The last year has not been a good one for American Eagle (AEO) shareholders. Shares are down 45% since this time in 2007, which I believe is due to the stock being unfairly caught on the wrong side of a cyclical sector rotation. With the company’s unveiling of 77kids - its new concept – today, the stock bounced slightly on that news and some improved visibility on the earnings front.

AEO has closely followed the trajectory of Starbucks (SBUX) in more ways than one: both core brands have continued to perform well, although an unreceptive investment community has halved both stocks in value over the last year. But one major difference lies within: SBUX was very richly valued when it began its fall toward average valuation at 50x earnings, whereas AEO was already modestly priced and has now fallen into the bargain bin.
Full year estimates for AEO place the company earning $1.80/share, with a loss of 16 cents coming from Martin + Osa. Adding that back, and deducting the $3/share in net cash from the current $19 stock price, gives an adjusted P/E of 8x core earnings.
Typically I wouldn’t give any weight to that kind of pro-forma analysis, but Martin + Osa should have a short leash and if a turnaround isn’t imminent within the next two years, I believe American Eagle will move to close the stores and focus on other opportunities like high-margin accessories. I’m not a fan of the M + O concept and feel American Eagle went too far in extending their reach there at the present time, but I don’t anticipate the segment becoming a perpetual drag on earnings. Further, there are enough growth channels through aerie, AE.com, and internationally (Korean Eagle, anyone?) that overall earnings power should continue to expand at a reasonably high rate (conservatively, high single digits) for years to come.

As for the 77kids concept announced today, I’d guess that it will do good but not great – CEO Jim O’Donnell knows kids clothing and this seems to be a personal goal of his – but I don’t see the natural extendibility of kids clothes relative to something like aerie, where there already exists a built-in customer base. At the same time, this is all going to be incremental revenue and bringing customers into the American Eagle fold early could aid the AE brand as they mature and move up. Next question, of course, is when we get a “tween” brand from American Eagle to bridge whatever gap exists in the brand portfolio for 10-15 year olds…

The big investment issue here is, as it frequently is, when to buy. I’ve watched the shares make that rather ugly descent for the better part of a year now, and while I became very interested around $23 I’m still waiting to pull the trigger - something I might do before this month is out. In terms of catalysts, I see two related ones developing:

1. Retail sector rotation
2. Economic stimulus/bailout

While I’d never speculate on a situation that required those things to happen, the fundamentals are sound here and I really see this as a realization of value problem. What will cause that to occur? We have the slowing economy, and that has led to heavy selling of a wide array of retail stocks. As the economy troughs, however, retail should begin to outperform as the growth estimates come up and the sector catches some of the general enthusiasm that is so absent right now. Given that this downturn has that slow-motion trainwreck quality where everyone sees it coming, a recession already looks baked into AEO’s stock price – plus, the time to buy retail is when the economy looks to be doing poorly. So, you say, there have been widespread economic concerns since the middle of 2007 – agreed. Now, however, policymakers seem desperate to do almost anything to avoid a recession. Do I necessarily agree with that? No. But once you have the Fed slashing rates and Congress offering hundreds of dollars in tax rebates to tens of millions of families, you have the recipe to reignite confidence and spending. It won’t be immediate, but it will be visible and oversold sectors dependent on the consumer (i.e. retail) will rally ahead of the actual economic recovery.

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My thesis on American Eagle (AEO).

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