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American Eagle Positioned to Win Amid the Upsurge in Denim

American Eagle Outfitters Inc. is in a very good position in the teen retail space.

That’s according to D.A. Davidson analyst John D. Morris, who on Wednesday initiated coverage of the company’s stock with a “Buy” rating.

“We view [American Eagle] as an innovative competitor that is rising above their rivals with their on-point messaging, which is solidifying their market-share gains and helps to dominate in the denim and intimates categories,” he said. “As the denim destination for teens, [American Eagle] is best positioned to capitalize on the ongoing resurgence in the denim cycle.”

Looking at the competitive landscape, Morris said, “We expect direct competitors–such as Forever 21, Aeropostale, Abercrombie & Fitch, and PacSun–are losing market share to [American Eagle] due to their own missteps.”  For two of those competitors, Forever 21 is on the verge of a bankruptcy filing, while Abercrombie last month posted a wider second-quarter loss attributable to one-time charges connected with the exit from certain flagship store locations.

As for its denim business and how that helps the bottom line, the analyst said the uptrending cycle for the category will help drive traffic improvement and margin upside. The company’s shift in silhouette offerings from skinny to include wide-leg bottoms, according to Morris, is a good opportunity for American Eagle to continue as the denim leader in its space. While the retailer has been the market leader in style, fit and fabric for the skinny bottoms category, its ability to shift gears puts it ahead of competitors who aren’t on top of their assortment transition.

“American Eagle won’t walk away from its core [skinny bottoms] customer who may not be quite ready for the change and is well-positioned to stay current with the new trend towards wide-leg bottoms, which is happening not just in denim, but across other fabrications and in a variety of styles,” Morris said.

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American Eagle’s challenge will be assorting to the right amounts without confusing the customer. While competitors might have some difficulty in handling the “complexity of the shift,” D.A. Davidson’s merchant field team gave the company favorable reviews after assessing the back-to-school and fall assortments. Morris said the reviews indicated that the company “has the right choices in wide-leg denim and non-denim and with a balanced marketing message.”

And beyond the denim offerings, Morris also saw strength in knits and sweaters in the women’s business at American Eagle. Channel checks also show that seasonal categories in the back half of the year, like fleece, sweaters, outerwear and plush knits, appear to be performing well so far.

What’s perhaps of greater note, however, Morris said the company’s rising intimates brand, Aerie, makes it “one of the strongest retailers in its market.”

“Investors should expect a store mix of 65 percent stand-along and 35 percent side-by-side, which will continue to reinforce shopping between [American] Eagle and Aerie,” Morris said.

Aerie has demonstrated a strong correlation between store openings and increased digital revenue, with a 50 percent to 60 percent pick-up, after new concept store openings, according to the analyst. And with a majority of the Aerie store concentration on the East Coast, there’s a significant portion of the West coast that’s a growth opportunity for the brand, as well as the potential to steal more market share from Victoria’s Secret and Pink. And as everyday wear becomes more relaxed, Morris said there’s a rise in athleisure loungewear across multiple categories, as well as a blurring of sports bras and everyday leisure styles as innerwear evolves into outerwear.

American Eagle has a strong balance sheet and cash flow, pluses that help it continue with its expansion plans, Morris said. Going into the Fall and Holiday seasons, the analyst expects higher store comps for American Eagle as store traffic will be driven by more customers purchasing denim and newer styles. The company’s gross margin rate in the third quarter, according to Morris’ projections, should come in at 39.2 percent.

The company has slightly over $330 million in cash and minimal debt. Shares of American Eagle are currently in the $16.70-a-share trading range, and his target price is $21.