American Eagle Outfitters Is Cheap Relative to Its Peers

Chances are if you are holding retail stocks in your portfolio, you feel as if the Grinch made an early visit to your portfolio this year.

The poor performance of retail stocks in 2007 has been attributed to the subprime mortgage environment and related credit crisis, the potential for a recession and last but related, reduced spending by an overextended U.S. consumer. However, it is this writer's opinion that both the market and media may be missing a couple of very favorable factors which could serve to reverse the impact of the negative factors on our nation's retailers.

First, employment statistics have not shown any weakness as witnessed by the unemployment rate which continues to stay below 5.0%. While wage growth was higher than expected; productivity gains were also higher than expected. Productivity gains should serve to keep inflation at bay. Secondly, the Fed has continued to pump liquidity into the economy and is now expected to cut rates again this month in response to the credit crisis. Third, the recent 5-year federal subprime rate cap will eliminate the debilitating rate resets until such time as these consumers have received the benefit of 5 years worth of pay hikes. The combination of these more recent factors may well serve to set the stage for improved results at our nation's retail stores going forward. Of course such prognostication begs the question of where to look to play a retail rebound.

When evaluating an industry for a rebound investment, it is always wise to look for the strongest companies amongst the wounded. Under this theory, I screened for companies with low price-to-earnings ratios, combined with insider buys, and found American Eagle Outfitters (AEO) trading around $22 per share. AEO has a trailing PE ratio of 12 and a forward PE ratio of 10. Both measures are lower than its competitors - Aerostopale (ARO), Abercrombie & Fitch (ANF) and Hot Topic (HOTT) to name a few.

Even more interesting were the tens of millions of dollars in insider purchases by the chairman, CFO and others in August and September. A quick look at AEO's balance sheet reveals a rock solid, debt-free balance sheet with $6.60 of book value per share.

While a recent look at AEO's operating performance reveals relatively flat same store sales comparisons, a closer look reveals a 16% increase in November sales. This overall sales performance was achieved with only a 10% increase in square footage driven by a 5-6% increase in store count. As it turns out, the additional growth is the result of two other initiatives: Aerie and internet sales.

Aerie is AEO's new undergarment offering that has been so successful that AEO is now opening standalone Aerie stores. This Aerie line and new store initiative provides AEO plenty of ability to continue to increase retail square footage going forward.

With respect to internet sales, a look at the www.ae.com website provides some interesting information. Per Alexa, traffic at www.ae.com is up 34% over the last three months. During this same time, ae.com's ranking has improved from the 2,420th most visited website to the 1,730th most visited website. Clearly AEO is making significant progress on the web. In early 2008, AEO is expected to launch its Martin + Osa website which should provide continued growth in its internet sales volume.

After performing all this research, the reasons behind management's significant insider purchases become more clear. The combination of new store growth from Aerie, AEO's growing internet sales and performance, and same store sales growth at AEO stores should provide the formula for increased EPS results and expansion of AEO's PE multiple. A peer multiple of 17 on analysts' estimates of $2.09 for next year would put shares at $35.50 as compared to a current $22 share price. Such returns would make us all forget about the Grinch's early visit in 2007.

Disclosure: Author is long AEO.

Comments

[CanadianDollars]

Nice article. I whole heartedly agree. AEO is very cheap compared to its competitors.

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[pprimo]

I made 40% on AEO last year when it was this low. Have loaded up. But, I wonder why everyone thinks they should be in the underwear business. That does concern me a bit that a teen retailer sees their future in underwear. Have not really looked hard at exactly what they are doing in that regard.