American Eagle Outfitters' (AEO -2.20%) stock recently tumbled after the apparel retailer posted its third-quarter earnings. The drop might have surprised some investors since AEO beat analysts' expectations on the top and bottom lines.
AEO's revenue rose 6% annually to $1.07 billion, beating estimates by $10 million. Its net income fell 6% to $80.8 million, but its EPS -- buoyed by buybacks -- stayed flat at $0.48 and beat expectations by a penny. Let's look beyond the headline numbers at six main issues to see if its post-earnings drop was justified.
Image source: Aerie.
1. 19 straight quarters of stable growth
AEO's total comparable-store sales rose 5% in the third quarter, marking its 19th straight quarter of positive comps growth. Its namesake brand's comps rose 2%, while its lingerie and activewear brand Aerie posted 20% growth.
The growth of both brands accelerated significantly from the second quarter, with back-to-school sales boosting its American Eagle brand and market share gains lifting the Aerie brand:
|
Brand |
Q3 2018 |
Q4 2018 |
Q1 2019 |
Q2 2019 |
Q3 2019 |
|---|---|---|---|---|---|
|
American Eagle |
5% |
3% |
4% |
(1%) |
2% |
|
Aerie |
32% |
23% |
14% |
16% |
20% |
|
Total |
8% |
6% |
6% |
2% |
5% |
Comps growth by brand. Source: AEO quarterly reports.
2. Light holiday guidance
AEO's comps growth looks impressive, especially compared to mall-based rivals like Gap (GPS -3.83%), which posted negative comps across all three brands (Old Navy, The Gap, and Banana Republic) in its third quarter, or L Brands' (BBWI 1.04%) Victoria's Secret, which posted a 7% comps decline last quarter.
However, AEO expects its comps growth to stay flat in the fourth quarter, compared to analysts' expectations for 4% growth. It also expects its EPS to drop 19%, compared to expectations for 7% growth.
During the conference call, CFO Bob Madore admitted that the beginning of the holiday season had been "softer than expected" as its "challenges in the AE apparel business" spilled over into the fourth quarter.
3. Bigger markdowns at American Eagle
CEO Jay Schottenstein noted that AE's back-to-school sales were strong, led by robust demand for its jeans. But after that initial growth spurt, the brand "experienced softer demand in certain categories, primarily in men's and women's tops, which led to higher markdowns."
Schottenstein claimed that the company was "working harder to strengthen the areas of underperformance" and that the brand would "be back on track in short order," but AE brand president Chad Kessler admitted that its "product challenges in tops" in the third quarter were continuing into the fourth quarter.
4. Strong growth at Aerie
AE's troubles overshadowed Aerie's impressive growth during the quarter. Aerie's comps have risen for 20 straight quarters, and president Jen Foyle stated that the brand continues to "gain meaningful market share in a healthy manner" and generate higher revenue per shopper. AEO also opened 24 new Aerie stand-alone and side-by-side stores during the quarter, boosting its store count to 312 -- compared to 945 locations for its namesake brand.
Foyle also noted that Aerie's "store traffic was well ahead of mall averages," and that its higher transaction sizes were led by higher average unit retail prices instead of aggressive promotions. This indicates that it's pulling shoppers away from Victoria's Secret, which is still trying to boost its comps with aggressive markdowns.
Image source: American Eagle.
5. Rising digital sales
AEO is primarily known as a mall-based retailer, but digital sales accounted for 28% of its revenue during the quarter, marking a 100 basis improvement from a year ago. Aerie's digital sales also accounted for 40% of the brand's revenue.
AEO noted that it saw the most digital growth from its app and mobile channels, which now account for "over half" of its digital business. However, higher digital sales can be a double-edged sword -- they keep the brand relevant for online shoppers, but they dent its margins with higher fulfillment costs.
6. Margin pressure and rising inventories
AEO's gross margin fell 160 basis points annually to 38.2%, mainly due to the ongoing markdowns at American Eagle. Its operating margin also fell 110 basis points to 9.7%.
AEO's inventories rose 9% annually during the quarter, partly due to higher demand for AE jeans and Aerie products. However, AE's aggressive markdowns indicate that it's still struggling to clear out excess inventories.
During the conference call, Madore warned that AEO's fourth quarter would face "greater gross margin pressure than in the third quarter," as it used higher promotions to clear out its inventories and "enter spring with fresh collections."
The bottom line
AEO's third quarter was messy, and its guidance indicates that it's struggling with the same challenges as other mall-based retailers. However, Aerie is still growing, AE remains a top brand for teens, and its low forward P/E of 9 and its high forward dividend yield of nearly 4% should set a floor under the stock.
Simply put, AEO's stock won't rally anytime soon, but it's still a well-run apparel retailer that should survive the retail apocalypse and reward patient shareholders.
