AEO Is Almost Attractive

Last September, when the stock was trading around $26, I said American Eagle (AEO - commentary - Cramer's Take) was ready to fly. Now trading around $18, the stock is down 30% since then, vs. a 9% loss over the same period for the S&P 500.

Despite this poor performance, the Pittsburgh, Pa.-based retailer still has a compelling reward-risk profile, based on my understanding of the business.

In this column I want to show you how I reach this conclusion. Even if you don't own American Eagle, consider applying this type of analytical framework to the companies you own to tip the odds of Wall Street success in your favor. In this tough market, every edge helps.

We begin by creating two parallel scenarios in order to estimate American Eagle's intrinsic value based on optimistic and pessimistic outcomes.

Best-Case Intrinsic Value

The first is estimating what the company is worth if everything proceeds as hoped.

For American Eagle, analysts forecast 14% annual growth for the next five years. This seems ambitious, because management just lowered fourth-quarter EPS expectations to a range of 64 cents to 65 cents, compared to 66 cents per share for the same period a year ago. Also, we may already be in a recession, which dampens consumer spending.

So instead, let's use 10% growth during years 1-5, followed by 5% growth in years 6-10. Terminal growth begins in year 11, at 3% a year. Assuming a 10% cost of equity, share dilution of 1% a year and adjusting for $787 million of net cash, I arrive at a best-case intrinsic value of $42 for American Eagle.

Worst-Case Intrinsic Value

Now, downside risk. This is what the company is worth if things get real bad. (Real, real bad is bankruptcy, but this is unlikely given the quality of American Eagle's balance sheet.) We'll start by knocking revenue down 15%, to $2.6 billion from actual trailing 12 months figure of $3.03 billion. Let's also assume that gross margins decline to the eight-year average of 42.6%, vs. 48% for the fiscal year ended February 2007. Our gross profit forecast, therefore, is $1.1 billion, vs. actual results of $1.4 billion.

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At the time of publication, Heiserman was long American Eagle Outfitters, 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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