Why I'm Buying More Shares of American Eagle Outfitters

I bought shares of American Eagle Outfitters (AEO 0.18%) back in June because I admired the apparel retailer's standout comps growth in a low-growth industry, the surging sales of its Aerie lingerie and activewear brand, along with its e-commerce strength, rising margins, and low valuations. The stock slipped after its second quarter earnings beat didn't dazzle investors, but I added more shares on that dip.

Image source: American Eagle Outfitters.

I'm sitting on an 11% gain in American Eagle as of this writing, but I don't plan to sell the stock anytime soon. Instead, I plan to continue buying the stock for three simple reasons.

1. Aerie's just getting started

Aerie's comparable store sales rose 24% last quarter, compared to 18% growth in the prior year quarter. That marked the brand's fifth consecutive quarter of 20% or better comps growth, and it posted record margins and profits during the quarter. AE claims that the brand continues to draw in new customers, particularly those in the mid-teen demographic.

Aerie is still a tiny player in the lingerie market compared to L Brands' Victoria's Secret, but it's carved out a unique niche with its "I am Aerie Real" campaign of untouched photos, body-positive ads, and relatable models. That move made Aerie the antithesis of Victoria's Secret, a brand defined by hyper-sexualized ad campaigns and heavily airbrushed models.

The company recently expanded the Aerie Real push with the "Share Your Spark" social media campaign, which encourages women to share "positive thoughts and words of advice" on social media with the #AerieReal hashtag.

Image source: Aerie.

During last quarter's conference call, Aerie Global Brand President Jen Foyle declared that Aerie was in the "very early stages of a remarkable growth plan" with "seemingly endless opportunity." Foyle noted that Aerie only has a brick-and-mortar presence in 11 states so far, leaving it with plenty of room to grow domestically, and that it is launching yoga apparel to expand its reach in activewear.

2. Better comps growth than its peers

Aerie's comps growth is impressive, but it's still tiny compared to AE's namesake brand, which posted just 1% comps growth last quarter. That compares poorly to 10% growth in the prior year quarter, and was mainly attributed to a comps decline in men's apparel. As a result, AE's total comps rose just 3%, compared to 11% growth a year earlier.

That slowdown is disappointing, but AE is still easily outperforming its closest rivals in terms of comps growth. Gap's comps fell 2% last quarter, with a 3% decline at its namesake stores, 9% decline at Banana Republic, and flat growth at Old Navy. Abercrombie & Fitch's comps fell 4% last quarter, with an 8% drop at its namesake brand and flat growth at Hollister.

Urban Outfitters (URBN -0.11%), arguably AE's healthiest rival, posted just 1% comps growth last quarter, with 5% growth at its namesake brand, flat growth at Free People, and a 3% decline at Anthropologie. Therefore, if AE achieves its target of low single-digit comps growth for the current quarter, it should still remain a "best in breed" pick among U.S. apparel retailers. Moreover, its newly acquired Tailgate brand for university students might help Aerie offset any additional weakness in its namesake brand.

Tailgate. Image source: American Eagle Outfitters.

3. Expanding margins, rising profitability

American Eagle's gross margin rose 160 basis points annually to 37.3% last quarter. It attributed that gain to lower production costs and higher selling prices. Its operating margin rose 160 basis points to 8.3%. Those numbers indicate that "cheap chic" rivals like H&M aren't forcing American Eagle to slash prices to stay competitive.

Analysts expect that bottom line growth to continue, with 17% growth for the current quarter and 19% growth for the full year. They also expect AE's earnings to improve 13% annually over the next five years. This gives AE a 5-year PEG ratio of 1.1. While that's slightly above the "undervalued" threshold of 1, it's still lower than Gap's ratio of 1.7, A&F's ratio of 1.7, and Urban Outfitters' PEG ratio of 1.3 -- indicating that it's cheaper than all three companies based on its earnings growth potential.

That bottom line growth also gives AE room to grow its dividend. The company pays a trailing yield of 2.7%, but it only spent 39% of its free cash flow over the past 12 months on those payments.

Should you buy American Eagle Outfitters?

The retail apparel industry can be a brutal one, but I believe that American Eagle will outperform its peers over the next few quarters. Its namesake brand is admittedly weak, but the growth of Aerie should offset that slowdown. Meanwhile, its double-digit profit growth, low valuations, and decent dividend should limit the stock's downside potential.