This Eagle Could Soar

Barron's: 02/18/2013

American Eagle Outfitters suddenly looks hip.

Maybe it's that touch of Williamsburg the teen-apparel retailer has injected into its standard jeans and T-shirts merchandise mix, exemplified by such ur-Brooklyn garb as knitted hats and woven shirts.

Then again, it could be the stellar growth in earnings -- averaging 75% per quarter -- that American Eagle has rung up since CEO Robert Hanson, a Levi Strauss veteran, took the reins in January 2012. As a result, the company is expected to report March 6 that profit rose 63%, to $279 million, or $1.40 a share, for its fiscal year ended Jan. 31, on a 10% jump in revenue, to $3.5 billion.

Only on Wall Street, it seems, has American Eagle's coolness quotient slipped, with the shares (ticker: AEO) down 10% since mid-September, to $19.99. Yet the stock could soon be back in style, too, if recent corporate initiatives succeed in lifting operating profit margins, providing a further boost to earnings.

Dana Telsey, of the Telsey Advisory Group, argues that a three-percentage-point increase in margins, to 16%, would result in annual earnings power of more than $2 a share, which could propel American Eagle's shares to $32, up 60%. Add a 2.2% dividend yield, plus the likelihood of more special dividends -- like the $1.50 a share the company paid last September -- and investors could enjoy returns exceeding 60%.

The stock isn't expensive at 12.7 times fiscal '14 estimated earnings of $1.58 a share. Exclude the company's $2.75 a share in cash -- its balance sheet is unblemished by debt -- and the price/earnings ratio drops to 11, well below similar retailers' valuations. 

Founded in 1977, Pittsburgh-based American Eagle is the nation's second-largest merchant of teen and young-adult apparel, behind Abercrombie & Fitch (ANF), which has about $4.5 billion in annual revenue and caters to a more affluent demographic. American Eagle operates more than 1,000 mostly mall-based American Eagle and aerie stores, the latter specializing in intimate apparel, as well as 75 factory outlets, and a robust online store, which accounts for 14% of sales. Management expects to raise the total store count to 1,255 by year end, after opening 41 more outlets, 20 overseas units operated by licensees, six stores in Mexico, and six in New York, Miami, and Los Angeles. At the same time, it is closing underperforming units, and remodeling 50 stores, including the one in New York's Herald Square.

American Eagle hit a rough patch during the financial crisis, and has struggled in recent years with rising raw-material and manufacturing costs, uneven merchandising, and heavy price promotions. Hanson, hired to succeed retiring CEO James O'Donnell after a long search, was charged with returning the retailer to historic growth levels. Under his guidance, the company aims to deliver consistent revenue gains of 7% to 9% a year; annual growth in earnings before interest and taxes of 12% to 15%; and returns on invested capital of 14% to 17%, up from 11% in fiscal 2012.

"We have two years of work in front of us to fortify the brand, improve the assortment architecture, and sharpen the inventory investment," Hanson says. "We had a lot of waste in inventory in the past."

So far, his inventory-management skills have been winning kudos and leading to impressive financial results. In the October quarter, sales rose 9.4%, year-over-year, to a record $910 million, while inventory fell 13%, a result that David Berman, head of Durban Capital, calls "remarkable."

To better control inventory and compete with price-sensitive, fashion-forward chains such as Forever 21, Joe Fresh, and Uniqlo, which are targeting the same young-adult market, American Eagle has begun shipping more merchandise from its Asian factories to the U.S. by air, instead of boat. Although air freight is costlier, speedier delivery helps maintain a more timely merchandise assortment, pre-empting heavy markdowns of stale goods.

Management also is trying to ramp up online growth. American Eagle recently hired Joe Megibow from Expedia to manage its e-commerce business, which saw third-quarter revenue jump 27%. The company ships to 77 countries, and hopes to eventually get 20% of its revenue from online sales, nearly 43% above the current level.

The Bottom Line

American Eagle could rally to $32 from the current $20 as profit margins widen and earnings improve. With ordinary and special dividends, investors could reap returns in excess of 60%.

American Eagle's shares have rallied more than 40% in the past year, and some analysts contend that the stock is ripe for a pullback of roughly 10%, particularly if first- quarter sales or earnings are disappointing. Most retailers benefited from last year's balmy winter, while the current season is proving more challenging.

Not even weather, however, can shake American Eagle's quest to become the nation's No. 1 teen retailer, surpassing Abercrombie. Aéropostale (ARO), struggling with operational challenges, is a distant No. 3, while Urban Outfitters caters to a slightly older audience.

"We will stay humble and hungry," Hanson assured investors on the third-quarter earnings call.

That suggests that this Eagle will continue to fly.