American Eagle Outfitters (AEO) reported mixed second quarter results this morning before the bell. Revenues of $1.19 billion (+35% YoY) missed estimates of $1.23 billion, while adjusted earnings per share of $0.60 was higher than the $0.55 consensus estimate.

"It's extremely gratifying to see significant growth across our business, as we delivered another quarter of record revenue and profitability. Results underscore the strength of our brands, outstanding product and a leading customer experience across selling channels. We are running our business with a laser focus on profitability through inventory and real estate optimization initiatives and investments to enhance our supply chain," CEO Jay Schottenstein said in the press release.

"Led by an expanding customer file, Aerie is achieving consistent, robust multi-year growth and very strong profit flow through. American Eagle posted meaningful top-and bottom-line increases with significant unlock still ahead. Our Real Power, Real Growth plan has been a guiding light for all facets of the business, positioning us to successfully navigate a dynamic macro environment. Despite external challenges, I believe we are on path to achieve $600 million in operating income this year, well ahead of our previous target," Schottenstein concluded.

The CEO comments are not any source of comfort this morning as shares are down 10% today. Today's decline adds to what has been a major disappointment for the market, although we will be discuss how this selloff is a reset and it's important we need to stay the course in this stock, it outlines our correct prediction as we tried to lighten our position going into the quarter. I was too busy to write a post about this, but if you read our trade records, we lighten up AEO after we saw the major theme with these retailers after they report: they talk about supply chain issues and the stocks get hit.

While our own and Wall Street expectations were too high and unfortunately in need of a major reset (that's in the process this morning with the selloff), American Eagle Outfitters business is still performing well and the long-term outlook remains strong. In other words, we think today's trading action reflects more of an expectation reset, not a business reset.

Looking at sales, consolidated store revenue increased 73% from the second quarter of 2020 as customers returned to the stores. This shift back to in-store shopping explains why digital revenues declined by 5% YoY despite a 9% increase in total online demand. Compared to pre-pandemic 2019 levels, store revenue increased 4%, and digital revenue increased 66%. Digital sales made up 35% of the company's total revenues and long term, the company continues to see that figure increasing to 50% of total sales.

By brand, American Eagle revenue of $846 million represented an increase of 35% versus 2020, and demand was positive versus 2019 levels. Profitability was a strong point too with operating margins of 23.5%, an expansion of 1400 bps from 2020 and over 30% from 2019 levels. The brand's leading position in denim (AE is the #1 jean brand within its demographic and the #1 women's brand across all ages) was a highlight of the call as management pointed to great results across genders. The company also believes current trends and shifts in silhouettes will be a tailwind for the women's business in this new denim cycle. And by the way, management is not seeing any problems with getting the denim to their stores. The CEO said on the call that all the factories that produce their denim are running and the stores are getting shipments on a regular basis.

At Aerie, revenue of $336 million represented an increase of 34% over last year, marking the 27th consecutive quarter of double-digit growth. The company cited broad-based, double-digit strength across all product categories - core intimates, bras and apparel, and swimwear. Aerie's operating margin of 21.0% expanded 890 bps from 2020. The company said the strong demand they are seeing allowed them to strategically remove promotions, leading to higher full-price sales. Aerie is also seeing more and more customers come to the brand, evidenced by a customer file that has grown by over 20% year to date. And as for existing customers, management said they are transacting more frequently and spending more. Looking ahead, Chief Creative Office Jen Foyle said, "Momentum has continued into the fall season as customers embrace our amazing brands and cozy comfy collections. I'm highly encouraged by our results and excited for our upcoming season. We remain focused on driving consistent double-digit growth and improving profit flow-through."

Gross margins were strong at 42.1%, higher than estimates of about 39.9%. American Eagle Outfitter's gross margins expanded 1210 basis points form 30% last year, reflecting significant revenue and merchandise margin expansion across brands, primarily driven by strong demand, higher full-priced sales, lower promotions and inventory optimization initiatives.

Operating income of $168 million was higher than estimates of $153 million. Aerie's operating income of $71 million increased 132% from $30 million in the second quarter of 2020 and American Eagle's operating income of $199 million increased 234% from $60 million in the second quarter of 2020. Operating margin of 14.1% was the company's highest rate since 2008 and was better than estimates of about 12.5%.

