Dividend Focus April 2014
American Eagle Outfitters Stock Report (NYSE: AEO)
Contents
Company Background ____________________________________________ 2
Balance Sheet Analysis ____________________________________________ 3
Company Management ___________________________________________ 7
SWOT Analysis __________________________________________________ 8
Company Strategy _______________________________________________ 10
Current Fashions ________________________________________________ 13
Dividend Track Record ___________________________________________ 19
Valuation/Projected Return _______________________________________ 21
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Company Background
1977 - American Eagle Outfitters was opened by two brothers, Jerry and Mark Silverman, as a single
outdoors-themed clothing store in a Michigan mall. It was part of a portfolio of businesses held by a
parent company called Silverman’s Menswear. The AE mall store was a success and shortly thereafter a
nationally distributed catalog put American Eagle on a much larger nationwide map. It’s difficult to find
specific information, but in general, it appears as though the company and brand was seen as rugged
and appealed primarily to men.
1980 - Silverman’s Menswear became known as Retail Ventures, Inc.
1981 - 50% ownership of Retail Ventures, Inc. went to the Schottenstein family, a wealthy Ohio family
with a long history of retail success. Throughout the 80s, RVI launched multiple chains of various types,
including a bulk food store.
1986 - The company began to focus more on growing American Eagle.
1989 - By 1989, American Eagle had become the primary focus of the company managers, who decided
to sell off the other chains.
1990 - The American Eagle brand and concept that we know today really began in 1990 when the
company started selling clothes under its own private label. At this time, there were roughly 140 AEO
stores.
1991 - The Schottenstein family bought out the remaining interest held by the Silverman family.
1992 - Jay Schottenstein became CEO of American Eagle Outfitters.
1994 - AEO has its IPO, becoming a publicly traded company for the first time.
2000 - AEO opens its 500th store.
2001 – AEO makes a grand entrance into Canada via its purchase of an existing clothing store change.
Basically, AEO bought the existing chain and converted many of its stores to AEO stores, and then sold
the rest to a private company.
2006 – AE launches aerie, its own line of women’s intimates.
2010 – AE goes international with store openings in Dubai, Kuwait, Hong Kong, Russia, and Shanghai.
Click on this link for a more detailed company history of American Eagle Outfitters.
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What American Eagle Owns (A Quick Look At The Balance Sheet):
American Eagle, as of the latest financial statement, owns:
1) $429 million in cash
2) Trademarks and service marks
3) 186,000 square foot corporate HQ building in Pittsburgh, PA
4) 150,000 square foot corporate HQ building in Pittsburgh, PA
5) 1.22 million square foot distribution facility in Ottawa, KS
6) 423,000 square foot distribution facility in Pittsburgh, PA. 120,000 of which is office space.
7) 45,000 square foot data center building in Pittsburgh, PA
8) Machine, furniture, and equipment listed with a book value of $732 million
To hear stock analysts tell the story of late, American Eagle’s brand is basically worthless. They cite lack
of customer loyalty in a fickle teen market when lamenting the lack of brand value. As you will see later,
I believe they overstate the problem and make large leaps to incorrect conclusions.
The total book value of Land and Improvements ($20.2 million) + Buildings and Improvements ($143.9
million) is roughly $164 million. Normally, book value of real estate is on the low side of estimated value,
unless the property has depreciated significantly. Still, without an intimate knowledge of the features,
location, the local market supply, demand, etc. book value is the best estimate we have for true value.
Either way, the bottom line is that there are not a lot (relative to market cap) of hard assets owned by
AEO. But, there is also no debt of any kind carried by AEO. So what they do own is owned outright.
Inventories + prepaid expenses + accounts receivable totals to roughly $449 million. This is more than
enough to offset total payables, deferred revenues, and other accrued expenses of $415 million.
However, it is best, under a conservative framework, to ignore the excess since the value of inventory
can fall very quickly.
American Eagle leases its retail space with long term leases. I imagine the majority of them have early
termination options, though the company reports only note that: “Certain leases also include early
termination options, which can be exercised under specific conditions.” I called investor relations to try
to get an idea or estimate of the amount that would be required to terminate all store leases tomorrow.
Unfortunately, they were in their quiet period and could not talk to me at all. Further, commercial real
estate is not a standardized market. There are some common practices, but nothing is so common that
we would be able to accurately estimate the early termination costs American Eagle would face if it
decided to liquidate or go to an all online sales model tomorrow. From what I can tell doing some basic
online research, the costs of early termination could be so low as to be negligible (unlikely), or they
could be up to 50% of the remaining lease term. We could try to estimate a midpoint at 25%, which
would put the cost of terminating all leases tomorrow at around $438 million. But we would basically be
guessing. The fact is, American Eagle’s store leases represent huge liabilities. However, they are
different from debt. Debt can never be “cancelled” or terminated early. Leases can. Debt can be
renegotiated, but only after a default that leaves equity holders with nothing. Leases can be
renegotiated without a default.
