Okay. I gave you Johnson & Johnson. I analyzed the less-than-stellar 0.89% average annual return Coca-Cola has provided investors from 1996 to 2006. I’ve even talked about how easy investing should be if we follow Warren Buffett’s lessons. Still, you have asked for something more exciting-a smaller company offering the potential for a ton of growth.
So, here it is.
Here’s How It Started
I have been getting a lot of emails from people asking me what other companies I like and what stocks I can recommend. My answer is always the same-I don’t recommend stocks. I analyze businesses. My goal here at F Wall Street is to give you the tools you need to start doing it on your own and to help you change your perspective on investing.
Hey, persistence pays off. S O asked the following at Seeking Alpha:
Joe;
I recently read that Buffett would prefer to invest in small companies if he were just starting out and had only a relatively small amount to invest. How would your analysis change if it were a small cap instead of a mega cap?
Thanks.
Wednesday Night
Late on Wednesday, I sent my friend Todd over at ValuePlays an analysis of American Eagle Outfitters (AEO). Timely, considering that the stock price ran up nearly 7% today. Of course, the gamblers will do what they’ll do. Let’s look at this non-mega cap company from a silent partner standpoint:
The Business
“Shop ae.com 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 sells clothes, and for roughly $25 a share, you could be in the clothing business as well.
But 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). Then again, AEO is the baby when looking at its competition: Gap (GPS), Nordstrom (JWN), Limited (LTD), and Abercrombie (ANF).
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 2½ years and increasing your monthly savings by 35.4% a year for ten years.
Hey, you’d be doing all right.
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? Few companies can. Should you be penalized and lose money if management or the company stumbles a bit? I don’t think so.
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 with tough competition and very little moat-AEO becomes attractive at $26.31 a share. (It was just under that price yesterday when the article was written)
The Buffett-esque Result?
Simple business. Undervalued by more than 50%, even 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.
Filed under: Companies Analyzed (Generals)
Related Stocks: AEO
Tiago,
When Buffett coined the phrase “Owner Earnings” back in 1986, he was pointing out the uselessness of the traditional cash flow numbers Wall Street was touting. He then went on to explain how he calculated Onwer Earnings – and that calculation became the basis for what is now known as Free Cash Flow.
The difference between Free Cash Flow and Owner Earnings is that Buffett allegedly averages the capital expenditures over a number of years. Because I look at everything in multi-year timeframes, my numbers are also spread over a number of years.
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Morningstar is a wonderful site specifically because it provides the 10 years of data and has the free cash flow already calculated.
I like to double check my calculations by going through the annual reports of the companies. At times, you’ll find that certin companies are growing rapidly, but don’t seem to be generating a ton of cash. Looking at the annual reports, you’ll see that they are plowing most of their cash back into capital expenditures, but in the interest of opening new stores.
A perfect example of this is Walmart. Very little free cash flow according to Morningstar. Still, if you dig deeper into the annual reports, you can find out how much cash they actually generate from operations before they spend it all for growth.
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Hi Joe,
I recently found your blog and enjoy reading your posts. Why do you use a 20 year analysis rather than a 10 year analysis? In the example of AEO, it is the difference between a possible buy with a 50% margin of safety at todays levels versus being fairly valued at todays levels looking at 20 years versus 10 years respectively.
Thanks!
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Hi Georgia,
Sorry for the delayed response. I use 20 year timeframes because I expect AEO to be in business for at least that long. Any calculations beyond 20 years are so unreliable and small that they are negligible. On the other hand, using a ten year timeframe is not practical because you are buying a business that will operate (hopefully) for much longer than that.
Finally, intrinsic value – the value we try to calculate – is the value of the business’ ongoing operations. If you have a reason to believe that a company will shut down in ten years, use ten years in your calculation.
It all comes down to the estimated life expectancy of your business.
Hope that explains it!
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Hi Joe,
Morningstar does not have cash flow for the financial services sector. Is there any other site to go to for 10 year FCF data other than subscribing to Value Line?
Thanks for your generosity, hope you are having a great weekend. You can see what I am doing on a Saturday evening!
Mike
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Mike,
I’m right here with you on Saturday night. You are right about Monringstar, an issue they are (hopefully) resolving. I have yet to find another site that has the numbers as easily accessible as Morningstar, so I go straight to the annual reports filed with the SEC.
Navigating the SEC’s EDGAR database can be overwhelming at first, but it eventually becomes very easy when you get familiar with the components of an annual report.
Check out this link to do an EGDAR search on your company. Look for Form 10-k, the annual filing for each company.
Let me know if that helps, or if the EDGAR database is too overwhelming.
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Joe,
Thanks, that link to Edgar is going to be very helpful. I can dig the FCF data out of the 10-Ks now that I can have ready access to the past 10 years of them. Actually, I only have to dig out 7 years worth since the last 3 years are easy to obtain from places like yahoo finance.
WFC is the one I am currently interested in investigating.
