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Tim Welland
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Tim is a graduate of the University of Michigan, with a degree in economics. He works in the litigation consulting industry and has been investing for a few years. Tim is a value investor, but likes to work in special situations as well.
My blog:
Parkside Value Investing
  • American Eagle (AEO) looks like a good "heads I win, tails I don't lose much" play 0 comments
    Jun 9, 2010 12:31 AM | about stocks: AEO
     Background:
    AEO sells men's and women's clothing from their AE brand and aerie brand stores.  They also sell children's clothing through their 77kids stores.  AE is an established brand, aerie and 77kids appear to have growth potential.
     
    Stats (as of June 6, 2010):
    Market Cap: 2.54B
    Price: $12.14
    P/E: 16.16
    P/S: 0.9 (more on this later)
    Yield: 3.29%
     
    Thesis:
    AEO has taken a beating over the last few days, due mostly to a "poor" guidance issuance.  AEO has been hit, just as over stocks have, by the economy over the last two years, and it's stock has fallen along with it.  However, sales have held up relatively well, and the company remains in great financial condition.  The balance sheet is clean, and cash flows continue to be strong.  In fact, AEO has approximately $1.50 per share of net cash/short term investments/long term investments.  Management has cut back on expansion and CapEx as sales have been hurt.  EPS has fallen in half since 2007.  In addition, the company announced the closure of its MARTIN+OSA brand for older shoppers.  This is expected to cost the company up to $40 million over the next few months.  M+O was losing about $20 million per year for AEO.
     
    For me, AEO represents a very compelling investment opportunity.  AEO is in sound financial condition, and stands to benefit from any reversal in economic fortunes.  In my opinion, there are a number of metrics by which AEO is undervalued:
     
    1.  Subtracting net cash, AEO trades at a P/S of approximately .75.  Any increase in sales would obviously increase the market cap, and AEO has traded at a P/S ratio maximum of 2.8 in recent years.  Even a more conservative ratio of 1.5 would double my money.
     
    2.  By my calculations, normalized EPS last year was approximately .20 per share higher than reported.  GAAP EPS included approximately $40 million in charges that were either one time or are in the process of being dealt with: a one time write down of some assets owned by M+O, and M+O's yearly loss.  After taxes (I calculate this using AEO's last year tax rate of 27% and a more realistice 40%), this represents 11 to 13 cents in incremental income, leading to a potential valuation of $14.95 to $15.35.  In summary, merely normalizing earnings gives you a 25% potential upside.
     
    3.  Lastly, I firmly believe in AEO's products and business, and their ability to turn things around.  A key metric, net sales per avg selling sq ft has fallen from $642 in FY2007 to $519 in FY2010.  If you assume that this can come back up to $575-600, EPS (assuming a 10% net margin, lower than the historical 13%) would increase to $1.41-$1.47.  If P/E stays constant, the stock price could hit $23.50!  If P/E were to decline to 10 (which seems completely unrealistic), the stock price would still be $14.70, a small gain.  AEO's close competitor Abercrombie and Fitch (ANF) trades at a P/E of 34.  I'll let you salivate over that math.
     
    In sum, AEO looks incredibly attractive and I think this is a classic case of the street overreacting to temporary bad news.  AEO is still an attractive business and is very undervalued at current prices, especially when you factor in that $1.50 of your purchase price is going to buy pure cash (and some illiquid investments that I will acknowledge could potentially be removed from this calculation).  And hey, if AEO doesn't move any time soon, I'll be happy collecting my nice 3% dividend for the time being.

    A few other points that I should mention on why I like AEO (more generally):
    1. AEO has a large deferred tax asset, a sign that earnings might increase in the near term (this basically means that AEO is being more conservative in their GAAP reporting than their IRS reporting, something that is a harbinger for higher future net income).
    2. Directors and Officers collectively hold 10% of the company, a nice sign that their incentives are aligned with the shareholders (as they are, themselves, shareholders).
    3. Though they haven't purchased shares recently, AEO's board has authorized the repurchase of up to 20% of the firms shares.


    Disclosure: Long AEO.
    Themes: retail, long ideas Stocks: AEO
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