Why The Fall In American Eagle’s Stock Is Warranted Despite Strong Q2 Results

American Eagle Outfitters (NYSE:AEO) recently reported strong top line and bottom line gains for the second quarter of fiscal 2015, comprehensively beating market expectations. Even the company’s guidance for Q3 EPS at $0.28-$0.31, was ahead of the Thomson Reuters consensus of $0.28. And yet, the company’s stock has been down almost 10% since. This is surprising considering that American Eagle is one of the few apparel retailers in the U.S., who are performing very well amid an edgy retailing environment.

We believe that investors were overly optimistic about the company, which is evident from our $15.30 price estimate for the company, which is now about 5% below the current market price. Also, there are a couple of factors that can suppress American Eagle’s bottom line growth going forward, thus keeping a check on its growth potential. Another reason behind the fall in stock price appears to be the exit of American Eagle’s chief marketing officer, Michael Leedy, who played a pivotal role in the company’s several e-commerce efforts and marketing campaigns.

For the second quarter, American Eagle reported 12% growth in its revenues driven by 11% rise in comparable sales (including the online channel). The company’s gross margins expanded 230 basis points and its SG&A rate declined 220 basis points. It reported earnings per share of $0.17, a year-over-year increase of 14 cents, and ahead of its earlier guidance of $0.11-$0.14. ^[1]

See our complete analysis for American Eagle Outfitters

Market Overoptimism And Bottom-Line Concerns

American Eagle has shown tremendous resolve with its revival strategies over the last 12 months, and it even has some results to show for it. However, investors overshot the level of the improvement in the company’s performance, pushing the stock up almost 40% in the year coming into the release, leaving it exposed. American Eagle’s comparable sales were down 7% in Q2 2014, 5% in Q3 2014 and they remained flat in the fourth quarter. Although the metric improved 7% in Q1 2015 and a hefty 11% in Q2 2015, much of that was attributable to weak comparable periods. No doubt that American Eagle is moving faster than its counterparts, but we believe that it will face significant bottom line pressure going forward, that can suppress its cash flow.

To continue its expansion in the U.S., the company is aggressively expanding its factory store network, which is a lower margin business. Through its factory outlets, American Eagle offers relatively older merchandise at discounted prices. As the retailer is consolidating its mainline store network and expanding its factory channel simultaneously, there will be a negative pressure on overall gross margins going forward. This will significantly offset the benefits related to a decline in promotional activities attributable to better fashion merchandise.

Moreover, the company is aggressively deploying omni-channel initiatives to propel its web business by leveraging its store network, in the wake of the ongoing online customer shift. However, the increasing reliance on the web channel comes with an unwanted margin pressure. E-commerce is by nature a low margin business, since retailers incur higher costs in storage, packing and delivery than they do in a typical retail outlet. Although effective integration of store and web-based inventory will provide significant synergies in storage and administrative expenses, packaging and delivery will keep costs high. Hence, growing penetration of Internet in overall revenues will negatively impact EBITDA margins. The combined effect of the aforementioned factors will ultimately trickle down to American Eagle’s cash profits.

CMO Steps Down

Just a day after its earnings release, American Eagle announced that its chief marketing officer, Micheal Leedy, will step down from his position. ^[2] Mr. Leedy was credited with the success of American Eagle’s marketing strategies that have played a crucial role in the brand’s turnaround. He has also helped the company establish its loyalty programs, which have brought in increasing numbers of loyal customers over the years. Moreover, Micheal Leedy has made some contributions to American Eagle’s e-commerce channel as well. He joined the company in 1994, left for a couple of years to head Chico’s marketing and rejoined American Eagle in 2011 as the CMO. Investors have reacted negatively to his departure, which seems justifiable to an extent.

Although American Eagle’s turnaround is attributable to the collective effort of the merchandising and marketing teams, individual contributions cannot be neglected. Micheal Leedy’s approach towards marketing, such as the #aerieReal campaign, has had a positive impact on the company’s brand image. Mr. Leedy was fixated on using “real people” instead of models, a strategy which earned the brand a lot of appreciation. Even American Eagle’s executive creative director, Roger Markfield, said that Micheal Leedy was actively involved in establishing the brand DNA.

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1. American Eagle Outfitters Reports Record Second Quarter Sales and Strong EPS Growth, American Eagle, Aug 19 2015 [↩]
2. American Eagle Outfitters Announces Management Change, American Eagle, Aug 20 2015 [↩]