Despite Strong Financials, American Eagle Flies Far Below Its Fair Value

American Eagle Outfitters, Inc. (NYSE: AEO) is a retailing company engaged in the design, marketing, and sales of clothing in the U.S. and Canada. It targets 15-25 year olds and has 906 American Eagle Outfitters (henceforth: AE) stores as of February 2007. In addition to brick and mortar stores, AE distributes its merchandise through its e-commerce site.

As of market close on November 26th, 2007, AE shares are currently trading at $21.37, well off their 52-week high by nearly 40%. The downturn of the economy, coupled with fears of a recession, have more than unfairly punished this high quality clothing company that is wildly popular among young adults and teens.

Financial Strength

Trading at a serious discount to fair value, AE boasts fantastic financial strength and outperforms industry averages in many categories.

As you can see, AE is beating the industry averages by significant quantities, most notably ROE, P/E, and Profit Margin. The financial position of AE is even more indicative of a company that is seriously undervalued. AE has a pristine balance sheet, with more than $630 million in cash and $0 debt. AE’s largest competitor, Abercrombie & Fitch (NYSE: ANF), only has $360 million in cash. That’s less than 50% the amount of cash AE has, yet Abercrombie is 45% larger than AE.

In addition, AE has a very nice operating cash flow of nearly $435 million. Both the cash it gains from operations and the cash it has on hand allow AE to fund expansions in America and Canada.

In terms of valuation metrics, AE has an extremely low 10 forward price-to-earnings ratio [FP/E], and a price-to-earnings growth ratio [PEG] of only 0.82, while Abercrombie has nearly a 13 FP/E and a 0.96 PEG, 30% and 17.1% higher than AE, respectively.

It is likely that AE will use the cash to fuel growth and reward shareholders with stock buybacks and increased dividend payouts. This is, of course, only going to happen if management is shareholder friendly. There is a quick test to determine how friendly management is to its shareholders, as we discuss next.

Insider Buying

It is my belief that AE is trading at a heavy discount to fair value. What better way to test the theory that this stock is undervalued than to look at the actions of those who know the company best, the insiders?

In the past three months, insiders have purchased nearly $23 million worth of stock at prices above today’s price of $21.37. It’s obvious that the insiders think the stock was undervalued at $24 per share, the price at which the majority of shares were purchased. With the stock sitting at $21.37 now, it must be seriously undervalued. Insiders believe this stock is cheap, and we agree.

Dividend Record and Rate

AE has paid out a dividend since the second quarter of 2004, and has increased it each year, by over 100% in 2005, 45% in 2006, and 30% in 2007. It is likely that AE will increase the dividend again in Q4 of 2007 or Q1 of 2008 by at least 15%. The dividend for AE now sits at nearly 2%.

52-week target

AE shares might take a hit if the economy goes into a recession. If it does, you will still be rewarded with dividends and dividend increases. Management should also seriously consider implementing a stock repurchase program at these depressed levels. With high insider ownership and a shareholder friendly board, this is a likely scenario.

If the economy doesn’t go into a recession, shareholders will be rewarded handsomely by a bounce in this stock, back to its fairly valued levels. Using the industry average P/E of 17.2, AE could see a gain of more than 60% in the next 52-weeks, not including dividends, dividend raises, or an implemented share repurchase program. Buy and hold, and you won’t be disappointed.

Disclosure: At the time of writing, the author of this article did not own any shares of the companies mentioned.

52-week price target: $34, representing roughly a 62% gain (including dividend).