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No. of Recommendations: 16
Since I have written about AEO a few times, I need to bring this item to your attention:

http://biz.yahoo.com/ap/080229/american_eagle_auction_rate.html?.v=1&printer=1

Part of my investment thesis for buying AEO was its cash-rich balance sheet, which results in a low enterprise value-free cash flow ratio.

Before I wrote about AEO for Real Money (and then posted the column then here), I asked AEO to describe the quality of their cash and short-term investments. I wanted to know if their liquid assets were cash-equivalents, or were some auction-rate securities (ARS). Management said all of their cash and equivalents were of the highest quality.

The problem with auction-rate securities is that no one wants to own them, given the today's credit contraction. I think the credit contraction will continue; we didn't get into this mess overnight, and we won't get out of it overnight, either.

In the link above we learn AEO has $338 million of auction rate securities, of which $134 million failed auction since mid-February. I do not have an auction timetable for the other $204 million, but probably in the next few months, given the short-term nature of these securities.

A write-down seems inevitable. And if management says some of its cash and equivalents are overstated, then net worth drops and enterprise value increases.

Because capital preservation is always my top concern, I intend to sell my position 24 hours after this post appears. My position is in a tax-deferred account, and the commission is nil. I want time to go over AEO from top-to-bottom, as we should do with all of our companies at least once a year. The 10-K should be out in early-May, so by then we should have a better sense of the quality of these ARS's, as well as how last year went.

I still like my original thesis for buying AEO, but I also recognize that one of the reasons why I bought the company is not as solid as I first thought. Even though I did my due diligence on the quality of AEO's cash, my research was not as thorough as it should have been.


Hewitt
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No. of Recommendations: 10
Hewitt,

Is that information you believe you can generally obtain? the quality of the cash?

What size write-down do you believe they'll have to take?

I'm not convinced that an ARS "failing" at auction means that the value has decreased. Many people issue ARS that are financially viable and are not financial companies. For example, the Port Authority of New York. I mean who wouldn't want to own debt of a toll collector for NYC's subways/airports, etc? The fact that they failed at auction just means that there are not enough buyers there. And the issue is the ARS were backed by Ambak or MBIA, and no one wants to touch something like that anymore.

Now, technically, yes, if there are not enough buyers, then the value of what you owned goes down. But what it means in practice is the interest rate on these gets reset to something ridiculous, like 20+%. (I'm sure this isn't the case for all ARS, but from what I've heard, it is for many.) So while AEO holds these, they're making 20% interest on something they can't sell.

Of course the Port Authority of New York doesn't really want to pay 20% interest, so they'll eventually issue fixed rate bonds if this continues and call the auction rate securities, and AEO will be made whole.

As long as AEO doesn't need to sell these ARS, they'll be fine. It's not like a CDO where the underlying property is worth less than the debt...

Do you understand it differently? Should I be more worried about ARS than I am?

Cameron
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No. of Recommendations: 0
Management said all of their cash and equivalents were of the highest quality.

Hi Hewett,

Do you believe management was misleading you? Misleading themselves? Or do you think this was this an assessment made in good faith at the time?

Thanks,

Ciclo Man
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Oops, meant to write "Hewitt."
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CicloMan -

1. Good faith. Until mid-February, I doubt they ever had a problem with ARS's.

2. On this board we like to know the origin of off-beat nicknames, such as yours. So, please explain.


Hewitt
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No. of Recommendations: 1
On this board we like to know the origin of off-beat nicknames

Hi Hewitt,

You are the only one who's ever asked... thanks!

My passion is cycling, and cycling in Italy is as close to heaven as you can get on earth. The user name I wanted to reflect that was taken so I settled for an Italo-Anglo substitute. I was in a hurry and couldn't think of anything more creative. :)

Ciao,

CM
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Cameron -

Accountants like to say everything on the balance sheet is an estimate, except cash. Now, cash is also an estimate, it seems.

You ask good questions. But I do not have enough information about ARS's to speculate about the size of a writedown, if any. Plus, I think this credit squeeze is going to linger. So I want to see how things play out.

I pay attention to how management treats stockholders, and I note AEO does not have this press release http://biz.yahoo.com/ap/080229/american_eagle_auction_rate.html?.v=1&printer=1 in the press release section of its website http://phx.corporate-ir.net/phoenix.zhtml?c=81256&p=irol-news&nyo=0. This omission bothers me.

For now, Wall Street isn't worried about AEO's ARS's, as the stock hasn't moved much. I prefer to wait on the sidelines until the situation is resolved, however.


Hewitt
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