American Eagle Outfitters' Wings May Be Falling Off

Over the past 10 years, the eagle has soared into the stratosphere. From about $1 a share in 1997, American Eagle's (AEO) stock price rose to over $30 in 2007. Like poor Icarus, who flew too close to the sun and ended up in the Icarian Sea, American Eagle's wings are now damaged, and its new flight pattern is unfortunately down.

American Eagle's new same-stores sales were just released. Down 12% from last March. Total sales were down 2%. Ouch! But wait, the numbers get even worse. AEO is now lowering its earnings guidance to .18 -.20 a share for the first quarter of 2008. This is about 50% less than last year. Also since last March, AEO has bought back about 8% of its outstanding shares, so actual net earnings will be down about 55% from last year's Q1. Margins are obviously getting squeezed big-time.

What should also concern investors is that just one month ago, AEO published an estimate of .26 cent a share for the first quarter. This new estimate is a 27% reduction from AEO's estimate from just 30 days ago. This calls into question whether upper management really knows what is happening on the ground.

This article from just a few day ago presents the bull case for American Eagle. The author did a great job of showing how well AEO has done in the past. The data shows AEO's remarkable growth from 1998 to 2006.

But as stated above, American Eagle's stocks price had risen 30x during that time as well. One cannot ignore the last 4 quarters when trying to predict future cash flows, IMHO. Here is a chart of what I call earnings velocity. This is the past 4 quarters of AEO's net earnings' year-on-year growth rates. I am including AEO's most recent estimate for Q1. (Click to enlarge.)

As you can see, earnings growth has fallen from a 5-year average of 33% to flat, and now for the first quarter of 2008 a 55% reduction in net earnings. I believe this trend will continue. Consumer spending during this US recession will be soft. Also Aéropostale, AEO's teen competitor, posted 14% sales increase, with same-store sales increase of 2.5%. This shows that American Eagle is losing market share as well, and underperformed its peers.

While the new baby eaglet's concept looks promising, the more upscale M&O concept has been a failure and a major drag on earnings and cash flow. Free cash flow for the year ending Feb. 2008 was about $270 million, versus last year's amount of $525 million - a decrease of 50%. I estimated AEO's Q4 cash flows from its balance sheet since the eagle failed to report cash flows in its earnings release. A quick note to all public firms - always report your cash flows with your results!

As if American Eagle needed any more bad news, their short-term investments balance in now a question mark. As of year ending Feb. 2008, AEO had $418 million of investments in auction rate securities ["ARS"]. This ARS amount is on the balance sheet as a current asset in "short-term investments." But since then, other retailers like Best Buy (BBY) have moved their ARS balance out of short term investments and into long-term investments (out of current assets). AEO may be forced to do the same, lowering its current ratio. AEO has also stated that future impairment charges may be needed for these ARS's.

My estimate for AEO's current year is now for earnings per share of $1.30. My free cash flow estimate is $200 million for this current year. This would give AEO a free cash flow yield of 5.8%. This yield is too low for me to invest in a firm with declining fundamentals. My current discounted cash flow value for AEO is now 2.8 billion, or 13.75 a share.

Longer-term, I hope the eagle still has some wax left on its wings, but if American Eagle gets wet, don't blame me or Daedalus.

Disclosure: Author has no current position in AEO.

Comments

[Dan Jacome:]

Nice Joyce reference, we like BKE -- look for an article from us within days. We're looking for an entry in low 40s

2008 Apr 11 06:06 PM

[forest:]

The cash flow numbers you cite are somewhat irrelevant. You need to adjust the prior year's free cash flow downward to account for the "Proceeds from sale of trading securities". Otherwise your prior year cash flow is overstated.

Looking at EBITDA-CapEx as a more comparable metric, you'll find that 2007 was actually up about 2%. I know that doesn't include some relevant working capital outflows, BUT many of those outflows were for inventory builds at the new concepts and we just can't tell if those are going to be successful yet. In any case, you either need to give them credit for sales growth or some slight working capital inflows in the next year or two if they decide to exit these concepts. They are going to get some future value out of the cash spent on inventory and new stores.

