This year, retail stocks have been punished by fears of recession and a slowdown in consumer discretionary spending. The S&P Retail Select Industry Index has seen a 29.2% decline in 2022. Continued inventory issues have also plagued retail stocks this year. Young adult apparel retailer American Eagle Outfitters (AEO 1.94%) is no exception.
Beyond the broader issues, American Eagle has taken on debt for the first time in its history in 2020 as a cushion at the onset of the coronavirus pandemic. Now it's looking to take on more. The stock is down more than those of other retailers and may look like a bargain. Here's why it may not be.
Too much of a good thing
After COVID-19-related stimulus checks hit consumers' checking accounts, they had extra money to burn. At the same time, discretionary spending was also fueled by stay-at-home orders that saved folks money that would've otherwise been spent on dining out, going to the movies, or traveling. The extra padding in checking accounts provided a banner year for American Eagle in 2021. The company ended the year with record sales topping $5 billion.
The company also ended the year with its highest level of inventory. Shortly after, the Fed began raising interest rates to cool the red-hot U.S. economy. The rate hikes continued, and are likely to continue this year. The timing couldn't have been worse for American Eagle.
The company's first-quarter earnings report said inventory jumped by 23% to $682.1 million. It also reported that, due to macroeconomic shifts, it expects sales to increase in low-single-digit percentages. The modest increase in sales will make it difficult to sell its elevated inventory, especially as fashions change from spring to summer.
American Eagle's inventory issues can be solved with painful markdowns, which could hamper its gross margin in the coming quarters. It could also take write-downs on the inventory. Investors could argue that, after the stock's 53% collapse this year, all the bad news is already reflected in the stock price. But American Eagle has additional issues to deal with beyond its inventory glut.
Questionable capital allocation
Fearing the worst-case scenario at the onset of the COVID-19 pandemic, American Eagle took on $643 million in long-term debt. The debt included 3.75% convertible notes and borrowings under its variable-rate revolving credit facility. Since then, the company has paid down most of the debt on its revolver and announced that it would exchange most of the convertible notes.
The convertible notes will be exchanged for cash and additional company shares. The shares will be dilutive to current shareholders, and the cash will be funded by drawing on the variable-rate revolver. In the face of rising interest rates, using variable-rate borrowing to exchange low-fixed-rate debt seems a bit questionable. On top of that, American Eagle said it is looking to increase the limit on its revolver from $400 million to $600 million. If the company chooses to borrow that much, additional rising interest payments could harm profits over the next few years.
Investors combing through the retail wreckage for stocks that could return to their past glory may find plenty of opportunities. But American Eagle may not be one of them.