning too aggressively for the holiday season given that mall traffic remains weak.

While the improvements in the merchandise portfolio are a good development, the company seems intent on managing its inventory with care. We believe that a gradual transition of the assortment, rather than a complete overhaul, will allow American Eagle to better anticipate customer response to its launches. Also, a slow transition will allow customers the time to digest the changes in merchandise design and variety. If American Eagle stops selling its logo t-shirts, hoodies and jeans altogether, and replaces the entire portfolio with fashion-forward merchandise similar to Zara, Forever 21 and H&M, it will only drive customers away. This is what happened to Aeropostale (NYSE:ARO) last year, when it made drastic changes to its portfolio in an attempt to reposition itself as a fashion brand. American Eagle’s management said during the earnings call that they are trying to find the right balance between new fashion and update heritage looks, to keep customers engaged.

The biggest problem for American Eagle during the third quarter was low foot traffic, which is mainly attributable to the industry-wide shift from store shopping to online shopping. The company, as have several other apparel players in the industry, is looking to address this issue with the adoption of omni-channel retailing, which refers to leveraging buyers’ online shopping interest to enhance sales across the board. American Eagle has made substantial investments in omni-channel retailing in the past and it continued to do so in the recently concluded quarter. Its “buy online and ship from store” (BOSS) service is now live in 530 stores, up from 255 at the end of Q2 and 50 stores at the end of Q1. The retailer stated that about 15% of the digital orders are now fulfilled with this service, and it is likely to go higher in the future given that American Eagle plans to expand its BOSS service to all the stores by early next year. The company is also planning to launch the “reserve online and pick at store” service and has already improved its delivery time by 50%, thanks to the new distribution center. ^[2] It is evident that American Eagle is aggressively pushing towards the development of its omni-channel platform, which should help its offset the impact of falling foot traffic in the long run.

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1. American Eagle Outfitters’ Outlook Misses Expectations, The Wall Street Journal, Dec 4 2014 [↩]
2. American Eagle Outfitters’ Q3 Fiscal 2014 Earings Transcript, Dec 4 2014 [↩]