On that topic of new concepts, I will concede that it is a bad time to be spending all this CapEx on new stores ($250mm in 08). They won't be able to judge long term potential in an environment like this one, especially with an adult concept (adults are even less likely than teens to spend money on clothing during a recession). Furthermore, they're going to be able to get better lease terms by waiting and it just makes sense to tighten the belt when times get tough so that there is flexibility in case things get really bad.

There are big economic headwinds, but this company looks somewhat cheap to me. I'd love to see what assumptions you used for sales and margins to get to your rock bottom DCF price. This company has $3/share in cash and securities (the ARS are real securities which will either eventually be redeemed by issuers or held with higher interest rates). Additionally, you could cut margins by 40% and stall growth, and as long as CapEx was reigned in (no smart managers would keep spending if the environment remains weak), they could produce cash flow north of $200mm. That means they would be trading between 10-13X free cash flow (market cap adjusted for excess cash), or a FCF yield of 7-10% in a nearly worst case scenario. My opinion is that their margins and sales won't suffer that drastically, although they should fall some for sure.

Teens and parents will want fashion at decent values in these times, and that's what AEO offers (unlike ANF whose price points are much much higher). Many teens work part time jobs and spend most of their discretionary income on clothes and entertainment, not food/bills/rent/etc. I would think that should lend some stability to the business. Just my two cents...

2008 Apr 11 07:13 PM

[William Ellard:]

Forest;
Thanks for the post. The cash flow/ ebida numbers you present were in line what I was forecasting several months ago. At that time my DCF value was about 24. Since then AEO's management appears to be out of touch with trends, markets, and the current economic recession the US is in. Also I should note, I believe that the US economy is in worst shape than most other economists, and analysts.

I also thought AEO would be more recession proof than other retailers. But look at BBY's 2008 estimate, and it appears they will outperform AEO as well as AEO main rival ARO.

I use 5 different metrics of cash flow, never EBIDA. Check out this blog from my CAPS page about my DCF modeling:
caps.fool.com/Blogs/Vi...

I am not sure what you mean by your above reference about prior cash flow being too high? The 525M number?? I usually strip out balance sheet changes for cash flows, but did not do that for the year ending Feb. 07 - AEO had 130M of increased liability padding their cash flow to get the 525M of free cash flow. I should have back that out, so Free clean cash flow would have been closer to 400M that prior year.

For the next 3 years, I have AEO at around 200m per annum of free cash flow. After that I have lowered my earnings, and cash flow growth rate down to 6%. At the same time I have increased my discount rate to 9% for all my models. These changes have lowered my current DCF value of AEO from 24 to 14. I may be grading AEO a bit harshly, but I have many other sectors and equities I like better.

2008 Apr 12 12:58 AM

[brombonz:]

Beneath the numbers, let's look at the basic businesses.

The parent chain is essentially maxed out domestically. How much promise there might be for it overseas is a question scarcely raised, let alone argued. M+O doesn't yet show much (and ANF's lack of success with its Ruehl stores, aimed at the same demographic, isn't encouraging). I visited my first M+O store last month, at the Mall of America, and was startled by stratospheric price points -- any number of triple-digit items, including a tee-shirt (okay, maybe a "pullover" at $148 (if I remember correctly). It doesn't seem the right time for it, as now configured, really to take off. Their imitation of ANF's kids division is still pie in the sky; ANF has had a checkered history with "abercrombie" They shuttered stores in 2004 and 2005 (dropping from 175 to 161) as returns had become disappointing, only to add 17 in 2006 and 22 last year, encouraged by a string of positive double digit comps. The times being what they are, its sales have gone sour again.

It seems to me the only really imminent prospective payoff for AEO is the aerie concept, but whether the tail can propel the whole donkey is another question.

