Is Now the Right Time to Buy American Eagle Outfitters Stock?

American Eagle Outfitters' (AEO -2.27%) stock price surged 18% on Nov. 22 in response to the company's third-quarter earnings report. The apparel retailer's revenue declined 3% year over year to $1.24 billion, but still beat analysts' estimates by $40 million. Its net income dropped 47% to $81 million, or $0.42 per share, which also cleared the consensus forecast by $0.21.

American Eagle Outfitters' (AEO) headline numbers cleared Wall Street's low bar, but its stock price remains down nearly 40% for the year after its latest rally. Should investors buy this beaten-down apparel stock as a turnaround play?

Image source: Getty Images.

What happened to AEO?

In the years preceding the pandemic, AEO consistently generated stronger comparable store sales growth than many of its mall-based peers. Its namesake banner remained popular with teens and younger shoppers, while its smaller Aerie banner expanded rapidly across the lingerie and activewear market. AEO also continued to increase its store count as other brick-and-mortar apparel retailers shuttered their stores to cut costs and pivot toward digital sales.

But in fiscal 2020 (which ended in January 2021), AEO's revenue declined by 2% as the pandemic forced it to temporarily close its stores. Its gross margin plunged 480 basis points to 30.5% as it cleared out its inventories with steep markdowns, and it posted a net loss for the full year. In fiscal 2021, its revenue surged 33% as it reopened its stores and started to increase its store count (especially for Aerie) once again. Its gross margin also expanded to 39.7% as it posted a full-year profit.

AEO's brisk recovery impressed investors, and its stock closed at a record high of $36.24 last April. But over the past year, AEO's declining revenue, rising inventories, and shrinking gross margins drove away the bulls.

Data source: AEO. YOY = Year over year.

Those problems can be attributed to inflation, which curbed consumer spending and boosted the company's freight costs, and supply chain challenges, which prompted it to buy the logistics company Quiet Platforms in late 2021. It also couldn't consistently offset the softness of AEO, which struggled with tough comparisons to its post-pandemic recovery, with Aerie's growth.

However, that pressure eased in the third quarter as its inventories rose at a slower pace and its gross margin expanded sequentially. The stabilization of its gross margin was encouraging, since it's still been relying heavily on markdowns to boost its sales and reduce its inventories.

Will AEO's growth stabilize next year?

But AEO isn't out of the woods yet. For the fourth quarter, it expects its total revenue to drop by the mid-single-digits and for its gross margin to slip sequentially to 32%-33% as it implements more holiday markdowns. That murky outlook seems similar to Gap's (GPS -5.96%) recent guidance for a mid-single-digit sales decline in the fourth quarter.

On the bright side, AEO expects its inventories to decline year over year in the fourth quarter. Therefore, it could start fiscal 2023 with a clean slate and ease off its markdowns to stabilize its gross margins again. It also continues to expand its digital business, which brought in 33% of its third-quarter sales, to reduce its long-term dependence on its mall-based stores.

During the conference call, chief operating officer Michael Rempell said its "costs continue to stabilize" with easing cotton prices and lower freight costs, which he believes will generate a "significant tailwind" in 2023. Rempell also noted the expansion of the company's Quiet network was driving down its delivery costs and helping it process its high inventory levels on its own.

Is AEO's stock too cheap to ignore?

AEO didn't provide any guidance for 2023, but it seems confident its growth will gradually stabilize over the next few quarters. For now, analysts expect its revenue and earnings to decline by 2% and 69%, respectively, for the full year as it works through a rough holiday quarter.

But in fiscal 2023, they expect its revenue and earnings to grow 2% and 41%, respectively, as it laps that tough slowdown. Those estimates seem achievable, but they also rely heavily on AEO successfully reviving its namesake banner with fresh products while aggressively expanding Aerie's banner with new stores. 

If AEO can achieve that stabilization, then its stock looks fairly cheap at 15 times forward earnings. It also pays a hefty forward dividend yield of 5.5%. By comparison, Gap -- which faces many of the same headwinds as AEO -- trades at 17 times forward earnings and pays a lower forward yield of 4.1%.

AEO's low valuation and high yield might limit its downside potential, but I can't consider it a value play until a few more green shoots appear. Until that happens, I'd rather invest in other dividend-paying retailers than AEO.