The total for other long term liabilities listed on the balance sheet are $112 million. So, what does all of
this mean?
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It basically means that the company could pay in full all of its non-lease long term liabilities tomorrow
and still have $317 million in cash, in addition to some significant level of real estate holdings that are
owned outright. It would also own some level of excess machinery (mainly in the distribution centers),
equipment, furniture, shelves, store displays, etc, the liquidation value of which is probably significantly
below book value. As an estimate, assume a liquidator would receive 40% of the carried value for these
assets, which comes out to $293 million. It’s important to understand asset value when viewing
valuation measures for any company. Common sense would dictate that a company with a lot of debt
and very few hard assets should carry a much larger risk premium (of course the market isn’t always
sensible).
You will sometimes see analysts and writers subtract cash from the company’s market cap in order to
come up with adjusted multiples. They are using a similar reasoning, but an oversimplified framework.
Companies have to use cash for various purposes. You can’t just assume that company cash is there for
the taking of shareholders who want to buy a majority stake in the company. Instead, you basically want
to understand how a larger company, a large investor, or a private equity firm might look to value this
company. However, we can’t do that accurately without more information on the lease liabilities.
The base measure of tangible shareholder value can be determined by thinking through a liquidation
scenario. The reality is that we can’t determine the value to shareholders in a liquidation scenario
because of incomplete information about leases. However, I do think it’s a useful exercise to think about
a hypothetical scenario where the leases don’t exist. If we ignore the leases, and simply take the value of
AEO in a liquidation scenario, it should be somewhere in the neighborhood of ($317 million in excess
cash + $164 million in real estate + $293 million in equipment) $774 million, or $3.94 per share (196.67
million shares). In our hypothetical world, this would give us a conservative estimate of the value of
shareholder’s equity. Why is this information useful? It tells us there really isn’t much of a natural floor
on this stock, in spite of the fact that the company carries no debt. If the leases didn’t exist, the
theoretical floor created by tangible assets would only be around $4 per share. But the leases do exist.
Even in the best case scenario that the company could terminate all of its leases tomorrow for say 10%
of the remaining total liability, that would be $177 million. That would knock us down to $597 million, or
$3.04 per share in asset liquidation value, which is probably a best case scenario. In the more likely
scenario that lease termination costs were at 25% of total outstanding liability ($438 million), that would
knock us down to $336 million, or $1.71 per share. So, it’s very likely that there is some positive
theoretical floor on the price of American Eagle stock. But we don’t know that for sure, because it’s
possible that many of the leases have no early termination option and are therefore 100% enforceable.
We’ve got a feel for the inherent tangible value of shareholder equity, but definitely no guarantees.
If our estimate of 10%-25% for early termination costs proved correct, the $336 - 597 million estimated
range would give us some feel for the base tangible value of shareholder’s equity at present. Why is that
information relevant? Well, if we could get an accurate estimate of tangible value of shareholder’s
equity, it should tell us, for example, that if this stock were to drop to the range of $1.71 – $3.04 per
share in the near future, it would make sense for large investors to back the truck up and buy as much
as possible. In other words, the liquidation value number, accurately calculated, would be a rock bottom
floor for the price of this stock, given its current balance sheet. Obviously that number would change as
the balance sheet changes.
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But the reality is that the company isn’t currently in a distressed situation. Therefore, a private equity
firm or other large buyout investor would probably look to enjoy excess equity returns though the
issuance of debt to purchase most of the equity in this company. Then they would keep the whole entity
as a going concern or divide up its brand and various assets in a way that extracts much more value than
the company is currently extracting. So the reality is that some large investor or private equity firm
would probably step in and buy this business long before it got down to $3.04 per share. That’s because
the business, being cash flow positive, clearly still has value that goes significantly above its liquidation
value.
Back to the subject of cash, I don’t think it makes sense to simply subtract total cash from market cap in
order to get adjusted valuation measures. What does make sense is to understand the company’s assets
and liabilities, for the purpose of realizing the quality of a company’s balance sheet. Because the
company has kept most of its liabilities as leases instead of debt, this is a low risk balance sheet. The
company has a solid financial position. In that respect, the company should enjoy a lower risk premium
to similar companies, all else equal.
Further, understanding the company’s financial position should help investors understand the level of
risk inherent in expected future dividend payments. The company’s current dividend rate amounts to a
payout of roughly $97 million annually to shareholders.
