American Eagle Outfitters, Inc. (NYSE:AEO) Q3 2022 Earnings Call Transcript

American Eagle Outfitters, Inc. (NYSE:AEO) Q3 2022 Earnings Call Transcript November 22, 2022

American Eagle Outfitters, Inc. beats earnings expectations. Reported EPS is $0.42, expectations were $0.22.

Operator: Greetings, and welcome to the American Eagle Outfitters Third Quarter 2022 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Judy Meehan, Senior Vice President, Corporate Communications and IR. Thank you, Judy. You may begin.

Judy Meehan: Good morning, everyone. Joining me today for our prepared remarks are Jay Schottenstein, Executive Chairman and Chief Executive Officer; Jen Foyle, President, Executive Creative Director for AE and Aerie; Michael Rempell, Chief Operating Officer; and Mike Mathias, Chief Financial Officer. Before we begin today’s call, I need to remind you that we will make certain forward-looking statements. These statements are based upon information that represents the Company’s current expectations or beliefs. Results actually realized may differ materially based on risk factors included in our SEC filings. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

Also, please note that during this call and in the accompanying press release, certain financial metrics are presented on both the GAAP and non-GAAP adjusted basis. Reconciliations of adjusted results to the GAAP results are available in the tables attached to the earnings release, which is posted on our corporate website at www.aeo-inc.com in the Investor Relations section. Here, you can also find the third quarter investor presentation. And now, I’ll turn the call over to Jay.

Jay Schottenstein: Good morning. Thank you for joining us today. I’m pleased that we delivered third quarter results well above our expectations despite current macro conditions and tough comparisons as we lap significant pent-up demand and stimulus. While down to last year’s record performance, revenue of $1.2 billion was our second highest third quarter in history and our operating profit of $118 million exceeded the third quarter of 2019. I’m also pleased that our profit margins reflected a material improvement compared to the first half of the year. Our aggressive actions to reset inventory and reduce expenses are paying off. We continue to make progress and entered the fourth quarter very well positioned. Our brands are strong and customer engagement continues at a healthy pace.

Aerie remains a standout in the industry, and I’m very proud of the multiyear growth we’ve achieved. I’m also encouraged with performance of our new Aerie and OFFLINE stores, which demonstrate strong acceptance by our customers. AE profits and margins improved compared to the third quarter of 2019, reflecting strong product assortment as well as the team’s focus on rationalizing unpredictive SKUs and closing unprofitable stores. Comp sales relative to 2019 were flat and as Jen will review, we have plans in place to improve the trend. Quiet Platforms is providing significant operational efficiencies and needed capacity for our brands, as Michael will review. The third-party customer base is ramping up as other brands look to upgrade their supply chain operations and drive efficiencies to better compete in the current retail environment.

I remain also excited about the potential for Quiet. As we evaluate go-forward plans, we are exploring different options to support future growth. Overall, our third quarter was a strong step in the right direction, yet we remain highly focused on driving further improvement. In an uncertain macro environment, we are leveraging the strength of our operations to control what we can and best position ourselves to respond effectively to changing macro conditions. As the supply chain environment continues to normalize, we are using this to our advantage. We are planning inventories tightly and exercising our capabilities to chase into demand. At the same time, we are also reducing expenses and capital expenditures with a firm focus on improving the bottom line and driving stronger free cash flow.

As we navigate the near term, we will cautiously invest across key strategic initiatives that provide a competitive advantage and allow our business to emerge from the current environment even stronger. I want to thank our teams for their hard work and dedication over the past several months. We were swift and took decisive actions across the business, and this is now showing up in our results. Looking ahead, we will remain focused and disciplined. Our brands remain incredibly strong. I am confident we will continue to make great progress. Now, I’ll turn it to Jen.

