AEO Analysis

AEO announced its second quarter results ending on May 3rd 2008 recently. The environment for retail has soured with the downturn in housing and the increase in gas prices, inflation.

AEO is now expected to earn about $1.41/share this fiscal year and things should improve around 2010 when the issues with women's apparel and Martin and Osa brand is fixed. Also, one should look at new product lines coming up. The American Eagle brand has reached saturation ( or about to reach saturation ) so all the cash flows must come from other brands.

Let us look at the numbers for a moment. While the top line increased by 4.5%, the bottom line decreased by 44%. ( excluding interest income ). The decreased number of shares helped hold the earnings per share somewhat respectable in this environment. The company has focussed on holding market share in this difficult period.

Management has provided guidance that the second half of the year is more likely to be like the first half without much improvement.

Let us look at some of the other things the management did. The company had 703 million dollars in cash and equivalents. In a dumb move, the company decided to hold some of the cash in auction rate securities which are illiquid. It is a move the management made most likely to get higher yield, yet management found that most of these securities are illiquid in the absence of other bidders. Now the company is forced to keep its securities till maturity. This ties up valuable cash that can be used for stock purchases held till maturity. The risk of default of the counter party is also unknown.

Deducting the 703 million dollars from the market cap, the company has 2.3 billion in market cap. ( ofcourse, this is assuming the auction rate securities will mature and can come into hand). The cash flow without including capex is around 490 million. The capex number is expected to drop next year which should bode well for this stock.

The management should aggressively buy back stock at these levels since the majority of stock buy back happened in the mid twenties. Instead of deploying the cash in dubious investments like ARS, stock buy back will provide most value for the stock holders at this time.

I still believe that the company's stock is attractively priced. The company carries no debt and has improved its inventory management. The company ships products in sixty+ countries via the internet. The gift card business provides about 4 million dollars ( annual ) revenue. If the company executes well and buys back stock, we can easily see this issue in the high twenties or low thirties in two-three years time.