Description

American Eagle Outfitters (AEOS) is a youth-oriented retailer selling at a bargain basement price. P/E=11.3, EV/EBITDA = 5.1, no debt and $3.56 per share of Cash+ST Investments at end of Q3. Maintenance Free Cash Flow (Op Cash Flow – Maint. CapEx) is typically higher than Earnings so EV/FCF < 9.4. ROE over the past 5 years (average net income/average equity) has been 18%, with little or no debt during most of that time. The company has bought back more than 7 million shares (over 4% of outstanding shares) since the end of August. There were also $123 Million of long-term investments and $982 Million of off-balance sheet minimum rent commitments. The stock is down over 35% from its high.

That said, AEOS has in the past had some missteps. Same store sales and earning fell in 2002 and 2003 before they came roaring back in 2004 and 2005. However, given the company’s five year average performance and its current low valuation, I think we are well compensated for that volatility. Assuming that AEOS remains reasonably in tune with the fashions and tastes of its target market, I’d expect to see AEOS trading back in the thirties within 12-18 months, based upon an EV/FCF in the 13-15 range which seems reasonable for a moderately growing retailer with a pristine balance sheet and good, albeit erratic, returns on capital.

I encourage you to read the fine write-up of Aerospatale (ARO) that ilpadrino98 just posted. AEOS and ARO are competitors, with AEOS targeting a slightly older customer(15-25 yo) and higher price-point than ARO. David101’s followup to the ARO posting noted his observations from recent visits to the two chains. Parenthetically, I started evaluating AEOS as a possible VIC writeup before reading these postings. Other competitors are The Limited, The Gap, Abercrombie & Fitch, Pacific Sunwear and Hot Topic, and The Buckle. ARO probably will grow faster than AEOS and has historically been a more consistent performer, which partially accounts for AEOS’ lower current valuation.

In the US/Canada, with current store count of 866, the American Eagle chain is getting close to saturation. They also have the obligatory e-commerce site. Results for that are not separately broken out. Besides the annual 5-6% increase in square footage expected for AE, there are some opportunities for growth. In the flagship chain, they are expanding their offerings into women’s underwear and loungewear. A few weeks ago, the company signed a Memorandum of Understanding with an Asian partner to expand AEOS into Japan. AEOS will be the majority partner and will have operational control. Details have not yet been released and if the agreement is finalized and executed well, that could result in a nice pop. In August, AEOS will open at least 5 stores in a new concept, Martin+Osa that will focus on 25-40 year olds. Until then, the expenses associated with this launch will be a drag on the bottom line. If M+O goes well, they plan to open 10-15 new stores in 2007, and 25-30 per year after that. They see a potential 300 store opportunity. These new initiative don’t have to be a big success however for the stock to do well, considering its current price.

Capital Expenditures this year will be around $80 million, excluding the new corporate headquarters that the company just bought in trendy Pittsburgh, close to their current location of Warrendale, PA. This will cost $21 million plus an undisclosed amount for renovation and will be reflected in the next FY CapEx. I’ve found new headquarters are often a leading indicator of executive egos gone out of control, so this bears watching. I estimate Maintenance CapEx at $50 million.

The 2006 plan for the AE chain is 40-50 new stores and 45-50 store renovation renovations. For new stores, the Average Investment is $528k, first 12 months Net Sales are $2.1 million, resulting in a Four Wall Profit of $406k, Cash Flow of $471k and Pretax ROI of 89%. For remodeled stores, Profits increase from $492k to $900k with Sales increasing from $1.9 million to $2.8 million.

On November 30, AEOS announced disappointing November results. Same Store Sales (SSS) were up by only 1.7% for the month, much less than the torrid performance earlier in the year (17.4% YTD). Sales increased by 6.9%. Q4 EPS guidance was cut by 4% to 70-72 cents, essentially flat from last year. It will probably earn $1.87-$1.89 this fiscal year (up from $1.49) and will likely be pretty flat next year, but in this industry these projections should be heavily discounted.

The Schottenstein-Deshe-Diamond families own 14.2% of AEOS. Mack885’s writeup of RVI has some good background on Jay Schottenstein. During Fiscal 2004, AEOS implemented a plan to eliminate related party transactions with the families. As a result, AEOS hasn’t had any material transactions with the families since January 2005.

Insider and company buying picks up when the stock is in the low-20s. For example, Jay Schottenstein bought $20 million in September. In Q3, the company repurchased 6 million shares at an average price of $23.10. On November 15 the Board authorized the repurchase of an additional 4.5 million shares. As of December 1, AEOS had repurchased 1.0 million shares under this authorization at an average share price of $22.30. The company expects Q4 ending share count to be 152-153 million.

Management recently has tried to manage conference calls like a Presidential news conference, with limited opportunities for followup questions. They also tend to give scripted answers even if the answer is not totally responsive to the question, so that needs to be taken into account.

For a retailer, executive compensation seems reasonable. Bonuses were not given out in 2002-2003 when performance was poor. Bonuses were high in 2004, but reasonable considering how good a year 2004 was.


Risks:
Retail traffic dries up as a result of normal economic recession or one that is pandemic induced.
Fashion vagaries result in a sustained sales slide.
The company is building a new corporate headquarters, which is often a leading indicator of egos gone out of control.
The Japan or Martin + Osa rollouts crash and burn.

Catalyst

Possible sales increases (not currently incorporated into analyst estimates) from Japan, Martin + Osa rollout, and/or expansion into Women underwear and loungeware

Continued share purchases by insiders and company