Thanks,
Mike
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Better yet, head over to Dow Jones’ Market Watch. They have four years of data – one more than most sites. Might as well save yourself an extra minute or two!
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Joe,
I am currently taking a closer look at American Eagle Outfitters. As expected, when I use data in the MorningStar Cash Flow and 10 year Balance Sheets I end up with the same indicators that you do (Equity growing at 31.6%, Median FCF of 35.4%, etc.). I went straight to the AEO annual report available on the SEC website to get the outstanding shares for AEO (218,759,933 shares as of May 31, 2007). I notice the “5-yr Restated” data in MorningStar indicates a different number of “shares” (2005=218, 2006=228, 2007=223) and it is difficult to align some of the Restated data with the other financial data sheets. Do we trust the outstanding share count in the Annual Report to be correct? Is the “shares” count in the 5 yr Restated a count of diluted shares or is it a correction to the outstanding share count that we need to incorporate into our valuation calculations?
Glenn
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Hi Glenn,
Go with the diluted shares as reported on the most recent 10-Q (quarterly) or 10-K (annual) report, but also check it against MSN’s stock page (right side of screen). When a company buys back stock, it may show up on MSN (or Morningstar) before the company makes its formal quarterly or annual report.
Hope that helps!
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Joe,
Would you please share your spreadsheet where you calculate the “next ten years are only half as good as the past ten years” and “years 11-20 slow to 5% again”? It would be a big help to see exactly how you figured it. I found your explanation of JNJ with the spreadsheet helpful to see exactly how you calculated it.
Rick
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I was reading this post again and did my own detailed analysis on AEO.
Everything to me looks good including management performance but ONE thing that concerned me was the fact that the CEO has an annual salary of 1 mil as well as 2.16 million stock options.
Is this type of compensation something that I should be wary of?
I dont fully understand the compensation thing but Graham in ‘The Intelligent Investor’ does state that you should be careful “overpaid” managers.
Can someone provide some help?
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Rick: Got your e-mail. Give me some time to look it over.
J: Unfortunately, there is no magic salary cap. Ideally, all the managers would work for peanuts.
When a company is generating a ton of excess cash, I don’t frown on high salaries and options. Sure, I’d like them lower; still, try convincing a CEO to run AEO for $80,000 a year bonuses based only on growth. Wall Street has created a system where those arrangements are the exception (if at all) and not the rule.
Where compensation really comes into play is when a company could be generating cash (or isn’t and can’t) and management is pulling huge salaries. In those cases – and there are a ton – watch out!
I don’t have a hard and fast rule like “compensation should be less than 3% of free cash flow” because it really depends on the managers and the business. If they are great people at a great company, odds are that compensation will be fair. As such, if it doesn’t jump out at me and scream, WATCH OUT! I’m not overly concerned.
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To add onto Joe’s comments, I think it also important to see what the insiders of the company are doing with their stock. Are they buying or selling?
In AEO’s case the CEO, James O’Donnel, has been selling his stock. In May, June and August of this year he has sold a total of 90,000 shares of AEO stock. But if you look back at the amount of shares that O’Donnell holds on average it is about 600,000 – 700,000 shares. So it is more then likely that we will continue to see O’Donnel sell more of his shares.
I would find this as a cautionary flag if it weren’t for the chairman, Jay Scottenstein, who owns over 6% of the company. In the last few months he has purchased 1 million shares of AEO Stock.
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I doubt he is going to continue selling shares when the price is clearly depressed.
Though he was selling at ~$27/share, would this be a hint that the exec’s don’t think the business ought to be valued much higher? Or that they just don’t think it will hit much higher of a value? I’m inexperienced with this, but I’m still happy to be in around $22/share
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Unless I see clear liquidation, I’m not overly concerned about moderate insider sales. After all, the majority of their net worths are often tied to one particular company. Maybe he needed cash to pay off a summer home? Perhaps his adviser told him to diversify?
Remember: These are people too. They don’t always make the best decisions – even when it comes to their own company stock. Though they are behind the helm of a major corporation, I’ll bet the majority of them fret over and sweat their stock prices on a daily basis.
Unless I see a big red flag, I consider this to be the ordinary course of business. Had the stock run up to $40, he’d feel pretty dumb for selling at $27. With the stock at $21 and change, he looks like a genius or someone getting out before the price dropped.
Either way, the business still looks good and I don’t see management running for the hills just yet, so I consider this more noise than news.
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Wow, and I thought I had found the bottom at about $20 a share. The market looks to just be going crazy though! It is down 10% today to $18.50! I need to scrape together more money to put in, as I haven’t seen any news that would result in something like this..except for overall market panic. Opinions?
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There is definitely overall market panic. The question is when is it a good time to start averaging down? I am in at about $23 and $21. AEO is trading at $18.30 as I write and they have $3 of net cold cash. So all those future cash flows are going for just $15 assuming the only asset is the cash AEO has. No guts, no glory, lol.
