Can Aerie Continue Its Strong Momentum For American Eagle In The Third Quarter?

American Eagle Outfitters (NYSE:AEO) is scheduled to post its third quarter results on December 11, wherein a 6% improvement in sales and an almost 30% increase in earnings per share is expected. In the previous quarter, besides strong digital sales, each brand posted positive store comps for the third quarter in a row, and for the company as a whole, it was the 14th consecutive quarter of positive comps. We expect these sales trends to continue in the third quarter, driven by improved consumer confidence and the back-to-school season. Meanwhile, the massive earnings growth is primarily a result of the reduction in the corporate tax rate, as well as margin improvement. The company has guided for a high-single digits comps growth, mid-single digits revenue growth, and an EPS of $0.45 to $0.47, lower than our expectation of $0.48.

We have a $27 price estimate for American Eagle, which is considerably higher than the current market price. The charts have been created using our new, interactive platform. You can click here for our interactive dashboard on Estimating American Eagle’s Performance In Q3 And Its Fair Price to modify the different drivers, and arrive at your own price estimate for the company.

Factors That May Impact Performance

1. Impressive Jeans Performance: A significant amount of market share in the jeans market is up for grabs as a result of bankruptcies and store closures in the apparel retail space in the U.S.  According to Statista, AEO’s market share was approximately 3.7% in the 2010-2015 time period. However, as per an update provided by the company, its share has risen to 7% by brand and by retailer. Moreover, the company is the second biggest denim retailer in the country, and in the 15 to 25 age group among specialty jeans, American Eagle jeans occupy the top spot with a 31% market share. There is scope for further improvement in this metric as more and more retailers fall prey to bankruptcies. In the second quarter, the company delivered its 20th straight quarter of record jeans sales.

2. Strength of Aerie: American Eagle’s lingerie and activewear brand, Aerie, has gone from strength to strength, driving sales growth for the company. It posted a 15th consecutive quarter of double-digit comps in Q2 2018, at 27%, building on the 26% seen in the prior year period. In addition to impressive growth in core intimates, the company has seen strength in apparel, active wear, and swim wear. The company expects the brand to cross $1 billion in sales in the next couple of years, with a lot of this growth coming from its digital channel, which grew at 30% in the second quarter. Looking ahead, the brand remains poised for long-term growth as it continues to push through new ideas and fabrics. Moreover, since only 50% of women who shop at the AE brand are Aerie shoppers, it presents the brand with plenty of room to grow. Aerie is also expanding its store count, with 40 new stores expected in FY 2018, and a further 50 to 80 planned for FY 2019.

3. Growth of Digital Segment: In Q2, AEO noted a 14th consecutive quarter of double-digit growth in its digital segment. Digital penetration increased 100 basis points, expanding to 24% of revenue, compared to 23% in the prior year period. The company saw the biggest improvements coming from its app and mobile channels, which together represent roughly half of the retailer’s digital business. AEO continues to invest in technology and its omnichannel capabilities, which should ensure sustained growth from this segment.

4. Opportunity for Margin Expansion: While the gross margin continued to slide throughout 2017, as a result of the increase in promotions, higher shipping costs, and a rise in compensation, the rate of deceleration improved as the year carried on, with the 270 basis points of gross margin erosion in the first quarter reduced to 80 basis points in Q4. The company had anticipated the sequential improvement in margins to continue in FY 2018, and consequently, we had expected the gross margin in Q1 2018 to be higher than that in the corresponding quarter of FY 2017. AEO was able to deliver on this, with the gross margin rate increasing 50 basis points in the first quarter, and a further 170 basis points in Q2. This was driven by higher merchandise margins, rent leverage, and investments undertaken to improve margins in the digital space, including automation of the pick and pack processes in the distribution centers and implementation of a shipping optimization software. We expect these trends to continue to drive an improvement in this mettric, helping the company improve its earnings.

5. Lower Tax Rate: As a result of the lowering of the corporate tax rate in the U.S. from 35% to 21%, effective January 1, 2018, the apparel retailer can be expected to benefit substantially. The company has had an effective tax rate averaging 36% over the past five years. In FY 2018, we estimate the metric to be 24.4% for the company, resulting in a significant improvement in the net income margin.

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