American Eagle Outfitters Competitive Moat Check (AEOS)

| About: American Eagle (AEO)
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This is one in a series of articles examining Joel Greenblatt's Magic Formula for picking value stocks. Today's stock: American Eagle Outfitters (AEOS).

I am pretty familiar with American Eagle Outfitters' stores. My old winter coat came from their store. However, I not as familiar with their business.

The first thing I want to find is whether American Eagle’s business can generate value by sustaining a long-term competitive advantage. In order for a business to do this, it needs to stave off competition with a wide moat. In order to determine if American Eagle Outfitters has a wide moat to protect it from competition in the future, I took a closer look at American Eagle Outfitters.

As a first step, I ran though the “Big Five” numbers Phil Town uses as a first step to check for a wide moat. First, I checked the return on invested capital (NASDAQ:ROIC). Since I’m just doing an initial review of this stock, I’m going to rely on online resources to quickly check these numbers. According to ADVFN, ROIC is currently 22.1 percent and has averaged 17.9 percent over the past five years. That check out good since it is above the 10 percent target.

The next factor is the growth rate of equity. I do this by looking at the growth rate of book value per share over the past five years. According to the financial figures on ADVFN, book value per share has gone from $2.61 in 2001 to $6.45 per share. That is a 25 percent increase in book value per share (=(2.61/6.45)^(-1/4)). This is well above the 10 percent target rate I’m looking for.

The next factor is sales growth. American Eagle Outfitters sales growth has been over 13 percent over the past five years and the current rate is even higher than that. These are some impressive growth numbers and well above the 10 percent target.

The final factor is the growth rate of free cash flow. American Eagle Outfitters free cash flow has grown from -$23.9 million for 2001 to $272 million for 2005. This is well above the 10 percent growth rate I want to see.

Given that all five factors are above 10 percent, there is a good possibility that American Eagle Outfitters has a wide moat. I’ll have to dig a little further to see if I can figure out what kind of moat that American Eagle Outfitters has. A good place to start looking is in the 10-K filing.

American Eagle Outfitters designs, creates and sells their own brand of clothing targeted at 15 to 25 year olds though their 846 stores and their website. Their competition includes The Limited, The Gap, Abercrombie & Fitch, Pacific Sunwear, Hot Topic, Aeropostale, and The Buckle. Seeing the Gap in that list reminds me of a time when people thought Gap had a sustainable competitive advantage. The Gap is no longer the “hot” store to shop in and I’m concerned that American Eagle Outfitters will face the same fate in the future.

I think the key to American Eagle’s past performance has been its ability to closely follow fashion trends in the youth market without trying to lead those trends the way Abercrombie & Fitch does. I think this enables American Eagle to sell trendy clothes at cheaper prices using their own brand. I think this is more of a sign of good management versus them having a wide moat. American Eagle Outfitters definitely has a competitive advantage, but I’m not confident that it is durable competitive advantage that is needed for a company to have a wide moat. What are your thoughts?