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We've been having a little discussion over on this post about the original purchase, current state, and future prospects of American Eagle Outfitters (NYSE:AEO). The stock is down roughly 50% from our original purchase, which begs the true value investing question: Is it down ... or is it cheap?

American Eagle Outfitters' financials are getting hit on a number of fronts. The consumer has slowed down. Commodity prices are up, leading to higher inventory costs and lower profit margins. Transportation costs are up which is putting additional pressure on the business. Compared to the previous year's Q1, net income is down 44%. The only real ray of hope in all of this is that AEO was able to get most of its $500 million in ARS securities liquid again.

Beware of Slim Margin/Poor Turnover Businesses

If you recall from Phil Fisher on Profit Margins, businesses with slim profit margins will generally fare worse than fat margin businesses during periods of business slowdowns:

If your company doesn't have a "worthwhile" profit margin, it has a problem: When tough times surface (as they always do from time to time), weak margin companies will probably start burning cash rather than generating it.

And as Pakorn Wong pointed out, turnover is just as important as profit margins. An annual profit margin of 10% with 100% inventory turnover is the same as an annual profit margin of 2.5% with 400% inventory turnover.

In the first fiscal quarter of last year, AEO boasted a GAAP profit margin of 13%. This year, the profit margin slipped to 7%. So, slower sales and higher costs are hurting AEO's margins.

Is There Anything Good About American Eagle?

I have to say that, in my opinion, management is handling this downturn well ... if not brilliantly. During the first quarter this year, AEO had an inventory turnover of 143%, compared to 114% during the same period last year and an average of 135% during the first quarter of the previous two years.

What does that mean? It means that, while foot traffic in the stores is down, American Eagle Outfitters is selling stuff faster than it did at this time last year or in the two years prior.

Let's look at the cash burn. Being a clothing retailer, American Eagle Outfitters generates the lion's share of its revenues — and thus, excess cash — during the holiday seasons. In the first quarter of last year, AEO burned through $90 million of cash (excluding capital expenditures). This year, on lowered sales and higher costs, operations ate up just $65 million of cash in the first quarter. For all intents and purposes, AEO had a better quarter, in terms of its ability to generate cash, this past quarter than it did at the beginning of last fiscal year.

With 208.1 million shares outstanding, American Eagle Outfitters has 8% fewer shares outstanding than it did this time a year ago, which means our stake in the company — our share of future cash flows — grew by 8% over this past year.

At the mercy of "The Consumer." Is that bad?

Some people believe that the consumer is dead in the water. So overwhelmed with credit card debt, inflated mortgages, high food and fuel costs, and more, consumers have allegedly stopped spending money on everything discretionary.

Why, then, did McDonalds (NYSE:MCD) report increased sales in the three- and six-months leading up to June 30, 2008, when compared to the previous year? I'm not talking about international sales or currency adjustments: US-based revenues for McDonalds grew 2% this past quarter versus the same quarter last year when cash was allegedly falling from the skies.

If McDonalds isn't the mother of all discretionary spending, I don't know what is.

I'm not saying that the consumer isn't strapped. What I am saying is that we, as Americans, have proven one thing over the past twenty or so years: No matter how bad things seem, we won't take care of our finances and we'll blow money on stupid stuff. We'll buy second-rate cheeseburgers even though we can make them better at home. We'll go to Starbucks, opting to spend $3.50 on coffee each morning instead of stopping in to Walmart to buy a $16.88 Mr. Coffee for the office.

I'm not criticizing. In fact, I'm just as guilty. This past weekend, I bought the entire bar a round of DiSaronno on the rocks because my friends and I were laughing about the commercial. A total waste of money, even if it got a few laughs.

My point is this: For as bad as the news and media make it sound, the consumer — feeling the effects of the credit crunch — is not clamping down to the bare essentials, clothing, coffee, and cheeseburgers be damned. Some people — moreso than in the past — are clamping down. Some had spent their stimulus check before it ever arrived.

Making a Decision on American Eagle

AEO is going through a rough patch right now, but it is not entirely consumer-driven. The company is facing higher costs as it works on launching its new baby stores. Higher transportation and commodities (thus inventory) costs are eating away at profit margins. But the company still reported a 5% increase in sales this past quarter over last year's first quarter.

The business has taken a turn for the worse, but not because of mismanagement or a faltering brand. It is taking an economic beating internally — a beating that may continue for some time.

So, we institute Phil Fisher's three year rule and wait it out. Because it is a cyclical business, we can't possibly judge the value of American Eagle until we get through another full cycle this year. Remember: Regardless of what the stock price does, businesses generally don't change all that fast.

When Uncertainty Turns to Panic

Do I think American Eagle is underpriced relative to its value? Yes. I'm just not sure how much of that pricing is because it is "down" and how much is because it is "cheap." That is, I don't know what my margin of safety is. At some point, a stock becomes cheap enough that your heart races and you can barely sleep because you can't wait to place your order when the markets to open the next day.

American Eagle is not there (for me) at this point, but it is getting awfully close. At some price level, you can look at it and say, "Yep. There's a fat guy."

When will I start worrying that consumers — as a group — are going to clamp down to the bare necessities? They may bail on their mortgages. They may ignore calls from creditors. But until they "just say no" to iPhones, Happy Meals, or Coach purses, I'll keep buying rounds of DiSaronno and looking for blood in the streets — even in the retailers.

Don't be an optimist. Don't be a pessimist. The best returns are made by realists.
Source: American Eagle: Down, or Cheap?