If the company were to simply break even on a cash basis, without making new investments, it could
sustain the current dividend for at least up to 3 years. However, under a break even cash from
operations scenario, the company would likely burn through at least some of its existing cash pool in
order to continue making new investments, at least for the coming 12 months, as it already has large
omni-channel investments lined up (guidance is for $230 million in capital expenditures for 2014). All in
all, the current dividend payout could withstand one really rough year, but would need to be fully
supported by positive cash from operations thereafter. However, such support shouldn’t be a problem,
considering that the company has been able to produce positive cash from operations through good and
bad times going back to 1997. Obviously, those bad times include the most recent 12 months and the
2008-2009 recession.
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Company Management
Currently, the company is being run by Jay Schottenstein, who is acting as interim CEO. Schottenstein
was the CEO from 1992 – 2002. He oversaw the company’s transformation from a clothing store that
sold third party brands, to a clothing brand with its own dedicated stores. He was at the helm when the
company experienced rapid growth in the 1990s and major marketing success, including providing
wardrobe for popular television shows such as Dawson’s Creek and Road Rules. However, he appears to
have relinquished the CEO chair during the midst of a challenging period in 2002. At that time, the
company was taken over by Roger Markfield and James O’Donnell, who acted as Co-CEOs, until Mr.
O’Donnell procured the top spot alone in 2003. He retired at the age of 70 in 2011. Jay Schottenstein
remained in the role of Chairman of the Board, a position he still retains.
Roger Hanson, a long time Levi Strauss executive, took over in January 2012. His departure was abrupt
and unexpected. It still is not clear why he left. This undoubtedly spooked some investors.
However, Jay Schottenstein immediately stepped in as interim CEO. Further, he displayed a vote of
confidence in the company by purchasing $6.4 million worth of AEO stock on the open market for
$12.84 per share.
Further, Roger Markfield, who had previously announced his retirement, decided to postpone his
retirement in order to help the company transition to new leadership.
The bottom line is that there are experienced leaders at the helm for American Eagle. Yes, they are in a
bit of a rough patch, but that’s nothing new for these guys. They’ve been through it before. No one
doubts their experience and expertise. Maybe they would rather be doing other things, but when you
consider their response to the situation, it’s tough to doubt their commitment to this company.
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SWOT Analysis (Strengths, Weaknesses, Opportunities, and Threats)
Strengths:
1) Jeans as core product
2) Strong branding and image. Brand is built around timeless concept
3) Polo shirts as core product
Weaknesses:
1)
2)
3)
4)
5)
Not as engaged on social media as some competitors
Not as quick to market with latest fashion trends as are “fast fashion” retailers
Low barriers to entry in this space
Brand loyalty is generally mild in the teen apparel space
Target customer market is always turning over. In other words, there is a 10 year window in
which someone is a target customer (age 15 – 25). There is no such thing as a lifelong American
Eagle customer.
Opportunities:
1) Omni-Channel marketing. American shoppers are buying more online than they did in the past.
People predicted this in the late 90s. But back then, people still loved to “go shopping”. They
were trained to think that they needed to be in a store to find what they needed, try on clothes,
etc. They also saw shopping as an enjoyable activity. It seems that it took a new generation of
shoppers to fulfill this prediction of people coming to view the in store shopping experience as
more burdensome than enjoyable. People currently in their teens, 20s, and 30s are fine with the
idea of buying everything online. They’ve become accustomed to making purchases and then
waiting for the arrival. They actually enjoy getting packages in the mail just like a shopper enjoys
the immediate gratification of impulse buys. They’re fine with sending something back if it
doesn’t fit. They enjoy the convenience of shopping from home. The first reason this should be
seen as an opportunity is that stores have to be supported by a base level of sales. Therefore,
rural and smaller areas won’t generate enough sales to justify having a store close by. Those
shoppers can be targeted through social media and other means in the hopes of creating a
larger repeat customer base. However, the more important aspect of online sales as an
opportunity, is that they generate a higher overall profit margin than do store sales. Obviously
it’s cheaper to send clothing from a warehouse directly to a shopper than it is to fill stores with
tons of clothes, and pay all of the expenses associated with stores, such as leases, more
employees, power bills, etc. So, it’s also an opportunity to increase profits by having existing
customers switch to purchasing their clothing online as opposed to only buying in stores.
