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No. of Recommendations: 13
American Eagle Outfitters is a 15 to 25 year old core customer retailer. They sell to both boys/girls and men/women.
Go to the website:

and you will see five very attractive people and a banner for $29.50 jeans. Denim has been very hot and the homepage is attractive. The website is easy to navigate and the clothing easy to find by type and the prices are clearly marked appear quite reasonable Most of what they sell is wonderfully crumpled, destroyed and casual It looks comfy and trendy at the same time. It is easy to see the appeal.The looks can be minimal shorts and tees to layers of undershirts, tees, polos and blazers. The look is very focused and you wonder how they will respond to a shift in taste. Continue to keep the relaxed destroyed denim or move to what ever is next? They are planning to open a new concept store. I think there is room for it. The chain now has a very narrow range of product. They could easily move into something a little more formal or preppy or “older”.

During Fiscal 2004, the Company announced plans to develop a new brand (the "new concept") that will target a different demographic than the American Eagle brand. The Company currently has creative and operational teams in place and we expect to open test stores for the new concept in 2006

Seems like a reasonably good idea. I had a chance to compare them to Abercrombie and Fitch(on line only) and the clothing is remarkably similar. ANF tends to be a whole lot more expensive. And the homepage has a half naked very attractive 20-something male model--far more sexy than AEOS. As far as the clothing is concerned, apparently the more “destroyed” you want your denim with paint and abrasion, the more you are going to pay especially at ANF where a pair of destroyed jeans can run $148 compared to $29-$39 you will pay at AEOS.

AEOS does not comment directly on the type of mall they are looking for in expansion other than to say they are flexible and consider urban areas, enclosed regional malls and lifestyle centers as suitable. There are different classes of malls and the best class “A” is around 900 total properites. At 846 stores currently, AEOS will have to consider a variety of types of retail space to expand. I don't know if class “A” space is important to them

They are expanding existing stores from 4000 square feet to 6000 square feet. If they maintain current sales per square foot and keep up recent levels of growth of sales per square foot, this alone will increase revenue.

From the following table check how number of net new stores is slowing year over year. My one concern beyond their response to changing fashion trends is how close they are to fully grown. In 2004 gross square footage increased 7% and in 2003 it increased 11%. The 2003 gross square footage increase accounted for all of the net sales increase as same stores sales declined due to lower number of transactions per store and lower retail prices.If growth of future new stores is curtailed by AEOS reaching saturation levels then any decline in pricing power, customer numbers and number of transactions will have a brutal impact on sales. They may not have as much room for expansion in the future to offset declining same store sales.

Fiscal Fiscal Fiscal Fiscal Fiscal
2004 2003 2002 2001 2000

------ ------ ------ ------ ------
Stores at beginning of period 805 753 678 554 466
Stores opened during the period 50 59 79 127 90
Stores closed during the period (9) (7) (4) (3) (2)

------ ------ ------ ------ ------
Total stores at end of period 846 805 753 678 554

All stores are leased.

The fiscal year 2004 was a turnaround year for AEOS. As they say in their own inimitable 10K-speak:

Fiscal 2004 was a record year. Our merchandise assortments were fashion right and clearly focused on our target customers. Strong full-priced selling led to significantly reduced markdowns which drove our earnings improvement throughout the year.

Their merchandise connected with their customer powerfully and the revenue and price per share climbed to record highs. The first half of 2005 was more of the same.

A look at some financial results


PE TTM diluted 14.4
PE TTM basic 13.9
P/BV 4.88

Through FY 2004(ends Jan 05) growth in revenue, net and EPS were strong and margins improved dramatically. The company commented that they had less merchandise liquidated below cost than normal and had very little in the way of markdowns.

Much improved full price inventory sales in 2004

Related Non-Related Total
Party Party

-------- ----------- --------
Fiscal 2004
Marked-down cost of merchandise disposed of via sell-offs $ 147 $ 15,633 $ 15,780
Proceeds from sell-offs 148 15,273 15,421

-------- ----------- --------
Increase (decrease) to cost of sales $ (1) $ 360 $ 359

-------- ----------- --------
Fiscal 2003
Marked-down cost of merchandise disposed of via sell-offs $ 12,924 $ 23,538 $ 36,462
Proceeds from sell-offs 13,256 18,688 31,944

-------- ----------- --------
Increase (decrease) to cost of sales $ (332) $ 4,850 $ 4,518

Cost to sales was $359K in 2004, down from $4.5 million in 2003. This is amazing improvement and shows the remarkable demand for their product.

The following annual magins and growth will give you an idea of why the stock did so well in 2004 and early 2005. Growth was astounding and margins increased impressively.

