American Eagle Outfitters (NYSE: AEO) and its rival Gap (NYSE: GPS) both faced similar headwinds in recent years -- sluggish mall traffic, the rise of fast fashion retailers like H&M, and the weed-like growth of e-tailers. Those challenges caused shares of American Eagle and Gap to respectively drop about 40% and 20% over the past five years. During that same period, the S&P 500 rallied almost 80%.
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While it's tempting to dismiss both stocks as toxic retail plays, I believe that American Eagle could still be a better value play than Gap for six simple reasons.
Image source: American Eagle Outfitters.
1. Lower valuations
AEO trades at just 10 times earnings, while Gap trades at 13 times earnings. Both ratios are lower than the industry average P/E of 18 for apparel retailers. Looking ahead, AEO trades at 10 times forward earnings, while Gap has a forward P/E of 11. Therefore, AEO is slightly cheaper than Gap relative to its profit growth.
2. Better comps growth
Lower valuations certainly matter, but the key metric for measuring retailers is comps growth. Let's compare AEO and Gap's comps growth over the past five quarters:
Source: Quarterly reports. *Impacted by a fire at a distribution center.
AEO generally posts better positive comps growth than Gap. Gap has been reporting better comps growth in the past two quarters, but that can be attributed to much easier year-over-year comparisons.
Looking ahead, AEO forecasts a "flat tolow single-digit decline" for the second quarter, but didn't offer guidance for the full year. Gap didn't offer guidance for the current quarter, but expects its full-year comps to be"flat to up slightly." However, Wall Street expects AEO's revenue to rise 2% this year, but for Gap's revenue to remain nearly flat.
3. A more dependable growth brand
Gap's three-tiered pricing strategy -- with Old Navy at the bottom, its namesake brand in the middle, and Banana Republic at the top -- arguably failed after companies like H&M and Zara lured away customers with clothes that were both cheap and fashionable.
All three of Gap's brands were in decline until the company hired former H&M exec Stefan Larsson to turn around Old Navy in2012. Thanks to his efforts, Old Navy became Gap's main pillar of growth as the other two brands faded. Old Navy's comps rose 8% last quarter, but Gap and Banana both posted 4% declines.
Image source: Aerie.
Meanwhile, AEO has Aerie, a rapidly growing lingerie and activewear brand for young women. Comps at Aerie surged 25% last quarter, which offset a 1% decline at AEO's namesake brand. Aerie generates a much smaller percentage of AEO's revenue than Old Navy does for Gap, but it likely has more room to run.
4. Better margins
Maintaining margin growth has been tough for apparel retailers. However,AEO still has slightly better operating margins than Gap:
AEO's operating margin has been slipping in recent quarters due to increased promotional activity and higher shipping costs from its shipping business, but that could improve as it closes more stores and expands Aerie's footprint.
5. Lower debt levels
AEO stands out in the retail apparel industry because it doesn't have any debt. Gap, on the other hand, finished last quarter with $1.25 billion in long-term debt -- just a slight decline from $1.32 billion in the prior year quarter.
That clean balance sheet gives AEO a lot of options for growth and expansion. That's probably why it'sreportedly mulling a bid for Abercrombie & Fitch (NYSE: ANF). I'm not a fan of the idea -- since it would make AEO bigger when it should be downsizing -- but it could help AEO cut costs by scaling up, while A&F's namesake brand and Hollister could patch up AEO's weakness in men's apparel.
6. A higher dividend
AEO currently pays a forward dividend of 4.5%. It hasn't hiked that dividend since 2013, but its low payout ratio of 43% indicates that it could certainly do so in the near future. Gap pays a forward yield of 4.1%, and it's raised that dividend annually for seven straight years. Its payout ratio of 54% is higher than AEO's.
It's a close call with the dividend, but I personally prefer taking AEO's higher yield (albeit with more limited growth potential) along with the company's other aforementioned strengths.
Should you buy American Eagle Outfitters?
AEO looks like a better overall stock than Gap, but it still isn't for the faint of heart. The recent collapse of other retailers (like Aeropostale, Limited, and American Apparel) could flood the market with cheap clearance items. Aerie's growth could also lose momentum before it becomes big enough to propel AEO's comps forward again.
But despite these challenges, I'll continue holding my shares of American Eagle Outfitters. It's still the "best in breed" company in the troubled apparel retailing industry, and its low valuation, clean balance sheet, and high dividend make it a compelling long-term play.
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