American Eagle Outfitters’ EBITDA Margins Will Be Slow To Bounce Back

American Eagle Outfitters‘ (NYSE:AEO) EBITDA (earnings before interest tax depreciation and amortization) margin over the past five years has had its ups and downs.  It increased from 24.8% in 2009 to 25.8% in 2010 with improving macro-economic conditions. Yet in 2011, margins declined to 22.9% due to an increase in cotton prices owing to floods in major cotton producing areas, which pushed cost of goods up. Things turned around in 2012, as gradually declining cotton prices and lower promotions drove margins back to 26.11%. However, the year 2013 was marked by heavy promotional activities throughout the U.S. apparel industry and American Eagle was no exception. Heavy discounting dragged the retailer’s margins down to 19.5%. Surprisingly, the retailer was able to get improve its margins slightly to 20.9% in 2014 with fewer promotional activities, thanks to better merchandise offerings.

While we expect American Eagle’s EBITDA margins to improve going forward, the rate of growth is likely to be slow. The company’s merchandise portfolio is getting better, which should allow it to operate with fewer discounts and store consolidation should help decrease operating expenses relative to revenues, but other factors will have a significant offsetting impact. Expansion of the factory channel (where gross margins are lower) and increased penetration of online revenues (which is a low margin business) will counter the improvement in margins on account of the aforementioned factors. We thus forecast EBITDA margins to increase slowly from 20.9% in 2014 to 22.3% over the next five-six years.

Our price estimate for the company at $15.28, is about 10% below the current market price.

See our complete analysis for American Eagle Outfitters

Supporting Factors

Better Offerings: American Eagle’s core products have struggled to garner customer attention, but its fashion assortments have found good acceptance. The company has seen demand of certain product categories go up driven by the adoption of new styles. The retailer is planning to simplify its design system to respond to changing fashions, trends and customer tastes quickly and effectively. It is removing layers within its designing teams, reorganizing the structure to implement direct accountability and enhancing its speed sourcing capabilities. All these efforts are intended to deliver better product offerings, which the company can sell at higher average prices and fewer discounts. Ultimately, this should push American Eagle’s gross margins up.

Store Consolidation: Since American Eagle is already struggling to attract customers due to low brand loyalty, it is planning to close underperforming stores to offset the impact of low store traffic. During fiscal 2014, the company closed a total of 49 mainline brand stores. Overall, the company has identified 150 stores, out of its 300 stores, to close by 2017 when its lease expires. Closing stores that do not generate sufficient revenues, but still account for their proportion of operating expenses, will help American Eagle improve its operating margins. Since the company is closing stores through lease expiration, expenses related to store closures are likely to be minimal.

Offsetting Factors

Factory Channel: While American Eagle is looking to consolidate its mainline brand network, it is simultaneously expanding its factory stores, that offer products at relatively cheaper prices. The initial response to this format has been good, which has encouraged the retailer to continue investing in new factory outlets. Although the contribution of this segment to the company’s overall revenues isn’t significant at the moment (the company doesn’t even report the number of factory stores), it will be notable once this format grows relative to the company’s store fleet. Subsequently, overall gross margins will be under pressure given the nature of factory stores’ business.

Online Revenues: The physical store format has almost run its course and the future of retailing is online and omni-channel. Almost all retailers across the industry are investing heavily in omni-channel and direct-to-consumer initiatives in order to increase their reliance on web-based sales. While this shift is essential for the sustenance of store-based retailers, it comes at a price. Online, by nature, is a low margin business compared to store retailing, as costs related to storing, packing and shipping are higher than store operating expenses. Hence, as a proportion of online revenues in American Eagle’s net revenues grows, it will have a negative effect on overall EBITDA margins. This proportion increased from 11% in 2010 to an estimated 17% in 2014, and is likely to grow faster in the future thanks to American Eagle’s store closures.

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