Denim War Could Squeeze American Eagle

Thursday's American Eagle Outfitters ( AEOS) conference call left little doubt that the preppy clothier is facing a tough operating environment. But exactly how tough wasn't evident until its big rival Gap ( GPS) released its earnings after the close.

Here's what worries me. Gap said weak denim sales caused the company to fall short of sales projections for August. On the surface, this is good news for American Eagle, which said its strongest area this past quarter was denim. The problem is that Gap isn't going to sit idly by and watch American Eagle tread on its turf.

To the contrary, just this past week Gap launched a coupon blitz meant to promote its brand. But that's not all. Gap's new president, Gary Muto, whose roots are in merchandising, has said that he plans to step up sales efforts over the next few quarters to wrestle market share away from competitors.

Needless to say, American Eagle is going to feel pressure to step up promotional activity, which could pinch margins. Morgan Stanley analyst Robert Ohmes predicts American Eagle's third-quarter operating margin will fall by about 90 basis points from last year to 12.5%.

Not only that, American Eagle is going against pretty strong same-store-sales comparisons for the next three months, while rising shares counts could dilute EPS in coming quarters. All in all, the trends for American Eagle look pretty ugly.

Bottom line: The company's back is against the wall. And Gap's difficulties will only make things worse in the back half of the year.

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