Fall 2014 Bain & Company Project American Eagle Outfitters Analysis
Travel Team Raymond Michuda Junior Carolina Gutierrez Junior Brendan Hurley Junior Lavinia Li Sophomore Anvi Ton Sophomore Mechanical Engineering Finance and Sociology Consulting and Political Science Finance and Philosophy Finance and Sociology Bernardo Elizondo Freshman Finance and ACMS Jenny Ng Sophomore Finance Aidan Coronel Sophomore Finance Colin Lillibridge Sophomore Finance and Economics Javier De Oña Freshman Finance and Economics 2
Executive Summary Client American Eagle Outfitters (AEO) is a casual clothing and accessories retailer that targets 15-25 year-old consumers Situation AEO is facing declining profitability in an uncertain market Questions What is driving AEO s decreasing profitability? What is the most effective way to increase profitability? Recommendations AEO can increase revenues by entering athleisure market It can decrease costs by moving manufacturing to Mexico 3
Operating Margin Stock Price ($) Declining operating margin and stock price indicate poor performance Operating margin has declined with a -40% CAGR since 2010 Stock price has declined since 2010 15% 12% 9% 11.5% 8.7% 11.5% 25 20 15 $14.75 $15.42 $20.55 $14.69 $13.47 6% 4.2% 10 3% 5 0% 2010 2011 2012 2013 0 Experts are worried about AEO s recent performance American Eagle was once among the most sought-after apparel brands in the U.S., but it has lost its essence Forbes Source: SEC 4
$ Billions Revenues have not grown quickly enough to keep up with increasing costs Components of AEO Revenue 4 3.5 3 $2.945 $3.120 $3.476 $3.306 2.5 2 1.5 1 0.5 0 2010 2011 2012 2013 Operating Costs Other costs Profit Revenue = 3.9% CAGR Operating Cost = 6.7% CAGR Source: SEC 5
Return on Sales The fact that AEO is positioned in the middle of the market, despite its poor margins, suggests the market is unattractive 20 15 Note: GAP is significantly larger because it owns Old Navy, Banana Republic, GAP, GAP Kids etc. GAP 10 5 Abercrombie & Fitch 0-0.5 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5-5 American Eagle -10-15 Aeropostale -20-25 Relative Market Share Sources: Yahoo Finance, Company 10-Ks 6
Operating Margin Industry margins have decreased by an average of 6.7 percentage points since 2010 21% Operating Margin by Competitor 18% 15% 12% 9% 6% AEO A&F ARO GPS 3% 0% Operating Margin Percentage Point Change 2010 2011 2012 2013 AEO A&F ARO GPS Industry -7.3% -4.8% -14.7% -.1% -6.7% Source: Morningstar, SEC 7
Solution Problem Revenue and cost problems each require a separate solution AEO revenue experiencing low growth AEO margins decreasing Market experiencing low growth Competitor margins decreasing Current market is unattractive Increase in costs is driving this trend Enter a new market with high growth rate Identify large costs and determine feasible actions to reduce them 8
Company & Market Analysis Opportunities in Athleisure Market Reduction in Cost of Manufacturing Final Recommendation 9
Athleisure market is the most appealing new market for AEO to enter Aligns with core competencies Barriers to entry Market Growth Margins Overall High-end Clothing Low High 0.6% 3.2% Athleisure High Low 16.3% 18.0% Outdoor Moderate Moderate 2.1% 10.0% Fast Fashion Low Moderate 12.0% 16.0% Source: IBISWorld, Euromonitor, NASDAQ 10
Sales in ($) Billions US athleisure market is about 10% of the US Sportswear market, sized at $8.17 billion Athleisure market is embedded in Sportswear market, which has experienced steady growth (5.6% CAGR) Athleisure Market Estimate US Sportswear Sales $85 $80 $75 $70 $65 $60 2010 2011 2012 2013 Top-Down Approach *Preferred method $81.7 Billion US Sportswear Market Bottom-Up Approach $1.7 Billion Lululemon Revenue Athleisure market is fragmented; Lululemon is the most recognized brand Lululemon Athleta (GAP) H&M Foot Locker Fabletics (Kate Hudson) Athleisure represents 10% of Sportswear ~$8.17 Billion Athleisure Market The company represents 20% of the athleisure market ~$8.5 Billion Athleisure Market Source: Euromonitor, Morningstar 11
