The other day I read Joe Ponzio’s commentary on retailer American Eagle (AEO), and where it stands as one of his portfolio holdings. I owned the stock for a short time earlier in the year – ultimately selling in order to take advantage of the opportunities in the credit default swap market – so the thoughts of a more disciplined holder offer a good contrast in perspectives.

As part of Joe’s analysis into buying the stock, he noted the fantastic growth rate American Eagle has posted over the last decade, and the resulting strong balance sheet – plenty of cash, and no long-term debt. The American Eagle brand is very well-received, and comparable with Nike (NKE) and Apple (AAPL) in terms of its popularity among the younger demographic. All in all, it looks like a good company – though it is a relative newcomer to the apparel retail space, which is known for its constant upheaval and lack of enduring competitive advantages.

American Eagle, like most companies, benefitted from the lending-driven boom that gave consumers much more flexibility with their discretionary purchases. Quantifying such effects are difficult, but with recent same-store comparable sales declines of around 10%, I wouldn’t be surprised to find out that the company slightly overbuilt in some areas, and will need to cut back store count accordingly. While I don’t believe this will be severe, the combination of declining comps and a contraction (or adjustment) in store base is not a good combination for investors. Declining comps force fixed expenses to deleverage and eat up a higher portion of profits, and the flagship line (AE) store base reaching a saturation point is going to pressure return on marginal invested capital, which historically has been excellent as the first-year ROI of a new store was in excess of 65%.

In my original analysis of American Eagle, I was guilty of misjudging the severity of the drop-off in consumer spending, as well as where the spending shifts would take place. As it turns out, the mid-tier consumer quickly moved down-market to Aeropostale (ARO), and the higher-spending consumer is not shifting away from Abercrombie (ANF) to American Eagle quickly enough and with enough purchasing volume to offset the market share losses. This has led American Eagle to heavily increase promotional activity via markdowns and sales incentives, as my email inbox with such offers can attest. While this will undoubtedly pressure near-term earnings, the bigger issue is whether these actions are necessitated by a lack of demand stemming from a shift in how the company’s product is perceived by consumers.

A further source of potential stress for the company is the shake-up taking place on the operational side, with the departure of Chief Merchandiser Susan McGalla. Seeing how McGalla was effectively running the show during a time when American Eagle’s sales were growing at an extraordinary rate, the uncertainty here over the effectiveness of a successor is generating a lack of enthusiasm from the sell-side analyst coverage I’ve read. In all likelihood, this does not prove to be a long-term issue that significantly impacts shareholder value, but it highlights the risks inherent in apparel retail where the brand name is not in the exclusive realm of established designer brands.

This is not to say that there are no bright spots for American Eagle and its investors; the company is very well-capitalized, has a capable executive management team, and plenty of goodwill among customers. The stock is trading at 2.1x book value, and at the end of the last bear market the stock bottomed just under 2.0x – and with the company remaining profitable even in tough times, the stock could breach that mark after one or two more quarters of earnings. While such a valuation doesn’t guarantee a bottom, it does help highlight the fact that AEO in the low teens is a compelling value with minimal improvement in the macro environment priced in. I was early on this stock, as was Joe, but that doesn’t change the fact that apparel retail can be very profitable and American Eagle is one of the better operators in the space. Ultimately, I think Joe’s sticking by the company versus my selling out is a reflection of the differences in our situations; he runs a concentrated portfolio but it is impractical, if not unreasonable, for him to make the kind of bet I made. If I had funds consistent with the need to own 5-10 names, I would likely be buying the stock at or near this level.

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