Why We Believe American Eagle Outfitters’ FY19 Profits Shrunk Despite Strong Revenue Growth

American Eagle Outfitters (NYSE: AEO) has achieved steady growth over 2015-18, with the company’s revenues increasing by more than 14%. However, the apparel company’s expenses have followed a similar trend over this period – resulting in profits remaining broadly level. Although the company’s revenues are likely to grow by 6.8% in FY 2019 (ending January), expenses are likely to have grown at a faster pace (7.4%). This should result in American Eagle’s earnings margin (i.e., revenues less all expenses, expressed as a percentage of revenues) contracting by 55 basis points from 6.5% in 2018 to an expected 5.9% in 2019 – resulting in a slight reduction in American Eagle’s profits for the year. Trefis breaks down the company’s major expense components in its interactive dashboard, ‘American Eagle Outfitters Expenses: How Does American Eagle Outfitters Spend Its Money?’ parts of which are summarized below.

Notably, operating expenses (which include selling, general, administrative (SG&A) and other costs) are expected to be $1.2 billion in FY 2019 – making up 30% of American Eagle’s $4 billion in total expenses for the year. American Eagle’s operating costs are less than half of the company’s most significant expense driver – its manufacturing costs or the cost of goods sold (COGS).

• American Eagle’s total expenses have increased by 14% since 2015 – going up from $3.3 billion to $3.8 billion in 2018 and are expected to grow another 7.4% in 2019. This increase has been driven by a combination of the higher cost of sales and operating expenses.
• The company is expected to have added $280 million to total expenses in 2019, likely driven by a $210 million increase in the cost of sales.
• Moreover, the company’s total expenses as % revenue would have nudged ahead from 93.5% in 2018 to 94.1% in 2019.

Cost Of Sales

• The cost of sales includes the expenses incurred to acquire and produce an inventory for sale, including product costs, freight-in, and rent & occupancy costs for company-operated stores. COGS is the most significant expense driver for American Eagle, accounting for nearly two-thirds of the company’s total expenses in 2018.
• COGS has increased by 15% over the last few years – rising from $2.2 billion in 2015 to $2.55 billion in 2018, in tandem with strong revenue growth.
• Higher revenues, partially offset by higher promotional activity and increased shipping costs associated with a strong digital business have helped the company maintain a gross margin of 37% over 2015-2018.
• American Eagle’s cost of sales would have grown by 8.3% in 2019, which represents a gross margin figure of 36%. This increase can be attributed to increased markdowns as well as higher buying, occupancy and warehousing costs.

 Operating Expenses

• American Eagle’s operating expenses have increased by 17% since 2015 – from under $1 billion to $1.1 billion in 2018 – driven mainly by increased salaries and advertising expenses.
• Moreover, restructuring and impairment charges incurred over 2016-2018 have also contributed to the rise in operating expenses.
• As a result, operating expenses as % of revenues are also on the rise – increasing from 27.9% in 2015 to 28.5% in 2018.
• Total operating expenses would have increased by 6.9% to around $1.23 billion in 2019, mainly due to the expansion of the company’s digital business, resulting in higher selling & distribution expenses.
• However, operating expenses as % of revenues are expected to remain constant – representing 28.5% of American Eagle’s Total Revenues of $4.3 billion.

Non-Operating Expense (Income)

• American Eagle’s non-operating expenses (income) have decreased from -($2 million) in 2015 to -($8 million) in 2018, mainly due to higher other income.

Additional details about how American Eagle’s Non-Operating Expense has trended over the years are available in our interactive dashboard.

Income Taxes

• American Eagle’s income tax expense has steadily decreased over the last few years (except for 2016 when this metric increased year-on-year).
• The company’s tax rate has fallen from 33.7% in 2016 to 24.1% in 2018 due to the enactment of the US Tax reform.
• The company’s tax rate for 2016 included a one-time charge resulting from valuation allowances on the $21.2 million of impairment and restructuring charges.
• American Eagle’s effective tax rate is expected to be around 23% in FY 2019.

Per Trefis estimates, American Eagle’s EPS for fiscal 2019 is likely to be $1.44. Taken together with a P/E of 11.4x, this works to a fair value of $16 for American Eagle’s stock, which is roughly 10% ahead of the current market price.

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