AEOS through 2004 annual ending 1/30/05
Jan Jan Jan Jan Jan
2005 2004 2003 2002 2001

Growth, revenue 31.1% 3.8% 0.8% 25.5% ---
Growth, gross income 59.7% 1.6% -1.2% 25.5% ---
Growth, operating income 172.1% -16.1% -4.6% 13.6% ---
Growth, EBIT 171.1% -16.1% -4.7% 10.7% ---
Growth, net income 156.7% -16.6% -5.6% 12.5% ---
Growth, Basic EPS 151.7% -16.0% -5.7% 9.5% ---
Growth, diluted EPS 147.3% -16.1% -4.2% 10.0% ---
Gross margin 46.7% 38.3% 39.1% 39.9% 39.9%
Gross operating margin 19.3% 9.3% 11.5% 12.1% 13.4%
Net margin 11.3% 4.2% 6.4% 7.7% 8.6%
Growth, SGA 8.4% -3.0% 27.2% ---
Tax rate 38.9% 38.6% 38.3% 37.6%

Sales per square foot and comps by fiscal year

2004 2003 2002 2001 2000
Comparable store 21.4% (6.6)% (4.3)% 2.3% 5.8%
Net sales per $ 504 $ 420 $ 460 $ 516 $ 558
average selling
square foot

2004 2003 2002 2001 2000

Total selling 3,709,012 3,466,368 3,108,556 2,705,314 2,092,864
square feet at
end of period
Net sales per $ 412 $ 343 $ 374 $ 417 $ 448
average gross
square foot
Total gross 4,540,095 4,239,497 3,817,442 3,334,694 2,596,863
square feet

Sales per square foot increased 20% in 2004 after declining in 2003. Does this give expansion plans a few more years to play out? I have not seen an upper end of number of stores they hope to have in the end. They are increasing square footage by almost 50% in selected stores by remodeling.

Comps were great in 2004. This was a turnaround year for them and the price per share reflected that. At the end of 2004 they had 846 stores and no new concept stores They do say they are working on a new concept to be launched in 2006. That could allow them to double up at existing mall locaations if the stores definitely segregate the core customers.
AEOS has 69 stores in Canada in 2004 and will increase that to 80. I haven't seen an estimate of store openings for 2005-2006.

Inventory turns seem to be slowing as of the last quarter.The average for AEOS has been a bit under 2 months so they are definitely slowing. Inventory levels are also increasing(no surprise) Same store sales declined quarter by quarter in July and August. No wonder inventory is stacking up

7/05 4/05 1/05 10/04
Days Inventory 88.4 48.1 46.7 74.0
Growth in inventory 48.2% 11.4% -32.7% 20.7%

Average days inventory on hand 4 years 53.1

Thie following monthly comps show the remarkable turnaround in 2004. Starting in July they became very hot. That continued for a year. We have to ask ourselves a couple of questions. Is the denim casual distressed look playing out? Is the consumer finding too many other calls on his or her dollars and has less to spend on clothes? Too much competition? No moat? The winding down of the retail sector as the easy money of the last 2 years of recovery gets spent?

Comps for the last 20 months

American Eagle Outfitters
08 07 06 05 04 03 02 01
11.8 17.1 28.0 17.1 20.0 29.2 32.4 22.0

12 11 10 09 08 07 06 05 04 03 02 01
32.8 24.3 31.7 22.7 26.6 21.7 8.7 11.4 8.3 7.6 15.2 0.6

Quarterly growth in income and margins

AEOS thru Q2 2005
Jul 05 Apr 05 Jan 05 Oct 04 Jul 04

Growth, revenue 13.1% -26.1% 22.0% 21.7% ---
Growth, gross income 2.6% -31.9% 37.4% 44.5% ---
Growth, EBIT 0.0% -50.3% 91.4% 84.9% ---
Growth, net income 5.1% -45.1% 73.4% 83.5% ---
Growth, Basic EPS 4.4% -46.5% 70.9% 81.7% ---
Gross margin 44.4% 48.9% 53.1% 47.2% 39.7%
operating margin 16.8% 19.3% 29.1% 19.0% 12.3%
Net margin 11.3% 12.2% 16.4% 11.5% 7.1%
Growth, COGS 23.1% -19.4% 8.2% 6.6% ---
Growth, SGA 5.9% -7.2% 0.1% 32.0% ---
Tax rate 37.8% 39.0% 38.8% 39.1% 38.6%

Disregard April as that is a comparison to the 4th quarter which is a large part of the annual income. We will have to wait until the end of January for the 2005 4th quarter. If it is disappointing, AEOS may have further to fall. Back to school and Christmas are going to be very important numbers after their weaker than usual summer.

Historically, our operations have been seasonal, with a significant amount of net sales and net income occurring in the fourth fiscal quarter, reflecting increased demand during the year-end holiday selling season and, to a lesser extent, the third quarter, reflecting increased demand during the back-to-school selling season. During Fiscal 2004, the third and fourth fiscal quarters accounted for approximately 61% of our sales and approximately 74% of
our income from continuing operations.

What we can see is that the second quarter ending in July showed slowing growth declining margins and a big jump in COGs which may mean that merchandise was being marked down. They have been maintaining and building margins because the inventory does so well it does not undergo massive markdowns. Is this a sign that denim distressed casual is not as popular as it was? Since same store sales are also down in July we might conclude that customers are not coming in the doors in the same numbers and transactions are smaller. This may be temporary in which case AEOS at current price may be a good buy.

