American Eagle Outfitters, Inc. — Form 10-Q Summary
Reporting period: 13 and 26 weeks ended July 30, 2011, compared with July 31, 2010. Although the request metadata states “2010 Q2,” the filing is for the second quarter of Fiscal 2011. The interim statements are unaudited and were reviewed, not audited, by Ernst & Young LLP.
Business context
American Eagle Outfitters operated one reportable segment comprising American Eagle stores, aerie stores, 77kids stores and AEO Direct e-commerce. At quarter-end, the company operated 1,103 consolidated stores: 931 American Eagle, 151 aerie and 21 77kids locations, plus nine international franchise stores. The former MARTIN+OSA business was closed in Fiscal 2010 and is presented as a discontinued operation.
Financial performance and liquidity
| Metric | 13 weeks ended July 30, 2011 | 13 weeks ended July 31, 2010 | 26 weeks ended July 30, 2011 | 26 weeks ended July 31, 2010 |
|---|---|---|---|---|
| Net sales | $675.7 million | $651.5 million | $1.285 billion | $1.300 billion |
| Gross profit | $232.1 million | $239.7 million | $463.8 million | $497.4 million |
| Gross margin | 34.3% | 36.8% | 36.1% | 38.3% |
| Operating income | $29.3 million | $38.2 million | $67.7 million | $91.7 million |
| Operating margin | 4.3% | 5.9% | 5.3% | 7.1% |
| Income from continuing operations | $19.7 million | $25.8 million | $48.0 million | $61.7 million |
| Diluted EPS from continuing operations | $0.10 | $0.13 | $0.24 | $0.30 |
| Net income | $19.7 million | $9.7 million | $48.0 million | $20.6 million |
Second-quarter comparable store sales were flat, while AEO Direct sales increased 16%. For the first 26 weeks, comparable store sales declined 4% and AEO Direct sales increased 9%. Transactions declined, but higher average transaction value offset the transaction decline.
At July 30, 2011, cash and cash equivalents were $389.3 million, short-term investments were $124.7 million and long-term investments were $0.6 million, for total cash and investments of $514.6 million. Working capital was $792.6 million and the current ratio was 3.19.
Merchandise inventory was $470.2 million, compared with $349.1 million a year earlier. Management attributed the increase to higher cotton costs for fall receipts, investments in year-round key items and planned accessory expansion.
Net cash used in operating activities from continuing operations was $85.0 million for the first 26 weeks, compared with $21.9 million provided in the prior-year period. The operating cash outflow primarily reflected a $167.6 million increase in merchandise inventory. Capital expenditures were $65.6 million, intangible-asset purchases were $33.5 million and net cash used in investing activities was $150.4 million. Financing cash outflows were $43.8 million, primarily dividends of $42.9 million.
The company had no demand-line borrowings and $56.0 million of outstanding demand letters of credit. Available credit facilities totaled $295.0 million USD and $25.0 million CAD, subject to lender acceptance and facility expiration dates.
Material changes versus the prior comparable period
- Second-quarter net sales increased 4%, but first-half sales declined 1% because of negative comparable store sales.
- Second-quarter gross margin decreased 250 basis points, driven by higher product costs and occupancy expenses. Merchandise margin declined 150 basis points and buying, occupancy and warehousing costs increased 100 basis points as percentages of sales.
- Second-quarter operating income declined 23% to $29.3 million, and operating margin declined to 4.3% from 5.9%.
- First-half income from continuing operations declined 22% to $48.0 million, while diluted EPS from continuing operations declined to $0.24 from $0.30.
- Net income increased because the prior-year period included $41.1 million of after-tax losses from discontinued M+O operations, including $43.7 million of pre-tax closure costs. There was no comparable discontinued-operation loss in 2011.
- SG&A improved as a percentage of sales, declining to 24.7% in the quarter from 25.4% and to 25.3% for the first half from 25.7%, reflecting expense-reduction efforts.
- The company made no repurchases under its publicly announced share-repurchase programs during the period; 14.5 million shares remained authorized for repurchase. It repurchased approximately 0.1 million shares from employees for tax withholding purposes.
Guidance, outlook, risks and unusual items
- Management described the retail environment as challenging and highly promotional, but stated that promotional activity was well controlled and that assortments and longer-term initiatives were improving.
- Fiscal 2011 plans included 11 new American Eagle stores, 12 new 77kids stores, 10 new aerie stores, remodeling approximately 60 to 65 American Eagle stores, closing 15 to 25 American Eagle stores and opening 18 new franchised American Eagle stores.
- Fiscal 2011 capital expenditures were expected to range from $90 million to $100 million, with approximately half allocated to store growth and renovation.
- Key risks include rising raw-material, labor and energy costs; weak traffic and comparable-store sales; markdown and inventory risks; potential impairment charges for underperforming stores; uncertainty regarding credit-facility availability; international expansion execution; and the success of aerie, 77kids and AEO Direct.
- The company held $7.5 million of Level 3 investments, including $6.9 million of state and local government auction-rate securities and a $0.6 million ARS call option. Management stated that the securities approximated par, but further market deterioration could require impairment charges.
- No store impairment charges were recorded in the first 26 weeks of 2011, compared with $18.0 million of M+O asset impairment charges in the prior-year period. No net investment impairment was recorded in 2011.
- The company stated that no material changes had occurred in market-risk exposure or risk-factor disclosures from the Fiscal 2010 Form 10-K. Management concluded that disclosure controls were effective as of July 30, 2011.
Investor verification points
- Verify whether inventory growth is converted into sales without materially higher markdowns, particularly given the $470.2 million inventory balance and negative first-half comparable sales.
- Monitor product-cost inflation, occupancy costs and gross-margin recovery.
- Assess operating cash conversion, since first-half operating cash flow was negative despite reported profitability.
- Review store-opening, remodeling and closure execution against Fiscal 2011 plans and the $90 million to $100 million capital-expenditure outlook.
- Evaluate liquidity and investment risk, including Level 3 auction-rate securities and the expiration and availability conditions of credit facilities.
- Distinguish continuing-operation performance from the prior-year discontinued M+O losses when analyzing net-income growth.