American Eagle Outfitters (AEO)

• Outstanding track record with positive net income & free cash flow generated in each of the last 10 years.
• Best-in-class retailer led by solid management.
• Barring liquidity issues, the company’s balance sheet is unencumbered and large enough to support expansion and returning cash to shareholders via dividends (2% yield) and buybacks (41.3M shares authorized through FY 2010).
• Even as their main AE brand may be facing consumer fatigue (Aeropostale appears to be taking share), the new aerie brand could do something similar to the “tired” Victoria’s Secret brand among younger women. The company senses a growth opportunity in this market and is aggressively pursuing it by opening 80 aerie stores in 2008 along. For reference, Victoria’s Secret generated $7B in sales & $1B in operating income in 2006

New brands (Aerie, Martin & Osa, 77Kids) do a better job segmenting their market and management has done grown them conservatively to reduce their risk to the economy. Martin & Osa especially has the most potential with only Banana Republic as its main competitor, which is driving GPS right now with its higher end merchandise.

In their flagship stores, AEO discounted heavily over the holidays, but did so to effectively clean out inventories and can go forward with lower carrying costs. Nevertheless, it was still able to uphold a fairly healthy 12% operating margin in its last quarterly, compared to around 10-11% with its competitors.

Plus, the discounting may help them take away market share from traditionally cheaper brands (Old Navy, ARO) with better quality and brand name and from more expensive ANF by offering a better price point.

AEO currently has great cash flow in how its current stock price is only five times trailing 12-month cash flow, which is less than comparative retailers that typically trade at 7-8 times cash flow. AEO also currently has no debt outstanding, despite its expansion in stores each year, with total cash of $640 million. This amount of cash is above average, representing more than $3.25 per share, which is relatively high compared to AEO’s average price of $14 per share. This cash could be used to support a leverage buy out and with recent acquisitions, such as J Crew and Gymboree, private buyers have been especially warming up to specialty retail targets.

Albeit startling, today's youth is captivated and motivated with being cool. With that said, a part of being cool and accepted is to wear preppy cloth from companies such as American Eagle and Abercrombie & Fitch. The other day I was visiting a middle school and a majority of the students had attire from a preppy cloth company, including American Eagle. Thus, I believe the volatile state of AF's stock value is a result of the season at which it has occurred. However, the spring season should stimulate the value into a positively linear fashion.

After reading the bears for AE stocks, I have an addition to my previous bull statement.

Although consumer spending is decreasing, I have discerned a noticeable drop in the prices of American Eagle products. Cheaper products are thus more appealing to the more frugal-minded consumers, and should result in a decent performance in AE stocks.