A word about stock options and shares outstanding

The company has authorized share buybacks and bought a fair amount in 2002, a bit less in 2003 and none in 2004. Perhaps the 2004 inactivity was reasonable in light of the very high price per share. They split 2:1 in March 2005.
Shares outstanding are 154.12 million and insiders own 14% There were 139 million outstanding in 2001--diluted at 2.5% per year.

On February 24, 2000, the Company"s Board of Directors authorized the repurchase of up to 7,500,000 shares of its stock. The Company did not purchase any shares of common stock on the open market during Fiscal 2004 as part of this stock repurchase program. The Company purchased 80,000 and 2,280,000 shares of common stock for approximately $0.6 million and $17.8 million on the open market during Fiscal 2003 and Fiscal 2002, respectively.

Options exercised in 2004 were 7.1 million. This is not too surprising since AEOS was trading at all time highs.There remain 13.5 million outstanding or around 8% of shares outstanding. The value is $6.43 or $82.4 million (54¢ per share)
Tax benefit was $28.8 million
The compensation in stock for 2004 was $25 million ($1.3 million in 2003)

Used in calculating value of options

For the Years Ended

January 29, January 31, February 1,

2005 2004 2003

----------- ----------- -----------
Risk-free interest rates 2.9% 2.6% 4.6%
Dividend yield 0.48% None None
Volatility factors of the expected market price 31.4% 50.3% 62.9%
of the Company"s common stock
Weighted-average expected life 6 years 5 years 5 years
Expected forfeiture rate 13.6% 11.5% 10.2%

Debt in rent
Retailers have an enormous debt burden off the balance sheet represented by their lease obligations.

Fiscal years: Future Minimum

(In thousands) Lease Obligations

2005 $ 135,410
2006 135,810
2007 132,950
2008 129,295
2009 121,059
Thereafter 327,896

Total $ 982,420

Total rent expense 2004 $ 142,560,000
Debt value of leases $941.4
EBIT $457 (difference $9.41 million)


Just a few examples to see how some of the last prices quoted on Friday compare to calculated values.

From the CBOE last price

Jan06 25 calls $5.00 to $3.00 Jan06 25 puts $0.70 to $2.10
Jan06 27.50 calls $1.65 to $2.45 Jan06 27.50 puts $3.80 to $2.35
Jan06 22.50 calls $10.00 to $4.40 Jan06 22.50 puts $0.40 to $1.35
Jan06 30 calls $0.90 to $1.25

Feb06 25 calls $ $4.80 Feb06 25 puts $1.50 to $2.50
Feb06 22.50 calls $8.90 to $5.00 Feb06 22.50 puts $1.45 to $0.90

Calculated value of options

Jan06 25 call $2.55
Jan06 25 put $1.82
delta 0.59

Jan06 27.50 call $1.51
Jan06 27.50 put $3.25
delta 0.42

Jan06 22.50 call $4.04
Jan06 22.50 puts $0.84
delta 0.76

Feb06 25 call $2.94
Feb06 25 put $2.09
delta 0.60

Feb06 22.50 call $4.38
Feb06 22.50 put $1.08
delta 0.75

Intrinsic value of AEOS

15% growth 3 years
transition 3 years
3% stable growth
beta 1.5

present value of FCFE high growth $5.11
Present value transition $5.04
present value terminal price $24.74
Value of stock $34.88

At 10% it decreases to $31.48

Neither price reflects the debt value of leases. I have to admit I am still struggling with a way to include debt in a DCF. Its not really helpful to deduct it from the net income in one lump sum, because it is not really money going out the door in the current year and unavailable to shareholders. And the current years rent is deducted as operating expense so subtracting it again would not be right. Any ideas?

AEOS may be slightly undervalued currently.

A synthetic long with Jan06 25 call looks a little overvalued with the lowest last price at $3. My calculations say its worth $2.55. In fact all the calls look pricey if my spreadsheet can be trusted

The Jan06 25 put OTOH looks like it could be sold for some decent return if the higher last price of $2.10 were to hold up until the market opens. Might be worth looking at.Some of the other puts look like they might be worth looking at too.

This is the first time I have actually used this spreadsheet to value short term options so its an experiment of sorts. Would appreciate any input on strategies and payoffs.

As far as actually buying AEOS, I am undecided. At current earnings and with a pretty conservative estimate of future growth looks like you could expect the stock to appreciate.
The unknown is the state of the consumer's personal finances(which are not looking great at present) and the viability of AEOS fashion sense. Denim has had a pretty long run for fashion trends and no doubt something else is going to knock it off the top performing pile. This is why I tend not to buy retail. I get the sense there was a fortuitous collision of consumer taste and AEOS product in 2004. I don't know how long the marriage will last. The new concept could help them reach a different demographic--or it could bomb.

I am not crazy about the 2.5% dilution from stock share increases per year and that figured into my growth in EPS. Normally I might have been tempted to go something with closer to 20%
The 54¢ that options cost per share if all were exercised in the future could be deducted from the per share value.

They will be expensing options the last half of 2005 according to the 10K.
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