2) International – American Eagle began in 2010 opening stores internationally and marketing
online internationally. Will American Eagle ever be wildly popular outside the U.S.? It’s certainly
possible. Though if they do experience rapid success, strong brand recognition, and positive
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brand image outside the U.S., it might be seen as even less permanent than the brand value it holds within the U.S. That’s because the brand is inextricably tied to the image of the United States itself, the view of which fluctuates wildly among the world’s citizens. However, this would likely be on a country by country basis, creating somewhat of a diversification effect. If the U.S. ever becomes a hated or despised country among say, Chinese consumers, the same may not hold true among Brazilian consumers. Fortunately, the company is staying nimble in terms of its international presence, largely entering new markets through the use of third party licensed stores selling its branded clothing, as opposed to acquiring or creating its own stores in foreign countries. Once they see that they are successful in a particular country, they are then purchasing the stores themselves. I find this to be a prudent, cautious strategy. The international opportunity is probably the most exciting opportunity, in terms of sales growth, that the company faces. Website sales could result in some growth, but more likely will simply replace lost store sales. In theory, with the world as its stage, the sky is the limit with international sales. It will all come down to successful marketing in each specific country. Basically, the international opportunity is one of high uncertainty, high reward. But high uncertainty will only translate to high risk to the extent they spend money on marketing, licensing, partnerships, and distribution in each country without earning a positive return. In other words, they can keep the risk low by being cautious in their approach, strategy, and expenditures, which they already appear to be doing successfully. 3) Opportunity to gain market share from competitors who aren’t able to weather the fundamental shifts occurring in the teen apparel space quite as well as AE. Abercrombie & Fitch in particular appears to have suffered permanent damage to their brand and reputation in recent years. Aeropostale seems to be suffering more than AE and has fundamentally changed their style and strategy, whereas AE is trying to return to more heavily marketing its core strengths (jeans, polos/knits, and cargo shorts). Threats: 1) Fast fashion retailers. This has been the primary threat in focus for most analysts of late. They are very concerned that fast fashion retailers such as Forever 21 and H&M seem to be faster with getting the latest trends from the catwalk to the store, doing so at better perceived value, and maintaining stronger brand image for fashion conscious teens than the 3 A’s of Aeropostale, American Eagle, and Abercrombie and Fitch. 2) Decline and possible death of the shopping mall 3) Americans getting less materialistic, focusing less on brand and more on perceived value 4) Fickle consumer tastes 5) Death of retail altogether (i.e. Amazon and other online channels have caused Americans to get more and more comfortable buying everything online – in this case, value investors should probably consider buying UPS and Fedex on dips) 6) Increased competition in factory outlet space. Factory outlets have been successful of late for American Eagle and other retailers. But as margins are high, competition is increasing. Rents are going up for outlet stores and there will probably continue to be a larger presence by competitors. 9 | P a g e Company Strategy You already know what they do: they sell clothing to 15‐25 year old males and females. But I wanted to include a quick word here to outline the company’s basic operating process. They basically have designers in New York that attempt to create and/or follow the latest fashion trends. The designers send those designs to third party suppliers overseas. The suppliers manufacture the clothing and ship it primarily to the company’s distribution centers (though some of it goes directly from the port to stores when feasible). From the distribution centers, it goes out to stores, remains in holding for store replenishment, or is shipped directly to customers’ homes via online sales or in‐store sales of out of stock product. Leftover inventory is either sold directly via markdowns and coupons (which hit a record amount in 2013) or shipped to factory stores for discounted sales. However, the company does produce some apparel and accessories that are deemed to be good fits, and therefore designed specifically to be sold in factory stores. Now that you hopefully have a little better picture in your mind of the operating process of the company, let’s move on to current company strategy. Teen apparel is a difficult industry. AE strategy has appeared to jump all over the place in the past, kind of like teen preferences. For a quick example, in 2008 the company was involved in creating and sponsoring what was supposed to be an annual event called the New American Music Union. It didn’t return for the second year because the company decided it no longer wanted to incorporate musicians as marketing tools. It’s difficult to say whether any particular marketing strategy will work. Teen styles fall in and out of favor. Therefore, significant fluctuation in earnings should be expected from any teen clothing company. My view is that this brand has the right image to win out over time. It’s well‐
established and defined by a timeless concept. Still, it’s important to review the current strategy. So, what is their current strategy? Per the latest earnings call: Continue to promote store traffic by refocusing on jeans, marketing events (such as the contests for customers to be featured in ads), and making the shopping experience fun, embracing a youthful spirit, and being passionate about their brand. Increase online presence. Engage teen audience via social media. For example, teens can be featured on AE.com by snapping photos of themselves wearing AE clothes and then loading to Instagram or Twitter with the text: #AEOSTYLE. Also listed in their current strategy, close Aerie stores and position that brand alongside AE. As factory stores are currently producing good results via strong sales and higher profit margins, they are looking to open more factory outlet stores. They are focused on developing more “made for factory” products. Other near term goals according to the latest earnings call: to strengthen product assortments via current trends, better value, and better quality. To be innovative with distinct finishes, fabrics, and washes. Capitalize on the strength and popularity of core programs such as AE jeans and shorts, aerie undies and men’s underwear. Maximize exposure of what they’re known for through more marketing support of core programs. Go back to emphasizing legacy categories that were successful in the past, such as accessories and outerwear, which were de‐emphasized last year. Build brand momentum through marketing campaigns such as AE’s real people and Aerie’s real campaign. Balance inventories better by matching them with sales/marketing plans. 