Jen Foyle: Thanks, Jay, and good morning, everyone. Although we faced difficult comparisons to a stellar year in 2021, we made good progress across our brands. During the third quarter, demand levels improved from August as we cycled past peak weeks of our record back-to-school season last year. Despite a less robust macro, I’m pleased that we delivered results ahead of our expectations. We also saw meaningful recovery in profit margins compared to the first half for both, AE and Aerie. Earlier this year, we took very deliberate steps to adjust forward receipts and clear through spring and summer goods. As a result, inventory is in much better shape, which enabled us to control promotional levels in a highly competitive environment.

In fact, we achieved our second best third quarter AUR down just 5% to last year’s record high and up nicely across brands to 2019. As I step back and look at the business, our brands are very healthy. Given the current environment, there are clearly different dynamics at play by brands. Aerie remains on a strong multiyear growth path. Since the third quarter of 2019, revenues have nearly doubled, growing roughly $170 million. Record profits have more than tripled since 2019 and also increased to last year. New store expansion and great brand affinity are fueling increased awareness, and I’m excited to note that Aerie crossed two new milestones this quarter, hitting 10 million customers for the first time and achieving an all-time high AUR.

Compared to last year, core intimates, fleece and apparel showed up well. I continue to be extremely pleased with our — with the expansion of OFFLINE where new stores are performing very well. Aerie’s cult like following in leggings is driving momentum and has given us the ability to expand into adjacent categories like sports bras and active tops, all are seeing great results. We expanded our winning Real Me leggings franchise, introducing a new holdup technology to our waistband. We incorporate this fabrication into our sports bras and have seen amazing results for matching sets, which are big trends. For the holiday season, I’m really excited for the new campaign, I want Aerie, our broadest campaign positioning Aerie as the gift destination.

Turning to American Eagle. Pressure was anticipated as we cycled last year’s record results, yet we did better than expected. Our actions to intentionally reduce inventory contributed to a nice profit improvement from the first half. As noted at last year’s analyst meeting, we’ve been focused on resetting the brand, reducing SKU counts and promotions and selectively closing unproductive stores. As a result of these efforts, we are seeing profits improve with operating income up 14% to 2019 and better margins across channels. Rationalizing excess SKUs is providing greater focus. We are making adjustments to address emerging fashion trends and feel really good about the newness we’re bringing into the customer. For example, the Strigid denim collection launched last quarter and is doing very well.

We’ve also shifted our assortment to emphasize new trends in woven bottoms such as cords, cargoes and wider silhouettes, all of which are seeing nice demand. As the supply chain environment continues to improve, we are becoming more nimble. We are getting back into a test and chase rhythm, which is a meaningful positive as we plan ahead. With new fashions, fabrics and silhouettes all emerging on the horizon and our renewed agility to respond to near-term shifts in consumer demand, we should have a great setup going into 2023. We are also excited to launch a new sub-brand in men’s, bringing innovation and newness to our men’s business. Prelaunch tests have been very encouraging. We continue to leverage social and commerce to explore new ways to engage with our customers.

Our efforts across TikTok and the Metaverse continue to drive strong engagement. Additionally, this quarter, we became the first major fashion brand to launch on BeReal. While the macro is certainly not easy, my confidence in our brands and overall consumer affinity for great casual wear is stronger than ever. We remain intensely focused on innovation and seeking opportunities to drive profitable growth across our businesses. A big thank you, as always, to the Aerie and AE teams for staying focused and forging ahead. I’m incredibly excited for our holiday collections, and I look forward to updating you on our performance next quarter. Thank you and wishing everyone a safe and healthy holiday. And now, I’ll turn the call over to Michael.

Michael Rempell: Thanks, Jen, and good morning, everyone. Overall, I’m pleased with how we managed the business in the third quarter, particularly as we navigated through an unpredictable environment. Let me start with a review of our channel performance. This year, we faced a more constrained macro environment than amplified pressure from tough compares. Store revenue declined 4% to last year, while digital revenue declined 5%. However, compared to 2019 pre-pandemic levels, I’m really pleased with what we’re seeing in the business. For example, brand revenue was up 14% with growth across both, store and digital channels. Our digital business, in particular, has grown 35% over this period, with digital penetration expanding to 33% from 28%.