Total consolidated ending inventory at cost increased $82 million or 20% to $504 million compared to a 21% decline last year. The company said inventory was up across both brands, positioned in key fall categories, yet remained below revenue growth, which is consistent with their focus on inventory optimization. The increase in inventory should help the company keep plenty of products in stock for what should be a strong fall season. Additionally, management said they have confidence in their ability to sustain high margins and offset inflationary pressures. We are encouraged by the fact that management believes they are in a good inventory position for the third quarter and the rest of the year.

On the supply chain, CFO Michael Mathias said, "There is no doubt that the global supply chain remains highly disrupted. Port shutdowns and factory closures are leading to longer delivery times and higher transportation costs across our industry...we're very focused on the things that are within our control. We are working closely with our partners, and we're moving production wherever possible to minimize disruption. Of course, we also will leverage the significant structural improvements we've made over the past several years, and we believe that we're going to be well positioned during the second half of the year."

So it appears that concerns around the supply chain have had a limited impact on American Eagle's business. In fact, the CEO said on the call that the cost of getting the goods to their stores over the past few months is actually lower than what it was one or two years ago. This is very impressive and should help American Eagle stand out from other retailers. That being said, management reiterated their target of $600 million of operating income for the full year and the step down in EBIT expansion is entirely due to incremental freight and transportation costs. On the conference call the company announced the acquisition of logistics provider Air Terra and we are looking forward to learning more about how this deal will support American Eagle going forward. Management also hinted their interest in making more acquisitions to support their logistics going forward. The company probably sees now as a great time to invest due to the positive impact it will have on margins in the future.

On cash and capital allocation, the company ended the quarter with total cash and short-term investments of $824 million. The company recently increased its quarterly dividend to $0.18 per share (implying a now very solid 2.6% dividend yield) to reflect confidence in the momentum of the business and sustainability cash flow generation, but we want more. Given the recent decline in stock price, we would like to see management deploy some of that cash into buybacks. Their liquidity position is simply too strong right now for them to not increase shareholder returns.

Overall, not the quarter we had hoped for, and we are not surprised by the selloff today. Many other retailers posted bigger bottom line beats and still saw their stocks get whacked on various concerns related to supply chain issues, uncertainty around demand, and questions around what the growth of the business looks like now that the companies have lapped their easiest comps of the year. Specific to AEO, we think the elevated expectations and the lack of an increase to the full-year operating income outlook are the main drivers of today's negative action, even as management pointed to a strong start to the Back-to-School Season and provided an upbeat outlook for the fall. This encouraging outlook for the second half of the year combined with our sustained positive views on the denim cycle (which AE is in a great position to benefit from) and incredible momentum at Aerie are why we think today's action reflects an expectation reset and not a business reset. We still think fashion trends are in AEO's favor and management's focus on profits over chasing sales adds to what should be a multiyear story.

In a note published this afternoon by Barclays, the analysts (who reiterated their $46 price target on the stock) wrote:

"AEO is shepherding in a new era of disciplined focus on profitably growing high-quality top line sales. While we can understand that the sales miss is disappointing, with growth vehicle Aerie significantly growing at a 30% CAGR and core AE brand 3x profitable as it was pre-pandemic, albeit on flattish sales, we believe the selloff reaction is overdone. Quite simply, AEO is intently focused on running a more valuable business entity...AE Brand has become the dominant teen retailer and we see Aerie as one of the most attractive regional-to-national growth brands in the U.S. We remain OW, as we believe there will be ongoing EPS upside and investor expectations adjust for more moderate top-line growth but with OMs that can return to past mid-teen performance levels."

Barclays is staying bullish on this name because American Eagle Outfitters is still one of the hottest teen retailers on the planet, with profits growing at AE while Aerie is continuing its impressive 27-quarter run of double-digit growth. Fashion trends are currently working in the company's favor, and management's focus on profits over chasing sales should result in a multiyear growth story that is underappreciated with a low-teens price-to-earnings multiple and 2.64% dividend yield. We are not giving up on this position just yet and are willing to battle for the reasons we just mentioned above. As for right now, we are holding off from buying this name at the moment to allow for the dust to settle. AEO has been a falling knife and we want to see the stock stabilize for a little before we make our next purchase.