10 | P a g e Development of omni‐channel project. Omni‐channel basically means selling through as many different channels as possible such as mall stores, factory outlet stores, and websites. I think it also means developing a presence in many different channels online. For example, if a brand has a large following on Twitter, that will obviously drive more sales. They can highlight new products and styles, as well as making customers more aware of promotions. Perhaps more importantly, they can engage teen customers and become a part of their daily conversations. They also claim to be “connecting the dots” between their stores and digital channels. I think this means aligning promotions, marketing, coupons, pricing, availability, etc. For example, if I shop online, I might like the option of picking up in store as opposed to paying shipping. If I find something I like in the store, but they don’t have my size, is it quick and easy to find and order my size through the website? Is it available for the same price I’m seeing in the store? This is more difficult than it sounds for clothing retailers. If they do this well, they will be ahead of the game. However, it’s very easy for companies in this industry to make missteps or otherwise miss the mark when it comes to having the right strategy at the right time, and executing that strategy. This article seems to indicate that they are a little late to the game when it comes to outlet stores. They are also implementing “ship from store”, which should allow online purchasers to get products quicker. They have a new distribution center opening this summer. The purpose is to basically operate with single pool of inventory. They have invested heavily in technology and support to align and manage all of these functions. To reach teens, retailers need to have the best possible mobile and digital customer experiences possible. They claim that their brands are highly relevant internationally, from Asia to Latin America and that they will pursue opportunistic growth as they are able to gauge demand in particular areas. There will be licensed stores as well as company owned stores internationally. They are entering the London market in 2014. Do they have a sustainable competitive advantage? Yes, but not nearly as much as say Ralph Lauren. For some reason Ralph Lauren is ingrained in many people’s minds as the #1 all American brand for men. That’s because of the classic, always in style look of his clothing. American Eagle has a little bit of that. They have the classic all‐American guy/girl image embedded in their brand. They are also known for their jeans, which of course are classic all‐American clothes in and of themselves. American Eagle is not as sought after as luxury brands, of course. But that’s not what they do. Their jeans sell in the $40‐50 range. Their shirts, hats, and other apparel are affordable, but not cheap (if you want cheap, you go to Old Navy). They remain one of the most popular apparel/retailer brands. Fashionista.com in December 2013 listed them as the #8 most Google‐searched retailer and apparel brands, right behind Macy’s, and right ahead of Nike and Dillard’s. Not bad for a teen retailer made up of smaller stores. Here is the full list from Fashionista.com of the most searched retailer/apparel brands: 1.
2.
3.
4.
5.
6.
7.
Kohl’s JCPenney Nordstrom Forever 21 Victoria’s Secret Old Navy Macy’s 11 | P a g e 8. American Eagle 9. Nike 10. Dillard’s The first thing I notice on that list is that 4 of them are large department stores. One is the largest footwear company. Nike represents the #24 most valuable brand in the world according to Forbes. But American Eagle beat them. One is the largest lingerie/intimates company. Only two of them are considered to be teen apparel retailers. There are a lot of teen retailers out there, but only two of them are among the most searched retail brands (American Eagle and Forever 21). That’s noteworthy. Facebook followers are rather meaningless now that posts must be boosted to reach followers. However, total Twitter followers still has some value as a relevant metric for a company’s social media reach. Urban Outfitters has more followers on twitter (851,000 versus AEO at 294,000). Still, no matter how you slice up the data, it is clear that American Eagle remains one of the most popular brands out there. And again, this is considered a bad time for this company. But somehow, because of poor results in the recent past, some analysts have gone so far as to conclude that AE’s brand is basically without value. In a recent report by Morningstar, its analysts concluded, “… we do not think that the strength of American Eagle’s brand intangible asset is enough to give it a moat.” I would have to agree with the premise that brand loyalty can be considered low, but I would have to disagree with the conclusion that the brand basically has no value. It has value. It’s just that the value is very sensitive to current conditions, kind of like analyst’s opinions and views of a company’s stock. The value of the brand fluctuates up and down, but should prove to remain over time. So, these are the kinds of views and opinions that create good buying opportunities for long term, patient, contrarian minded investors. 12 | P a g e Fashion Perspectives From An Out Of Touch Old Fogey I took a visit to my local AEO store, as well as the website to get a feel for their current fashion strategy. I remember shopping there as a teen and as a college student. If I recall correctly, the store itself had things like a canoe hanging from the ceiling, and maybe even some photos or renderings of Eagles. It had a wooden décor that almost gave it a log cabin feel. That’s how I thought of the brand when I used to shop there. I think that’s how many young men saw it, and precisely why they felt okay about going to such a “girly” place as the mall to buy clothes in the first place. But, forget the rugged outdoors look and theme, that’s long gone from American Eagle’s brand and image. However, I had hoped to see that this classic All‐American brand was still trying to target teens with classic All‐American looks. Unfortunately, I was disappointed. In fact, the first thing I noticed is that this classic All‐American brand isn’t sporting the classic All‐American look these days. They still sell polo shirts, jeans, as well as dress and cargo shorts. But none of the 12 foot posters showed people wearing those clothes. Instead, they showed this: I’m not trying to be mean or insensitive, but I had to do a double take to see if that was an advertisement for guy’s or girl’s clothes. This strange ensemble was also prominently displayed: 13 | P a g e There are a lot of guys out there who don’t like pink sleeves on super tight shirts and shorts. I kind of
wonder if they are seeing these displays, thinking that they have nothing in common with this brand any
longer, and refusing to even walk in or look further at anything in the store.