We continue to invest in the speed and functionality of our digital platforms. Our mobile app business continues to be a powerhouse, driving strong engagement for both brands and approximately 40% of total digital spend. Investments in digital capabilities is going to remain a strategic focus. As we noted last quarter, we have brought together store and digital operations, creating greater efficiencies and better integration of the customer experience. I see incredible opportunities as we ensure our go-to-market strategy is best aligned with how customers are shopping. Lifestyles have changed dramatically over the past several years and shopping behaviors continue to evolve, including the dramatic shift to digital, the need for speed and how, where and when customers are visiting stores.

Connecting the experience across all channels and creating a more seamless view of customers are top priorities. Our new mobile point-of-sale system is a great example of innovative technologies that we’re leveraging to further elevate the customer experience. All U.S. stores have now upgraded to the new system, and they’re seeing improved transaction speeds and shorter checkout lines. This is going to be especially beneficial as we come up on the holiday rush. The new system is flexible. It provides a compelling mobile checkout experience and it incorporates several new capabilities including a much more seamless integration of our loyalty program. We have an exciting road map to build out the customer engagement capabilities in 2023. This holiday, AE and Aerie will be offering virtual shopping sessions through Shop Live, a new platform connecting customers to our talented store associates for one-on-one style advice from the comfort of their homes and other one-to-many live stream shopping experiences that we’re testing with Aerie.

We are also focused on updating and modernizing our most productive stores, relocating in some markets to ensure we’re in the best locations, leveraging data to customize our assortments and inventory levels by market, continuing to close our least productive stores where we can confidently consolidate sales to other stores or transition to e-commerce and investing in new technology and leveraging artificial intelligence to improve inventory visibility, placement and ultimately, productivity across channels. There is significant value to be unlocked by all these focus areas. By approaching our physical store footprint from a variety of angles, we believe we can truly maximize our brands, elevate the customer experience and operate with a more efficient cost structure.

Turning to supply chain. The environment has continued to improve. Although some volatility still remains, lead times have normalized and factory capacity has freed up. This presents a dramatically different planning environment compared to the constraints we were operating under, this time last year. We have far greater agility in our operations, which is giving us the option to buy lean, lean more open and chase into demand. On the sourcing side, costs continue to stabilize. Cotton pricing has eased and freight costs are down significantly from levels seen over the past 12 months, which is going to provide a significant tailwind in 2023. On the outbound side, our investment in quiet platforms continues to fuel efficiencies and cost savings.

I really want to underscore that the Quiet new network provided much needed capacity to AE and Aerie over the past several months, enabling us to seamlessly handle higher inventory levels. Digital delivery costs in the third quarter were down to last year as we fulfilled orders more cost effectively and with fewer shipments. We’re also leveraging Quiet advanced fulfillment capabilities located near customers to further reduce delivery times with approximately 80% of online orders, reaching our customers within three business days following checkout. Our third-party customer base, service with the Quiet nodes continues to expand. Interest from prospective customers remains strong, as awareness of the business continues to grow. We are also signing new transportation, fulfillment and technology partners onto the platform, which is further expanding our capabilities.

As Jay mentioned, we believe Quiet is a very exciting business that’s early in its growth curve and has the potential to transform our industry. Thanks. And with that, I’m going to turn the call over to Mike.

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Mike Mathias: Thanks, Michael. Good morning, everyone. The third quarter results exceeded our expectations across both, revenue and profitability. As the team noted, actions to reduce inventory levels cleared through excess spring goods in the second quarter and lower expenses resulted in a profit recovery from the first half of the year. As we continue to manage through the current environment, we remain focused on improving profitability, cash generation and the health of our balance sheet. Third quarter consolidated revenue was $1.2 billion, down 3% to last year, including 2 points of growth from Quiet Platforms. Brand revenue declined 5%. The gross margin rate of 38.7% was ahead of our expectations of mid-30s due to better demand and lower than anticipated markdowns.