I should point out I have a coffee cup with that saying on it and also the name of the firm I got it from, Drexel Burnham Lambert. You younger guys should google that name.
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I just looked at AEO’s most recent 10-Q filed with the SEC. It shows (in thousands) $104,877 in cash and cash equivalents and $535,905 of short-term investments. On 214.25 million shares out, the company is sitting on roughly $3 per share in cash and short-term investments.
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another great reason why AEO and its management is top notch and makes for a great investment.
Jan 17 2008 CNBC Interview with CEO James O’Donnell
part 1 – http://www.cnbc.com/id/15840232?video=624839074
part 2 – http://www.cnbc.com/id/15840232?video=624839306&play=1
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I am pretty confident this is a good one, didn’t take any struggle from me.
Such a typical thing, “Company misses street estimates”.. precipitous drop in price.
I wonder if it will stay at this depressed level for long, or if we’ll have a return to low 20’s in a couple weeks. I hope it stays low for a month.. After CCU(*crosses fingers), I want to move some more back in.
I think that CCU is a good opportunity at 31 atleast, did I miss any of Joe’s steps?
Had a big run up the past 2 days to 34(from 31), now 34.50 in afterhours. I wonder if the spread might be closing for good..
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We’re heading in to (or are already in) a recession. Will AEO feel the pain? You bet!
What is a good business if not one that can thrive in good times and survive in bad times? Is AEO a good business? The answer to that lies in another question: Where will AEO be in five years? Answer that, and you’ll know whether or not you should be investing today.
(And it is perfectly fine for some to say yes and invest, and for others to say no and stay away. It’s not a question of “right vs. wrong” but “sphere of competence and confidence”.)
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Joe, I was wondering what your thoughts are on the large drop in FCF that occured in 2007 vs 2006? I understand we are in an economic downturn, but it is like a 50% drop, haha. Is such a drop acceptable in the short-term? (1 year) It looks like it is going to stay low through this year, so far, which makes it look like 2 years of bad FCF?
SSS have dropped consecutively, while competitor ARO’s have been increasing. I think this kind of hurts the economic downturn angle.. Or is it reasonable to point to ARO’s lower prices/constant sales as benefiting them during this economic situation?
Just looking at AEO’s SSS, and if we just consider march 2007 an anomaly due to its massive SSS growth(20%, I read), SSS for March 2008 were 108% of SSS in march 2005. So they haven’t exactly shrunk since 2005 and have infact grown (slowly); is this a reasonable way of looking at it?
Thanks for any answers!
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Night,
I’ve been poring over their annual reports lately since the price is so damn cheap, and one thing that caught my eye in their annual report was the realization of $184 million worth of trading securities that were sold. This is obviously a VERY one time gain and should be omitted from the cash from operating activities. Doing that would yield roughly $565 million as opposed to $749 million in cfoa. Free cash flow drops down to roughly $339 million, which is $45 million LOWER than 2006. Keep in mind though, that they are spending an inordinate amount of cash on their brand new, shiny headquarters and distribution facility lately, which skews the cash flow numbers. They really did have a great year operational-wise in 2007. Perhaps we should revise those 2007 numbers to come up with a more linear growth rate. Although, 2008 should more than offset it.
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Good call, I was staring at the 10-K for 2007 for a while but my brain was kind of.. ‘off’.
I am going to look at 2006 & 2007’s cash flows & operations in a more thoughtful way, soon. I’ll see what I think after I come to a more accurate picture of their FCF growth from 2006-2007.
I am probably most thrown off by the loss of shareholders’ equity. I don’t think I understand how that happened, yet. Is it just because they have a smaller amount of cash assets due to the capital expenditures?
Err.. I’ll post whatever questions and results I end up with 
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Hi:
Brand new to investing outside the mutual fund arena. I have to say, this is one of the best websites for helping me understand this style of investing (besides having lunch with Warren, but he isn’t returning my calls yet)
I was looking at AEO and have completed the analysis on the excel spreadsheet you guys use. (Fantastic resource by the way) With the stock now in the $13.50 neighbourhood, it looks almost too good to be true!! And that leads me to the question. Whats up? When it broke below $20, it seems everyone here (ok, almost everyone) was anxious to buy (and I undertsand why) But I don’t hink anyone seemed to think it would drop this low. Can someone explain if there is a GOOD reason why it has gone so low…or is Mr Market just behaving irrationally again?
Thanks..love the site!!
Darren
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Darren, I’ll tell you its Mr. market. IRRATIONAL FEARS Drive the market.
Remember Buffet’s quote, it goes something like this. The stock market is a voting machine in the short-term; nevertheless, the long-term , it has proven to be a weighing machine(companies with strongest fundamentals will go up, while more speculative investments will show up as losers). The reverse is said, in the short-term, popularity and NOT rational investing principles guide the market.
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Hello, why do you use FCF? Why dont you use Owner Earnings as Buffett?
Thank you.
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