2008 Apr 12 10:26 AM

[kmitch35:]

I have no idea what all that means. All I know is that my 5th grade daughter and her slew of friends are just waiting for the day when they will be big enough to wear AEO. Then, I go pick up her 6th grade friend from school and see everyone wearing an AEO sweatshirt - not aber, hollis, gap, or old navy. AEO is one of the only brands that my 5'10", 16 year old niece wears because they carry tall at a decent price. You think teens don't have much money to shop? Perhaps that's true. But again, all those middle school kids that were wearing the AEO sweatshirts were all talking on cell phones - 6th-8th grades and they don't have after-school jobs. This is rural Texas, dairy country, tractors and pick-ups. Gas is over $3.00 a gallon and I don't see anyone trading their Suburban in for an economical car. You can't haul around 3 kids, 6 bags of shavings and 4 bags of feed in a 45 mi/gal car. AEO has a decent product at a decent price and a whole lot of kids like it and that means a whole lot of parents will be driving them to the mall this weekend in their Suburbans right after they unload the feed from the back. Just my very down to earth, under-analyzed, common 2 cents.

2008 Apr 12 07:18 PM

[steve west:]

I would love to see how you arrived at your DCF model. what are you using for WACC since AEO has no debt.. what are you using as terminal growth. MY DCF model calls for over 30. I think your numbers are biased to further your position.
I think AEO has bottomed out and I firmly believe that earnings will only get better from here. you buy when all the bad news is out..

2008 Apr 13 09:09 PM

[William Ellard:]

Steve;
My new WACC or discount rate is now at 9% for AEO. I feel teen fashion, and consumer retail, are a bit risky, and I like to build a level of caution in my DCF models. I have AEO real growth at 6-7%.....
I have no position in AEO. I have been an AEO investor for years. I have never shorted, or owned puts on AEO. I would love to be wrong and see AEO go to 30.

2008 Apr 14 01:02 AM

[CrossProfit:]

bellard,

We do follow AEO and though we have not posted an e-line on the CrossProfit site for AEO the CP consensus is that we have not yet seen the bottom for AEO in 2008.

Where that bottom is/will be is non-consensus, though the range is as low as 11+ and the high end is 15+.

In 2007 the CP consensus was that AEO would bottom out at 23 whereas in December the actual low was around 20. So far, the high this year (2008) was 23+ (on a weekly close basis), very much in line with our expectations.

We do not see AEO touching 30 or even 27.50 in 2008.

Thanks for sharing your method and analysis.

consensus CrossProfit

2008 Apr 14 07:03 AM

[John from B...:]

All valid points. Some thoughts:

1). AEO could be a classic value play, but may go lower before finding a bottom. Women's apparel is very soft now for all. Denim may be flat for awhile -- or at least looking for new leadership in style. Consumer spending can be expected to remain subdued through 2008.

2). AEO has no long-term debt, yet still has an extremely robust ROE. Is cash about 800 million with about half of that tied up in the auction rate securites? Is that about $4.00 per share? Wow! I think the auction-rate issue will clear within a year or so. Having no debt in a soft environment sure is nice.

3). Will unsuccessful new store concepts rollouts wastefully burn through a few hundred million dollars before plugs are pulled or will the concepts succeeed? Don't know the answer here. Shareholders must hope that mgmt. remains rational here.

4). Will profit margins shrink due to consumer softness, weak dollar, Chinese inflation...yes, one would expect this, which will impact ROE. IS this already built into the price...mostly, it seems so.

5). Could AEO morph into a slower growth company with a great dividend.? Might happen, but Wall Street doesn't like these kind sof companies. Sure throws off a lot of cash.

6). Near-term valuation -- Maybe trading in a $13 to $20 range, depending on quarterly eanings. I have a block at average cost of $18. Would nibble again in the next few months if I see 15.

7). longer-term valuation -- $2.00 of earnings and a 16 PE could mean $32...if AEO can exceute. Could very well happen with three years

8). Does my 12 year-old daughter like this store? Very much so. She also likes ANF with Hollister. She tells me AEO offers better pricing, particulary on jeans. The kids like both AEO and ANF. The embroidered brand-lettering and the printed logogs give them that sense of belonging. My duaghter tells me AEO offers better fit to more body types than Hollister.

So there you have it. Yes, some negatives in the overall apparel market and with the company. Positives are the cash, lack of any debt, great ROE, share buy-back program, low p.e, great brand-loyalty from the kids.

Good company to watch.

2008 Apr 18 01:46 PM