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Retail? Now? A fine 2-year play on American success.

February 03, 2009 | About:
American Eagle Outfitters [NYSE:AEO] Feb. 3, 2009 $8.52/share

52-week range: $6.98 (Nov. 21, 2008) - $23.84 (Feb. 4, 2008)

Dividend = $0.10 quarterly = 4.69% current yield


American Eagle serves the casual apparel market targeting the 15 – 25 year old market segment. They have about 958 mall-based AE stores in the US and Canada plus 116 stand-alone stores.

Like everyone else in retailing their business is very poor right now. After hitting new all-time high EPS in FYs 2004 – 2007 (FYs end January of the following year) FY 2008 will be down about 45% in the year just ended. Including an expected Q4 drop from $0.66 to just $0.20 full year EPS were likely $1.00 versus $1.82. The current year should be even worse with EPS estimates now running $0.75 for FY 2009.

Why be interested in this stock then? The problems are the result of the recession and not AEO’s execution. When the economy picks up, so will American Eagle’s results. The company has just $75 million in total debt and held over $343 million in treasury cash as of Nov. 1, 2008. With just 206 million shares outstanding that’s $1.32 /share in cash (net of debt). Tangible book value is over $6.50 /share.

At today’s depressed price of $8.52 the well-covered dividend is almost 4.7% and represents just a payout ratio of 40% of last year’s earnings and just 25% of FY 2008’s cash flow.

Is there a near-term catalyst for these shares? No. That’s why I’m looking at a buy/write option combination that uses in-the-money calls and out-of-the-money puts that stretches out to January of 2011.

Here’s a play I put on for myself just a few minutes ago:

…………………………….....................………….. Cash Outlay ….....……… Cash Inflow

Buy 1000 AEO @ $8.52 ………..............……… $8,520

Sell 10 Jan. 2011 $7.50 calls @ $3.00 ……...........…………….....……….. $3,000

Sell 10 Jan. 2010 $7.50 puts @ $2.45 ……..........……………….....…….. $2,450

Net Cash Out-of-Pocket …………………................………... $3,070

On expiration date in January 2011:

If AEO shares are $7.50 or higher (where they are today):

Your $7.50 calls will be exercised.

Your shares will be sold for $7,500.

Your $7.50 puts will expire worthless (a good thing for you as a seller).

You will likely have collected $800 in dividends.

You will have no remaining shares and no further option obligations.

You will have $8,300 cash for your initial $3,070 outlay- a $5,230 gain.

The above result will occur if AEO shares go up, stay the same or even if they decline by up to 11.9% from today’s quote of $8.52/share.



What’s the worst-case scenario?


If AEO shares go below $7.50 you can be forced to buy an additional 1000 shares and would need to pay $7,500 more out-of-pocket at that time.

You would end up owning 2000 shares of AEO.

Your break-even point would be figured as follows:

On the original shares purchased at $8.52 it’s that price less the $3.00/share call premium = $5.52 /share.

On the puts you sold it’s the $7.50 strike price less the $2.45 put premium

or $5.05 /share.

Your average all-in net break-even point would be the average of $5.52 and $5.05 = $5.29 /share (not counting dividends).

Anything less than a 37% drop in share price (from already beaten up levels) would leave you with a profit.

While it’s conceivable that AEO could go that low, these shares have not traded at $5.29 since 2003 when EPS were $0.34 or about one third of current levels. Revenues and book value have each more than doubled since that time. In 2003 there was no yield as opposed to today’s 4.69% rate.

American Eagle has proven itself through previous bad cycles. It has shown profits in each year since coming public in 1994. Chairman Jay Schottenshein and family owned 15% of the stock as of the latest proxy statement.

If you think America will be in recovery mode by 2011 this looks like a good play on a solid company.

Worst case you’ll own 2000 shares of stock at a 5-6 year low price and with 37% downside protection. The best case scenario leads to a 170% profit cash-on-cash in 23.5 months.



Disclosure: Author owns shares and is short options on AEO as described.

