American Eagle Outfitters: 5 Reasons This Beaten-Down Stock Is Massively Undervalued

| About: American Eagle (AEO)

As a contrarian value investor, the fact that the best performing sector in the S&P 500 during 2010 was consumer discretionary (up 26%) leads me to be leery of jumping on the retail band wagon right now. I typically look for beaten down areas of the market.

However, sometimes you can find an unloved stock within a sector that has been on fire and today is no different. Shares of teen apparel retailer American Eagle Outfitters (NYSE:AEO) currently trade for $14 per share, down a stunning 30% from their 52-week high near $20 each. A quick glance at the valuation of the stock may not lead to much excitement (2011 earnings estimates are $1.12 per share, giving the stock a forward P/E of 12.5, just slightly below that of the broad market) but there are at least 5 reasons why AEO is an absolute bargain right now.

The Cash Flow Picture Is Brighter Than the Earnings Indicate

All too often investors look at a stock’s P/E ratio on a site like Yahoo Finance and that is the extent of their valuation due diligence. In the case of AEO the stock’s 2011 P/E of 12.5 is only about 10% below the S&P 500 so while it is cheap it does not necessarily stand out as a bargain.

However, digging a bit deeper shows that the cash flow story is much brighter. AEO trades at only 5 times trailing 12-month cash flow. Remember, cash flow is a much better indicator of an operating business’s health than earnings, which can be manipulated by one-time items and charges, as well as non-cash accounting entries like depreciation. Successful specialty retailers typically fetch 7-8 times cash flow (see the pending buyout of fellow clothing retailer J Crew (JCG) as an example), so AEO shares are about 50% undervalued based on cash flow, even though the P/E ratio does not make this abundantly clear.

AEO’s Dividend Is 50% Higher Than the S&P 500

Clothing retailers are typically not where investors go when looking for fat dividend yields. However, AEO has a very shareholder friendly management and the executives own a fair bit of stock. As a result, they are not shy about paying out excess free cash flow to shareholders.

Currently AEO pays out a 44 cent annual dividend, which comes out to 3.1% per year. Not only is that way above what their competitors pay out, but is it 50% more than the S&P 500 index as a whole.

AEO Has a Pristine Balance Sheet

It is not uncommon for retailers to carry debt on their books because expanding into new markets costs a lot of money (building new retail outlets is expensive). However, AEO currently has no debt outstanding and also maintains a cash hoard of $640 million in the bank. By only using cash flow from operations to expand their business, management at AEO is very conservative with their balance sheet, which shields them from getting into trouble when retail sales hit tough times.

AEO’s cash stockpile is well above average and represents more than $3.25 per share, not too shabby for a stock that only trades at $14 per share. Essentially, investors are buying the entire AEO retail operation for $10 and change per share.

AEO Still Has Expansion Opportunities

Although their core American Eagle concept is fairly saturated in the United States with more than 900 stores, the company plans to expand into international markets in coming years, which certainly could boost growth. Not only that, but AEO is not shy about creating new concept stores and both Aerie (147 stores) and their newest chain, 77kids (9 stores), have the potential to get just as big as the core American Eagle franchise.

AEO shares are trading at a price that indicates their growth opportunities are largely behind them, but simply looking at current store counts tells a vastly different picture. And armed with such a strong balance sheet, they will have no trouble finding the money needed to take advantage of this expansion potential.

AEO Could Very Well Be An Acquisition Target

Although investors should never buy a stock just for the possibility of a buyout, AEO has been mentioned by analysts as a potential acquisition target and I think they are right on the mark. Couple a strong brand with great cash flow, no debt, lots of cash to support an LBO, and a cheap valuation, and private equity buyers are undoubtedly looking at the company.

With recent targets like J Crew and Gymboree, there is no doubt that specialty retail is one area private buyers are focused on, now that financial markets have warmed up and they have excess cash to allocate. Given comparable sale transactions and the values of AEO’s peers, a buyout would likely occur around $20 per share, give or take a buck or two, which would be about 50% above current levels.

And the best thing is, even without an acquisition, AEO’s fundamentals will likely get the stock there all by themselves over time.

All in all, there are plenty of reasons to be bullish about AEO, even as retail stocks have led the market higher and bargains in the industry are quite hard to find.

Disclosure: I am long AEO.