American Eagle Ouch

October 27, 2008 by Joe Ponzio

In this comment, I had said that I was “way wrong” on American Eagle Outfitters, and that sparked some good questions. Namely: The price is down some 60%; but, what happened in the business that makes me feel like I was “way wrong”? The short answer: The business is taking a step back (due largely to the economy) before it can leap forward; so, I was wrong on my assessment of value and overpaid for the company.

If you want the long answer…

If you recall from Uncovering Opportunities in All Markets, businesses tend to go in cycles of growth, contraction, recovery, growth. That’s why I bought and sold Graham Corporation. I had said:

A lot of value investors try to find that absolute bottom – the point at which the business is beginning to turn around and growth is about to start happening. I’m not that adventurous; so, I try to buy in the recovery stage when it looks like the next growth cycle will be higher than the last (if I’m looking at these type of businesses). Turnarounds seldom turn; so, I wait until the turnaround is well underway.

As it turns out, I bought American Eagle right around the peak of its growth cycle, and it is now heading into a period of contraction. What that means for the company is that it will likely have a period of generating (much) lower owner earnings for the foreseeable future.

What that means for me is that I overpaid because I didn’t have a good enough grasp on the risks of the business and the economy.

What Am I Seeing Now?

AEO is experiencing lower revenues on higher costs. In Where Are We With AEO?, I had said:

AEO is going through a rough patch right now, but it is not entirely consumer-driven…But the company still reported a 5% increase in sales this past quarter over last year’s first quarter.

That situation has changed. The rough patch is now consumer-driven as well – not across the board, but enough to negatively affect sales. Though I think this is a temporary setback for AEO and the industry, there is no real need for people to rush back to AEO and start spending when the economy turns. They will have been buying clothes; so, there won’t be an immediate, nationwide wardrobe crisis. (Compare that to General Motors – sales were down 17% last quarter; but, peoples’ cars are getting older every day. Eventually, new cars will have to be sold. The question is: Will GM capture those sales?)

So, I see lowered owner earnings, both in the immediate future and as a starting point for future growth. In that case, I priced it too high and overpaid for the company.

(As an aside, I also don’t like the fact that AEO started issuing more shares than it is repurchasing. It’s a small increase; but, where are they going with it?)

When Does Fisher’s Three Year Rule Apply?

While I’d like to institute Fisher’s three year rule, it doesn’t really apply if you paid too much for a company. Knowing I overpaid, waiting three years would not be “intelligent investing,” it would be a strategy of “hope the price runs up past the business’ value so I can recapture some of this mistake.”

Fisher’s rule applies to businesses that are holding their value or becoming more valuable over time. If, however, the business’ value is deteriorating below your purchase price, you have to cut bait – even if that means you have to take a loss.

The Intrinsic Value of American Eagle

If I had to take a stab at it, I’d put AEO’s intrinsic value around $14-$18 a share…

  • if the shares outstanding do not continue to increase, diluting value even further; and
  • if the recession is not deeper than I expect it to be; and,
  • if I had to put a value on it.

I think long-term holders of AEO can do well at today’s prices. Then again, we’re looking for cheap dollars; so, holding AEO doesn’t make sense for me at these prices. If AEO gets into the $6 or $8 range, I might be all over it again (assuming those share issuances are under control), just like I was/am with Nutrisystem.

Two months ago, I chose to do nothing with AEO because (i) the trouble it was experiencing was not at the customer level (but at a temporary commodities bubble level), and (ii) I couldn’t determine the intrinsic value with any degree of confidence.

Today, I feel like I have a better grasp on its value based on what I think I can see in its future. (After all, that’s exactly what investing is – trying to predict the future based on information you have and assumptions you make today.)

Obviously, different people will see different things in American Eagle. Some visitors criticized the purchase all year; some insist that now is the time to double or triple down. With more than 10,000 companies out there vying for my investment dollars, I am choosing to cut bait and find an opportunity with more clarity and a bigger and/or better margin of safety based on my sphere of confidence and competence.

I never worry about converting a “paper loss” into a real loss. The overall impact to the F Wall Street portfolio was just under 5% – a sum I think I can make up in an opportunity offering greater clarity and ease based on my sphere. Remember: You don’t have to make it back the way you lost it.

A Note From Joe Ponzio

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