American Eagle Outstanding

July 12, 2007 by Joe Ponzio

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.

A Note From Joe Ponzio

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