Further to the point about weird ensembles, look at this ad from the top of their webpage for Polos:
Is he wearing swim trunks with his polo? When does that make sense?
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They’ve still got the classic All-American look. But it’s like they’re hiding it in favor of some horrible
trends. There were no pictures like this in the store, and they’re not very prominent on the website
either:
I realize I sound a bit old-fashioned here, but classic looks are “classic” for a reason. They always look
good. This out of touch old fogey would love to see AE get back to its roots somewhat with the outdoors
theme. The outdoors theme obviously fits with the idea of being American, as well as with the Eagle,
which represents freedom. It even fits with the term “outfitters”. The outdoors theme as a brand
identity, even if they sell clothing of all types, gave AE a distinctive niche and image that appealed to
young people. Many college age people like to think of themselves as “active” or “outdoors types”,
hence the popularity of brands such as North Face and Columbia. Even if they have cast off the outdoors
image forever, AE should, at the very least, always let its brand be defined by classic looks while also
offering some clothing that is driven by the latest trends (even when those trends are horrific).
Teenagers will be teenagers. Many of them will wear things that their parents think look awful, if for no
other reason than because their parents think it looks awful. But, classic looks will always be in style.
Brands like AEO shouldn’t alienate those who want a rugged image or a classic look to the point where it
becomes embarrassing for them to be associated with the brand.
Now, I can’t speak very much to women’s fashion in general. It’s one of those things that’s constantly
changing. At the same time, there are women’s styles that are classic and should always be in style. But
as with guy’s clothes, some of the young women’s clothing out right now looks equally terrible to me,
but for different reasons. It seems like fashion right now means wearing clothes that don’t match in
terms of color and style.
Here is the first photo that pops up when I clicked on “women”:
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Okay…? Is she going to a Pink Floyd concert in 1983 or a Pearl Jam concert in 1993? Or is that flannel just
tied around her waist to hide the one thing she’s wearing that looks normal? And what’s with the Mr. T
necklace? I get that a lot of 80s looks are trendy right now. I just wonder why they push the more “out
there” kind of stuff almost exclusively in their marketing.
Moving on, here is the top photo on their women’s t-shirts page:
This looks awful. I don’t even know how to explain why. It just does. It looks like she got out the scissors
and tried an experiment in making her own clothes. And whatever happened to matching one’s
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clothing? There’s a very clear message to: “Go way beyond basic.” The question I have for American
Eagle is, “Why?” Basic is always in style.
AE recognizes this because they always keep basic looks in their stockpile. But for some reason it’s like
they don’t want to be defined by it. They’re trying to hard to compete with other teen retailers that are
better at doing what they’re attempting to do here. If they’re going to do this, they should consider
coming up with a much broader range of ensembles for their “lookbooks”. Instead of telling teens how
they need to look with just a handful of super trendy ensembles, AE should maybe try to feature a wide
array of looks, leaving the ultimate choice up to the teen consumers themselves. As I mentioned, the
classic looks are there. They just aren’t being promoted. Featured less prominently, below the awful
ensemble shown above, they have some great classic looks:
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I didn’t intend for this to be a fashion review. But I really want to make a point here. American Eagle has
a timeless, classic, All-American brand. They shouldn’t lose sight of that. They should always allow those
classic looks to define their brand, at least somewhat. Fortunately, the solution is simple. Perhaps more
fortunately for investors, they’re already realizing this error. On the latest earnings call, they mentioned
several times their need to give “more marketing support” to their core styles and products. I hope I’m
properly translating that to mean, they’re not going to push the way out trends quite as hard. But
instead will go back to being defined by more classic looks. Fortunately, that’s an easy fix. They already
have plenty of nice clothing. Indeed, my second visit to the store was more encouraging. I looked past all
the weird displays and realized that much of their clothing really is nice. The website doesn’t do justice
to the vibrant colors, fabrics, and styles they use. Seeing the clothes in person helped me to realize why
someone would pay $50 for a pair of jeans. American Eagle’s jeans are a lot nicer than the ones I buy for
$20. So, hopefully they just need to revamp their marketing strategy a little.
