Wednesday, July 11, 2007

American Eagle Out...standing

ValuePlays contributor Joe Ponzio takes look into a business that Wall Street rates a “Hold” - American Eagle Outfitters (AEO).

“Shop for men's and women's clothes, shoes, and more.” That’s what their website says. Sounds like a pretty simple business to me - American Eagle Outfitters (AEO) sells clothes, and for roughly $25 a share, you could be in the clothing business as well.

Wall Street doesn’t want you selling clothes. The consensus on AEO is that you should not buy or sell, rather hold (and probably put the rest of your money into their mutual funds).

The Past Ten Years
Over the past ten years, AEO has grown its shareholder equity from $91 million to $1.4 billion - a median rate of 31.6% when you look at various time frames. In addition, it has grown its free cash flow at a median rate of 35.4%. If you look at it from a personal finances standpoint, that is like you doubling your net worth every 2 1/2 years and increasing your monthly savings by 35.4% a year for ten years.

Hey, you’d be rich too.

Management And Money
The company carries almost no long-term debt which is much better than if it were swimming in debt and being choked by interest payments. In addition, it has generated nearly $0.18 a year for every dollar it has invested in the company. Last I checked, business interest rates were not at 18% so AEO is doing a great job of using its (very little) debt to generate additional cash.

What You Are Buying
If you were to buy AEO today, you’d be buying your fair share of its net worth and the future cash it can generate. If the future is anything like the past, an investment in AEO makes a lot of sense...if it can be done at a “fair” or “bargain” price. Assuming it is business as usual at AEO, it is already trading at a bargain price. If AEO plugged along at the rate it has for the past ten years, then slowed to 5% growth for the next ten years, the company is worth about $149 a share. Even with a 50% Margin of Safety, AEO is anything but a “hold”.

What If It’s Not Business As Usual?
Ahhh, the quandary of analyzing a smaller, rapidly growing business. What if AEO can’t sustain its 35.4% growth in free cash flow? Should you be penalized and lose money if management or the company stumbles a bit? Besides, it is impractical to think that any company can grow its cash generation abilities at 35.4% forever.

Let’s say AEO does slow down a bit. In fact, let’s say the next ten years are only half as good as the past ten years. Let’s also say that years 11-20 slow to 5% again. Now what’s the value of AEO? To earn 15% or more on an average annual basis, today’s value of AEO would be about $52.61 a share. With a 50% Margin of Safety - a smart move when buying a smaller, rapidly growing company - AEO becomes attractive at $26.31 a share.

The Buffett-esque Result?

Simple business. Undervalued by more than 50%, assuming much slower growth. Generates a ton of cash without using a lot of capital to do so? What do you think?

So, Will Buffett Buy It?
That’s a different story. AEO only trades about 1.2 million shares a day. For Buffett to “sneak” in, he’d only be able to buy 1% of that, or roughly 12,000 shares every day. Over the course of sixty trading days - the amount of time he has to sneak into a position before he reports it to the SEC...and the rest of the world - he’d only be able to acquire about 720,000 shares, or $18 million worth. An $18 million investment is barely worth his time, considering the size of Berkshire Hathaway.

So no, I don’t expect to see AEO in Berkshire’s swelling portfolio any time soon.

Joe Ponzio blogs at F Wall Street. He owns a piece of AEO’s business, directly or indirectly.

blogger templates | Make Money Online