As noted last quarter, we ended the third quarter in a better inventory position with fresh fall goods. As a result of our inventory actions, we were able to control our promotional activity while successfully moving through units. We ended the quarter with more progress on inventories, as I’ll review in a moment. Compared to last year, the gross profit dollar declined 15%, with a gross margin rate down 560 basis points against a very strong rate last year. Higher markdowns and increased product costs drove approximately 400 basis points of the decline. The integration of Quiet Platforms drove approximately 70 basis points of incremental deleverage. Rent and warehousing also increased as a rate to sales, offset by lower compensation costs. SG&A dollars declined $3 million compared to last year due to lower incentive accruals and expense actions announced earlier this year.

We continue to make progress in resetting our expense base. As noted last quarter, these actions should result in over $100 million in annualized expense reductions from our original plan. We expect SG&A to be approximately flat in the fourth quarter. Although operating profit was below third quarter 2021, it was up to 2019. Operating profit of $118 million reflect a 9.5% margin. This included a $10 million loss from Quiet Platforms. As volumes ramp up into the holiday selling season, we expect Quiet’s bottom line to improve sequentially. EPS was $0.42 per share, included a $1 million interest addback to net income linked to the outstanding convertible securities. Our diluted share count was 196 million, down from 205 million last year. Now, I’ll provide some color by brand.

Aerie revenue increased 11%, driven by new stores. Comparable sales declined 3%, following an 18% increase last year. Aerie achieved an operating margin of 16.2%, marking a solid recovery back into the double digits, as planned. Compared to 2019, total revenue nearly doubled with operating income more than tripling to $56 million. Continued strong growth, combined with higher merchandise margins are driving improved profitability for Aerie. This combination creates a durable path of profitable growth for the brand. Additionally, as new stores continue to ramp up, we’re seeing improved productivity. American Eagle comps declined 10% following a 21% increase last year, fueled by an exceptionally strong back-to-school season. AE achieved an operating margin of 21%, also showing improved profit flow-through relative to the second quarter.

Markdowns were more controlled, reflecting more appropriate inventory levels. As Jen mentioned, our continued focus on initiatives to improve profitability is driving results. While revenue was down 4% compared to third quarter 2019, I’m pleased to note that operating profit was up 14% over the same period, and brand operating margin expanded 330 basis points to 20.8%. Consolidated ending inventory at cost was up 8% compared to last year with units up 7%. This reflects a meaningful improvement from last quarter’s increase of 36% as we work to bring receipts more in line with demand. Inventory is current for the holiday season. We continue to expect sequential improvement with fourth quarter ending inventory plan down to last year. We ended the quarter with $82 million in cash and total liquidity of $423 million.

Capital expenditures totaled $71 million in the quarter and $199 million year-to-date. For the full year, we continue to expect capital expenditures of approximately $250 million. As mentioned last quarter, we made significant strategic investments to support the future growth of our business. This includes 85 new Aerie and OFFLINE stores over the past year, which should provide comp benefits and fuel profit expansion in Aerie in the coming years. As we focus on absorbing and growing into these investments, we expect annual CapEx to be significantly lower in 2023. Before I move on to our outlook, I want to highlight that our third quarter operating margins for both, American Eagle and Aerie surpassed pre-pandemic rates achieved in the third quarter of 2019.

As we think about the opportunity for margin expansion in the long run, this is a notable point. The quarter we just completed was far from perfect. Product and freight costs, while easing were still elevated compared to third quarter 2019. We have a significant number of new Aerie and OFFLINE stores that are still in the process of ramping up to reach average fleet profitability. We’re operating in an intense promotional environment as the industry works through historical levels of excess inventory. Additionally, we still see significant opportunities to improve inventory productivity. Assessing these factors, I’m confident that our third quarter margin performance, while reflecting a nice improvement from the first half of the year, is not our ceiling.