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Dividend Track Record As readers are aware, the dividend track record is one piece of information to which I assign a lot of significance. However, it is only one piece of information. Investors have to develop a view of total value. That’s why I’m actually thinking of changing the name of Dividend Focus to “Value Focused Investing” or something along that line. But no matter what name I use, companies with a strong track record of dividend growth will always be a primary area of focus. American Eagle’s dividend track record goes back 10 years: Pay Date
4/16/2014
12/30/2013
10/16/2013
7/12/2013
12/28/2012
12/28/2012
10/10/2012
10/10/2012
7/11/2012
4/9/2012
1/6/2012
10/7/2011
7/22/2011
4/8/2011
12/27/2010
10/8/2010
7/9/2010
4/9/2010
1/8/2010
10/16/2009
7/17/2009
4/10/2009
1/9/2009
10/10/2008
7/25/2008
4/11/2008
1/11/2008
10/12/2007
7/13/2007
4/13/2007
1/4/2007
10/6/2006
7/7/2006
4/7/2006
1/6/2006
10/7/2005
7/8/2005
4/8/2005
1/7/2005
10/8/2004
Dividend Amount
$0.125
$0.125
$0.125
$0.125
$0.110
$0.110
$1.500
$0.110
$0.110
$0.110
$0.110
$0.110
$0.110
$0.110
$0.110
$0.110
$0.110
$0.100
$0.100
$0.100
$0.100
$0.100
$0.100
$0.100
$0.100
$0.100
$0.100
$0.100
$0.100
$0.075
$0.075
$0.075
$0.075
$0.050
$0.050
$0.050
$0.050
$0.033
$0.020
$0.020
19 | P a g e As you can see from 2007-2010, American Eagle does not have a track record of growing its dividend
every single year. Some investors place such importance on that metric that they won’t even invest in
companies that don’t produce at least some dividend growth each year. As much as I would like to see
annual dividend growth, it’s not rational to pass on a solid company just because they are prudent in
managing capital during lean years. What we are really looking for is evidence that the company is
committed to increasing cash flows to shareholders. American Eagle demonstrates that principle
convincingly. In October 2012, the company was sitting on excess cash. They could have used it to build
their empire, but instead chose to return the money directly to shareholders in the form of a special
dividend. The special dividend resulted in a lot more value to shareholders than if the company had
simply raised the dividend a penny each year. I expect the current dividend payment to continue. I fully
expect that if/when cash from operations gets stronger, and the huge one time investments are done,
this company will pay out increasing dividends. If/when they are awash with excess cash, I expect that
special dividends will be paid.
Conversely, if the company continues to struggle, I expect that the dividend would be cut or eliminated
in order to maintain financial health. That is always the risk dividend investors take. American Eagle’s
dividend is a lot more risky than say, that of General Mills (NYSE: GIS). But, the expectation of significant
cash payouts going forward is there, and the total picture of value is compelling.
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Valuation/Projected Returns
First, a few words about valuation. There are lots of different methods for valuing stocks. I like to think
about stocks in terms of whether they are cheap or expensive in light of their risk profile. I like to get an
idea of the expected return as well as how uncertain that return might be. For purposes of illustrating,
let’s take a couple of extreme (unrealistic) examples.
First, we have stock ABC. It offers an expected return of 25% over the next 3 years because it has a rock
solid dividend that equates to a 7.7% yield. The company is super boring, with almost no growth, but
almost no chance of decline. So, basically, we’re assigning a very strong (near 100%) probability that the
expected return of 25% is exactly what we will achieve with some certainty.
We also have stock XYZ. It offers an expected return of 25% over the next 3 years as well. But, that’s
because we can foresee a 50% chance of getting 100% return, and a 50% chance of getting a -50%
return. The expected return is calculated as E(r) = .5(100%) + .5(-50%) = 25%. But, there’s a lot more
uncertainty. The risk is higher. So is the potential reward. I might double my money… or I might lose half
of my money. Which stock represents the superior investment? They both have the same expected
return, but one has lower risk. It should be a straightforward choice. But human beings are gamblers.
Many of them would choose stock XYZ just for the chance of doubling their money. The point is that
investors should try to think rationally about investments using the concepts of risk and reward.