Percent of Teens (%) Athleisure market is the most favorable of all clothing markets Increasing preference for comfortable clothes over regular clothes Athleisure/Sportswear market is growing faster than regular clothing market 25% 20% 15% 10% 5% 0% Survey of Teenage Clothing Preferences Regular Apparel CAGR (2008-13) 1.3% Sportswear 3.5% Athleisure Denim The U.S. apparel industry, battered by a slowdown in mall traffic and stagnant wage growth, is still seeing one category thrive: athleisure. - Bloomberg Source: Mintel, Euromonitor, Bloomberg 12
Revenue ($) in Millions % of Revenue Lululemon s success demonstrates the athleisure market s potential Lululemon is a good indicator of the overall attractiveness of the athleisure market because it is one of the few companies that almost exclusively sells athleisure clothing Lululemon has been experiencing steadily increasing revenue with a 44.7% CAGR Athleisure clothing has lower associated COGS as a percentage of revenue 1600 70% 1200 60% 50% 800 40% 30% Lululemon COGS AEO COGS 400 20% 10% 0 2010 2011 2012 2013 0% 2010 2011 2012 2013 Source: Euromonitor, Morningstar 13
Barriers to entry include customer loyalty and advertisement spending, but can be overcome Customer Loyalty Barrier: Large players high quality and variety of products (i.e. Lululemon) Advertising Barrier: AEO currently unknown in the athleisure market and requires large marketing expenses to gain recognition Response Strategy: Attract consumers by offering a lower price point - 48% of Lululemon s customers extremely likely to switch to cheaper products Response Strategy: AEO can afford to incur higher advertisement expenses because it will not have to invest in additional capital expenses Source: Surverymonkey 14
Organic production strategy would be the best way for AEO to enter the market M&A Pros Strong market impact Faster growth Lower barriers to entry Cons Very expensive Highest risk Integration Issues Financial fallout Low product design flexibility Joint Venture Pros Sharing risk Medium design flexibility Lower barriers to entry Cons Medium costs R&D costs Medium product design flexibility Integration issues Not long term solution 80% of ventures end in a sale Organic Production Pros High product design flexibility Control over costs and revenue Lowest costs by using existing facilities and outsourcing contracts Least risk if failure Cons R&D costs Average barriers to entry Source: VR Business Sales Edmonton, Deal Capital 15
AEO s athleisure prices will be above H&M s and below Athleta s and Lululemon s Yoga Pants Fitness Shorts AEO: $65 Lululemon: $81 AEO: $35 Lululemon: $51 H&M: $25 Athleta: $69 H&M: $15 Athleta: $39 Fitness T-Shirt Hoodie/Sweatshirt AEO: $45 Lululemon: $52 AEO: $65 Lululemon: $112 H&M: $24 Athleta: $49 H&M: $40 Athleta: $94 Source: Company websites 16
Athleisure share of Sportswear Market Revenue in ($) Billions Revenue from Athleisure Sales ($Millions) If AEO captures 3% of growing US athleisure market, it will increase revenue by $423 million by 2018 100 80 60 40 20 0 Sportswear and Athleisure Markets Forecast 69 8 87 10 12 90 92 2014 2015 2016 2017 2018 US Sportswear Sales Athleisure Market Assumption: Athleisure s share of Sportswear market will grow from 10% to 15% in 2018 13 94 14 500 400 300 200 100 AEO s Athleisure Market Revenue Forecast 0 US Sportswear Sales 2014 2015 2016 2017 2018 Assumption: AEO will capture 3% of the athleisure market by 2018 Sensitivity Analysis for athleisure market and AEO shares AEO Market Share by 2018 2% 3% 5% 10% 10% 188 282 470 940 15% 282 423 705 1410 20% 376 564 940 1880 25% 470 705 1175 2350 Source: Euromonitor 17
