Why American Eagle Outfitters’ Stock Looks Undervalued

American Eagle Outfitters’ (NYSE: AEO) stock has lost more than 25% of its value since the beginning of the year, with the company’s share price shrinking from over $19 in January to around $15 now despite the company reporting a strong performance in each of the last three quarters. Notably, weak guidance for Q4 2019 (ending January 2020) weighed on the company’s share price as the company’s stock price tanked nearly 8% after the earnings. Although the company’s stock recovered some of its lost value due to positive developments in the ongoing U.S.-China trade stand-off, we believe that the company’s stock is still undervalued and estimate American Eagle Outfitters’ valuation to be $16 per share – roughly 10% ahead of the current market price. Our price estimate takes into account the latest earnings as well as the company’s guidance.

American Eagle’s total grew almost 6% y-o-y to $1.07 billion in Q3 2019 (ending October) – its highest-ever level for the third quarter of a year, largely driven by a 20% jump in comps for Aerie and double-digit growth in the digital channel business. However, the company’s gross profit rate contracted by 160 basis points – falling from 39.8% in Q2 2019 to 38.2% in Q3 2019. For the fourth quarter of FY 2019, the company expects earnings per share in the range of $0.34 to $0.36 while comparable sales are expected to remain flat.

Below we provide a detailed explanation of the key factors that could impact the company’s valuation:

#1 Aerie Is One Of The Fastest Growing Brands In The Apparel Industry

• Aerie has been the standout performer for American Eagles over the last few years – growing approximately 27% annually between 2015 and 2018.
• The brand continued its impressive performance in Q3 2019, with comps increasing 20% – marking the brand’s 20th consecutive quarter of double-digit comp growth. The brand’s revenue surged 26% in Q3 2019 led by strong sales volumes across product categories as well as due to the contribution of new stores.
• We expect this segment to continue its growth trajectory, with revenues increasing at a rate of 28% to more than $827 million in FY 2019.
• Aerie is expected to achieve significant growth from both the digital channel and retail stores, as the company’s store traffic continued to outpace mall averages.
• Moreover, the brand’s average transaction size has increased led by higher average unit retail prices.
• Aerie is also expected to achieve significant retail channel growth, as the company has opened 29 exclusive Aerie stores in year-to-date 2019 and plans to add up to 10 more stores in Q4 2019.
• Going forward, we expect the Aerie brand to continue to post double-digit comparable sales growth for the foreseeable future – helping drive the company’s top line.

#2 Digital Channel Continues To Expand

• Digital channel has been pivotal to American Eagle Outfitters’ growth over recent quarters. American Eagles’ digital sales were strong in Q3 2019 and increased to 28% of total revenue for the period – an increase of 100 basis points from the prior-year quarter. This growth can be primarily attributed to an increase in user sessions and better conversion rates.
• Moreover, the company’s digital traffic continued to see robust growth in Q3 from its app and mobile channels, which now represent more than half of the retailer’s digital business. American Eagle continues to invest in technology and its omni-channel capabilities, which should ensure sustained growth from the digital sales channel.

#3 Higher Markdown Is A Cause For Concern

• American Eagle Outfitters’ gross profit rate contracted by 160 basis points from 39.8% in Q3 2018 to around 38.2% primarily driven by increased markdowns while buying, occupancy and warehousing costs remained flat as a rate to revenue.
• The management indicated that markdowns and higher promotional activity, product challenges in tops have continued and will pressure the fourth quarter as well.
• Moreover, the company’s inventory increased 9% (y-o-y) to $647 million which would require the company to increase markdown to clear the outdated inventory.
• We expect the company’s net income margin to contract by 50 basis points to 6% in 2019 mainly due to higher markdown and increased promotional activities.

Per Trefis estimates, American Eagle’s adjusted EPS for 2019 is likely to be $1.46. Taken together with a P/E multiple of 11.3x, this works to a fair value of $16 for American Eagle’s stock. which is roughly 15% ahead of the current market price.

We highlight how American Eagle’s P/E multiple has trended over the years, and compare this key metric with that for its peers L Brands, Gap, and Urban Outfitters in our interactive dashboard.

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