American Eagle Is Ready to Fly

Thanks to a mix of profitable growth, a cash-rich balance sheet and an attractive valuation, American Eagle (AEO - commentary - Cramer's Take), one of the best stocks of the past decade, looks poised to deliver more market-beating returns in the years ahead.

Founded in 1904, American Eagle took its current form as a mall-based retailer of casual clothing in 1977 and has since grown to 926 stores in the U.S. and Canada. The Pittsburgh-based company, which has a $5.6 billion market value, designs, markets and sells its own merchandise, targeting 15 to 25 year olds. Management says it competes "on trend, but not ahead of the trend."

Its flagship AE brand was ranked the second "coolest" brand among 12 to 19 year olds, according to a recent study by Teen Research, just behind Nike (NKE - commentary - Cramer's Take).

Last year, the company launched a second retail concept, aerie, which sells intimates like bras and panties. Management expects to have 40 freestanding stores by the end of this year and to open another 50 to 60 stores in 2008.

A third theme, Martin + Osa, sells "refined casual" sportswear to 28 to 40 year olds, and was inspired by a couple from Kansas who chronicled their adventures in Africa and the South Pacific in the 1920s and 1930s. This concept is expected to be accretive to earnings in 2009. There are 10 Martin + Osa stores, with another nine slated for opening by year end.

American Eagle also has an online business, ae.com. Sales increased 48% in the most recent fiscal year.

Authentic Earnings Power

I use a three-step process to analyze stocks.

The first step is to make sure the company generates high-quality profits. American Eagle passes with flying colors, as the Quality of Profits chart below shows. Steady increases in GAAP earnings are matched by gains in defensive and enterprising profits.

The defensive income statement expenses investment in fixed and working capital because they are uses of cash. This approach is more conservative and can be thought of as the "commercial banker's" income statement.

The enterprising income statement depreciates intangible-growth-producing initiatives like R&D over their expected useful life, and also expenses the real, albeit noncash, cost of stockholders' equity. This treatment is more forward-thinking, and can be thought of as the "venture capitalist's" report card.

Using two alternate ledgers to assess earnings quality is common sense, just like looking both ways before you cross the street.

Turning to the Earnings Power Chart below, we find American Eagle occupies the desirable upper-right box. Even better, the clothier is moving in an upper-right direction, forging an Earnings Power Staircase. When a company forges an Earnings Power Staircase, this is your hallmark of profitable growth; the company is getting bigger and better.

If you want to own the next Microsoft (MSFT - commentary - Cramer's Take) (circa 1990s), a portfolio of Earnings Power Staircase companies will boost your chances. (To learn more, visit my Web site.)

Balance Sheet

As befits an Earnings Power Staircase company, American Eagle has a Fort Knox-like balance sheet, with $760 million of cash and equivalents and no debt.

Also, tangible book value is 99% of corporate net worth, meaning there are almost no intangible assets like goodwill that are at risk of an impairment charge.

As for capital productivity, American Eagle's three-year return on capital is 23%, and its three-year return on incremental investment is 71%. Both results are impressive.

Management began paying a dividend in 2004, which it has raised every year since. The current dividend yield is 1.6%.

Competitive Advantage

The second of my three-step process is to determine the nature and durability of a firm's competitive advantage. Because American Eagle is forging an Earnings Power Staircase and because it also has balance-sheet muscle, my view from the outside is they have a first-rate management team, led by longtime board chair Jay Schottenstein.

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At the time of publication, Heiserman was long American Eagle, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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