I have a framework in my mind for thinking about the risk/reward of each stock because I’ve studied
valuation methodologies extensively in the past.
So, I think it’s helpful to understand the concept of valuation and the various models that exist. They
provide a logical framework for understanding and thinking about investments. I will hopefully be
creating more lessons in the future that will explain the various methods of valuation in detail, for those
interested in learning.
Of course, the information that comes out of those models is driven not just by the methodology, but
also by what you put into them. That, of course, is driven by your view of a company’s future. That
should be driven by all of the available information. For example, if I know a company has been very
good at generating positive cash flows over the last 10 years, that’s relevant information. Unless there
are major fundamental changes to a business, industry, or consumer behavior, it provides reason to
believe that there is some significant probability that strong cash flows will continue for the foreseeable
future. So, past cash flows/profits/dividends kind of give you a baseline to work from. But you have to
make adjustments for what you can see is true today, as well as what you think may happen in the
future. The end result is that investors think in terms of what’s called a scenario analysis. Whether you
are actually crunching the numbers or not, you’re probably already thinking in those terms.
For example, with American Eagle, I can think of quite a few possible future scenarios. When I think of
American Eagle, I think of the various sales channels and markets. Specifically, I kind of simplify the
framework in my mind to come down to U.S. store sales, online U.S. sales, and international sales (both
store sales and online). I can envision lots of possibilities that may play out for each of those channels
over the coming years, and try my best to assign realistic subjective probabilities to each scenario.
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Unfortunately, I can’t find anything that breaks out online sales versus in store sales for the latest 12
months. It looks like AE management made the decision to stop reporting AEO Direct as a separate unit,
and instead has allocated AEO Direct (online) sales to each respective brand. That forces us to think
about sales and profits through two distinct categories: foreign and U.S.
In order to simplify, I can whittle it down to 5 scenarios for each category. 1) Business will decline
drastically 2) Business will decline moderately 3) Business will maintain the status quo by rising with
inflation 4) Business will experience moderate growth 5) Business will experience drastic growth. The
reality is that there are an almost infinite number of values at which these variables could materialize,
but I think it’s sufficient to have these five general scenarios.
I can now assign subjective probabilities to each scenario based on the knowledge I’ve acquired by
studying the company, the industry, the economy, consumer trends, historical evidence, etc. For
example:
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In this table, I’ve basically assigned probabilities to the different scenarios for profit growth, both negative and positive. Obviously, I think strong international sales are highly likely and that flat or declining U.S. sales are highly likely. I’ve used the current sales level along with the historical average profit margin (6.05%) for American Eagle in order to generate a baseline of where profits should be right now, if these were “normal” or average times for the company. Then, I’ve weighted the outcomes of those scenarios by the probability of each in order to come up with a weighted average profit level that the company should be generating 10 years from now. This is a simplified framework driven by my own subjective views of the probability of different scenarios for this company. The result is that I calculate expected annual profits for American Eagle to be roughly $275 million 10 years from now. In order to get a value 10 years from now, I need to apply a P/E multiple. It only makes sense to me to apply the historical average of 15.5. That’s because I really have no way to know whether the company will be experiencing a good year or bad year, where interest rates will be, what consumer and investor sentiment will be like 10 years from now, what phase of the economic cycle we will be in, etc. Applying the historical average PE, we get an expected market cap for this company of $4.27 billion implying price appreciation (CAGR) of 6.81% per annum for the next 10 years from today’s share price of $11.44. Assuming the company can maintain its current dividend, which is equivalent to a yield of 4.37% at today’s price, we can estimate expected future return on this stock to be 11.18% (add the dividend rate to the projected growth rate). In my mind, that is not a bad expected return for a stock with the risk profile of American Eagle Outfitters. Thank you so much for letting me share my views with you! Best wishes in your investing! Full Disclosure: Long AEO Wisdom’s Reward, LLC is a financial publishing company, not an investment advisor. We do not offer any personal financial advice. We do not advocate the purchase or sale of any security or investment for any particular individual. Investment markets have inherent risks. Past performance does not assure the same future results. Information and data is obtained from sources believed to be reliable, but no warranty or guarantee as to the accuracy, completeness, or usefulness for a specific purpose, is expressed or implied . Individuals should thoroughly research any investment opportunity, using multiple, reliable, third party sources of information, as well as seek the advice of legal and tax professionals, before considering investments. Protected by copyright laws of the United States and international treaties. This copyrighted material shall not be reproduced, copied, or redistributed, electronic or otherwise, in whole or in part, without the express written permission of Wisdom’s Reward, LLC. Please contact info@wisdomsreward.com with any questions or concerns. Thank you for reading. 24 | P a g e