Company & Market Analysis Opportunities in Athleisure Market Reduction in Cost of Manufacturing Final Recommendation 18
Price ($ per pound) $ Billions COGS are driving increased costs; manufacturing, labor, and logistics are addressable components of COGS 3.5 3 2.5 Operating costs are increasing; COGS are a significant portion of these costs COGS are increasing at a higher rate than operating costs CAGR of operating costs CAGR of COGS 2 Other 1.5 1 SG&A COGS 6.7% 7.5% 0.5 0 Components of COGS 2010 2011 2012 2013 2 Raw Materials costs have decreased 1. With raw materials costs declining, we do not need to address this component Raw Materials Manufacturing Labor Logistics Merchandising 1.5 1 0.5 0 2010 2011 2012 2013 Cotton Polyester 2. Data is not available to address merchandising costs This leaves manufacturing, labor, and logistics as the costs that we want to reduce Source: SEC 19
Currency Value Per US Dollar Cost of Manufacturing Index China/North Asia accounts for most of AEO s production; costs in this region are higher than and rising relative to other countries Majority of AEO s production is done in China and North Asia There are countries that are cheaper than China to manufacture in 59 5 22 58 Americas Number of factories 185 China & North Asia Europe, Middle East, & Africa South Asia Southeast Asia 100 95 90 85 80 75 100 97 96 91 91 87 83 China s Yuan has appreciated relative to the U.S Dollar; the Peso has depreciated 16 14 12 10 8 6 4 2 0 2005 2007 2009 2011 2013 Source: AEO, Economist, IBC, BetterWorld Yuan Mexican Peso Inflation pressures in China Within 5 years, wages are expected to be 25% higher in China than in Mexico China s unit cost has grown over 60% since 2007 due to Yuan appreciation Energy costs have risen and continue to do so due to China s industrialization and increased consumption by its people 20
Mexico is a more appealing location to manufacture than China These other companies have moved most of their manufacturing to Mexico China Cost of Manufacturing index is 96 (U.S is 100) Mexico Cost of Manufacturing index is 91 and shrinking relative to China Current natural gas prices are 64% higher than Mexico s prices Natural gas is tied to the U.S s natural gas resources, resulting in lower prices Long transportation routes to transport goods to the U.S, which also makes quality control more difficult Connected to U.S via land, making goods transportation easier and faster, and makes quality control easier Trends in Percentage of United States Imports Stats about imports U.S. imports from Mexico have steadily increased to 14.4% of all U.S. imports over the past decade U.S. imports from China have remained stagnant at 19% for the past 3 years Currently have export tariffs are 15.9% In recent events, intellectual property rights have been compromised by police forces and hackers Tariff free imports to the U.S under NAFTO Some concerns over security that are solved by using guards at manufacturing hubs Source: Census Bureau, IBC, USAToday, Economist, WSJ, 21
AEO can best launch Mexican manufacturing operations by following a five step process 1 2 3 4 5 Choose production facilities to terminate operations within China based on expiration date of contract, consistency and quality of work, social responsibility history and costs of manufacturing and logistics Initiate new sourcing relationships in Mexico, starting with Mexico City where AEO currently owns 5,800 sq ft of office space, 2 major flag ship stores, and maintains a highly competent management team Encourage other clothing retailers in different markets to partner with AEO in these sourcing relationships to reduce costs and share best practices Once locations to close and open have been selected, move production centers at staggered intervals, preferably at periods of low location usage Analyze the impact of moving production and continue to move production until the mix of factory locations is optimized Source: http://www.ae.com/images/corpresp/aebetterworldnew.pdf 22