Now on to our outlook. With key holiday selling weeks still ahead, the bulk of the quarter is yet to play out. With what is likely to be a highly promotional season in the broader market, we’re guiding fourth quarter brand revenue down mid-single digits. This implies brand comps trending similar to the third quarter. We expect fourth quarter gross margins to be between 32% and 33%, on the higher end of our prior outlook of low-30s. While we made significant progress in rightsizing our inventory position, we’re taking a cautious view, given the factors I just discussed. Our tax rate assumption is in the high-20s and weighted average share count at approximately 196 million. We’ve made significant progress over the last two quarters in resetting our business, and we’ll continue to prioritize profitability and cash flow improvement moving forward.

Additionally, as the team noted, we’ve regained the agility in our supply chain, and we intend to use this to our advantage. For 2023, we’re planning expenses and inventory tightly, knowing we have the ability to read and react to the demand signals as they evolve. I look forward to providing more detail on our 2023 outlook on the next call. With that, I’ll open it up for questions.

Q&A Session

Operator: Our first question is from Matthew Boss with JP Morgan.

Matthew Boss: Great. Thanks. And congrats on a nice quarter. So, maybe one for Jen. Could you just elaborate on the bold inventory actions that you took in the third quarter across both brands? And maybe any early read on holiday trend? And just how do you feel your assortments are positioned into the fourth quarter and holiday to potentially take market share in this competitive backdrop?

Jen Foyle: Of course. Thank you, Matt. Look, we really did move swiftly as we mentioned in the commentary, starting back in — actually even back as far as Q1. And as a reminder, in the AE brand, just remember what we’ve been up to, we’ve been rationalizing SKUs for over two years right now to ensure that we are just very highly focused on what the items are and what we want to stand for. Certainly, denim and bottoms at the helm of everything we do there. But back for both brands, we just — we knew what was coming, and we certainly took serious action on getting our inventories in shape. I like what I’m seeing in holiday. It’s still early. Mike mentioned it. It’s a little early right now. We have a big week ahead of us. But I — we just went to all the malls, we saw our competition and we are certainly playing in our own terms.

I’d like to say it that way. While we want to be competitive, as you can see by our earnings performance, we are certainly ensuring that our promotions are strong. But like I said on our terms, we don’t — we want to stand, and this is the long-term strategy. Mike mentioned it. And I think we’re really living up to what we told the analysts a few years back — a couple of years back, I should say, on what our strategy is, and that is to deliver bottom line results. I feel good about our inventory positioning, Matt, because at the end of the day, I think we’re going to be cleaner coming into January, less clearance inventory, and that should really help us position our earnings again where — and we feel confident about that.

Matthew Boss: And then maybe just a follow-up for Mike. So with your fourth quarter gross margin guidance more or less flat to a year ago, could you just elaborate maybe on the puts and takes if we’re thinking about markdowns versus freight versus Quiet Logistics? And I guess, even more so, if we think into next year, is there any reason why you couldn’t see merchandise margin expansion as we lap these inventory actions?

Mike Mathias: Thanks, Matt. Yes. For the fourth quarter, it’s a continuation with our revenue guide of the brands being down 5. As Jen just mentioned, we’re being strategic and competitive with our promotions, but not being overly promotional, but we’re ready to be competitive where we need to be. And then on that revenue guide and with negative comps implied. We’ve got BOW deleverage that we’d expect again in the quarter. And then Quiet will have a similar drain on gross margin as well. So if you piece those different aspects together, that’s — we’re on the higher end of our previous low-30s guide, but feel good about that cautious stance at the moment. And then for next year, I mean, something Michael and I can both maybe tag team here, I think we actually see some tailwind going into next year as just to recap where we’ve been for the last 4 or 5 quarters.