American Eagle Outfitters(NYSE: AEO) is a retail staple in the teen basics space. That said, teens are notoriously fickle customers, which complicates things. But American Eagle has just achieved something that should make the retailer's life much easier over the near term -- and it couldn't have happened at a better time. Here's what you need to know.
The backdrop is shifting in retail
When Dollar Tree reported third-quarter earnings, CFO Jeff Davis noted that a lot of the growth "is actually coming from that higher income customer" with incomes of $125,000 or more. Similarly, Burlington recently reported it was seeing increased demand from "trade-down" customers and was leaning into more higher-priced items, which were selling relatively well.
Image source: Getty Images.
There are more such examples within the lower-cost space of the retail sector. The clear implication is that people are feeling pressure financially and looking for ways to cut back. Seeking out bargains is one sure-fire way to do that.
That's potentially bad news for retailers that normally sell full price goods, such as Capri Holdings, parent of Versace, Jimmy Choo, and Michael Kors). So the retail landscape looks increasingly troublesome for retailers like American Eagle Outfitters.
Making an important improvement
This is why it is so notable that American Eagle has just reduced a key metric by 100%. The metric in question is leverage. You can measure this in any number of ways, but debt to equity is a common one. The figure is now zero, which is back to where it was before the coronavirus pandemic.
AEO Debt to Equity Ratio data by YCharts
That's actually an interesting comparison point, because the pandemic was a very difficult period for retailers that were deemed non-essential. Such retailers were effectively shut down by governments for a long stretch of time.
American Eagle was able to lean on its balance sheet through that stretch to keep its business going. Although people "just" pulling back during a weak economic period isn't likely to be nearly as traumatic as the effect of the pandemic shutdowns, it looks like it will be harder for companies like American Eagle to operate as people look for ways to stretch their dollars.
With no long-term debt on the company's balance sheet, however, the company is ready to take on this challenge. Debt reduces financial flexibility. Having no debt essentially means that American Eagle has more wiggle room to adjust in the face of adversity.
Interestingly, the company's Aerie brand continues to perform well, with sales up 12% year over year. Even in difficult times, hot brands can see success. But American Eagle's namesake store brand also saw sales increase 2%, which was a shift from the recent past when it was suffering declines. So not only is American Eagle entering a potentially difficult period in very strong financial shape, it also appears to be in strong operational shape as well.
A safe harbor in a storm?
To be fair, American Eagle Outfitters' stock is up notably over the past year, rising roughly 30% across that span. So Wall Street appears to have recognized the company's strengthening industry position. Still, current shareholders should be thrilled with the improvement on the balance sheet. And for investors looking at retail stocks today, American Eagle could hold up better than more leveraged peers if consumers continue to pull back.
That is a fact worth considering as you review your options in the sector. It could be the fact that tilts you toward one stock and away from another.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool recommends American Eagle Outfitters. The Motley Fool has a disclosure policy.