Considerations must be made in order to reduce risk, but overall this is a low-risk solution Certain factors must be considered in order to mitigate risks Production can easily be moved back to China due to AEO s sourcing model Gang-related violence in Mexico Mexican sourcing companies may not have the expertise to manufacture AEO products Mexico can possibly become more expensive to produce in, though this is highly unlikely However, overall this is a very low-risk solution Production can be moved one factory at a time, allowing for AEO to constantly assess the impact AEO does not own factories to begin with Low proposed risk 23
AEO can reduce COGS up to 2.4% by shifting production to Mexico Calculation process Savings based on two scenarios COGS Manufacturing & Labor Costs China Manufacturing & Labor Costs Mexico-China Mix Mfg. & Labor Costs Manufacturing & Labor Savings 60% of COGS are from manufacturing and labor* 56% of goods made in China/North Asia Manufacturing Cost in Mexico is 95.8% of that of China/North Asia (and will decrease to 91.8% by 2018*), then multiply by percentage of factories to be moved Savings = China/North Asia Costs Mexico Costs *Assumption Move 50% of Chinese and North Asian Factories to Mexico Year Manufacturing & Labor Savings ($M) Percentage of COGS Savings 2014 16.5 0.7% 2015 21.5 0.9% 2016 26.9 1.1% 2017 32.8 1.3% 2018 39.0 1.6% Move 75% of Chinese and North Asian Factories to Mexico Year Manufacturing & Labor Savings ($M) Percentage of COGS Savings 2014 24.7 1.0% 2015 32.2 1.3% 2016 40.4 1.6% 2017 49.1 2.0% 2018 58.5 2.4% Source: http://www.fcbco.com/articles-and-whitepapers/articles/bid/129456/controlling-and-reducing-your-fulfillment-costs, CBIC 24
AEO can also save money on shipping, with total combined savings reaching up to 4.5% of COGS Calculation process Savings based on two scenarios COGS Shipping China/North Asia Shipping Costs Mexico-China Mix Shipping Costs Shipping Savings 8% of COGS are from shipping* 56% of goods shipped from China/North Asia Shipping cost in Mexico is 37% of shipping cost in China/North Asia, then multiply by percentage of factories to be moved Savings = China/North Asia Shipping Costs Mexico Shipping Costs *Assumption Move 50% of Chinese and North Asian Factories to Mexico Year Shipping Savings ($M) Total Savings ($M) Total Percent of COGS Savings 2014 33.4 49.9 2.8% 2015 36.1 57.6 3.0% 2016 39.0 65.9 3.2% 2017 42.2 75 3.4% 2018 45.6 84.6 3.7% Move 75% of Chinese and North Asian Factories to Mexico Year Shipping Savings ($M) Total Savings ($M) Total Percent of COGS Savings 2014 50.1 74.8 3.1% 2015 54.2 86.4 3.4% 2016 58.6 99 3.8% 2017 63.3 112.4 4.1% 2018 68.4 126.9 4.5% Source: http://www.fcbco.com/articles-and-whitepapers/articles/bid/129456/controlling-and-reducing-your-fulfillment-costs, CBIC 25
Moving 75% of factories to Mexico will increase projected operating margins by 3%, but margins will continue to decline Operating Margin 14% AEO Operating Margin 12% 10% 8% 6% 4% 2% 0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 Known Projection if cost solution implemented Projection if no change Reducing costs alone is not enough. Revenues must also be increased in order to stabilize operating margin. Source: SEC 26
Company & Market Analysis Opportunities in Athleisure Market Reduction in Cost of Manufacturing Final Recommendation 27
Entering the athleisure market and implementing the cost savings strategy will cause operating margin to stabilize at 6.5% Operating Margin 14% AEO Operating Margin 12% 10% Margin stable at 6.5% 8% 6% 4% 2% 0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 Known Projection if both solutions implemented Projection if no change Projection if cost solution implemented Source: SEC 28
Questions? Thank you for your time! 29