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.gurufocus.com/peter_lynch.php
http://www.TalkMarkets.com
http://www.MutualFunds.com

Visit Dr. Paul Price's Website


Rating: 2.5/5 (13 votes)

Comments

kbodawala
Kbodawala - 5 years ago
Wost case scenario is that the company goes bankrupt, the shares are worthless, and you are forced to buy another 1000 at a price of $7.50 which means your total outflow would be $8520+$7500-3000-2450= a loss of $10,570.

Seems to me you do not believe that the shares could be worthless and that is actually the worst case scenario!!!
Dr. Paul Price
Dr. Paul Price premium member - 5 years ago
K,

Any stock theoretically can go to zero. That's the worst case on every stock and bond. What's your point?

Can you find me any stock recommendations that say "Warning: This stock could theoretically go to zero for a 100% loss of your investment?

Debt-free, profitable companies are not likely bankruptcy candidates but anything is possible.
kbodawala
Kbodawala - 5 years ago
My point is that you are misleading by saying worst case, when actually you should portray that the worst case is a loss of $10,570 as you are obliged to have shares put to you at a price of $7.50 if stock goes to zero. When speaking of the worst case you should highlight what the maximum loss potential is and then you can give your assessment of the probability of that occuring. That way a person has a true picture of what risks await them if they were to invest in your proposed strategy!
cm1750
Cm1750 premium member - 5 years ago
Is this going to be like the compelling opportunities in restaurant stocks like RT, RUTH, EATS etc. that you wrote about in Dec 2007?

Dr. Paul Price
Dr. Paul Price premium member - 5 years ago
Cm1750- Here are your Fair Value picks from 2007:

It was a tough time to pick winners, no?

ticker....date...Price Then... Price Now.... % change

KSS....11/15/07 ....$48.92 .......$38.60 ..... -21.83%

FTEK ..07/28/07 ....$27.40 .......$10.83 ..... -60.47%

INT ...06/13/07 ....$41.11 .......$34.56 ..... -15.93%

UTIW ..06/13/07 ....$28.03 .......$12.20 ..... -56.47%

JCI....05/09/07 ....$35.37 .......$12.22 ......-65.45%

RCII...05/09/07 ....$28.22 .......$17.01 ..... -39.72%

cm1750
Cm1750 premium member - 5 years ago
Wow, I think I struck a nerve. If you adjust for JCI's 3:1 split, I think my 2007 fair value picks are outperforming the market which is what I judge my picks against.

More importantly, I only recommend in the forum (and have big positions in) stocks that I have high conviction of them beating the market (I think I have only recommended PM/MO, HD/LOW and most recently, TBT). Let me know if I missed any.

I really hate people who recommend 100 stocks with no thought or analysis. I might as well watch Jim Cramer.

I know you like recommending lots of stocks using relative valuation - that is fine, and I am sure it provides value to other members.
Dr. Paul Price
Dr. Paul Price premium member - 5 years ago
Cm1750, the prices are already adjusted for splits.

JCI dropped big-time.

Why not comment on the arfticle I wrote up today? What do you think of my 2 year play?
cm1750
Cm1750 premium member - 5 years ago
You are right about JCI dropping - very ugly. I bought it a couple years ago after they bought York (HVAC services/systems) to diversify away from auto parts. I thought JCI's auto segment was OK as it had much less exposure to the Big 3 automakers and had lots of revenues from Asian and German makers vs. LEA, TEN etc. I just didn't think the Big 3 would potentially disappear and even mighty Toyota having problems. JCI would be even lower if not for the York deal.

My apologies - you did adjust for the stock split - I thought you just took the GuruFocus numbers. So it is trailing the S&P by about 20%. It did alot better than LEA, TEN etc., but you know what they say about a good house in a bad neighborhood :-)

I still think JCI will survive - I just haven't had time to figure out normalized earnings.

Regarding your AEO - I actually looked at AEO, COH, KMX etc. when I bought HD and LOW in mid-January 2008. I asked my niece about where all the kids shop and AEO and ANF seemed to have good franchises. I decided to buy HD and LOW as they had bigger moats and the industry is a consolidated oligopoly which protects gross margins. I actually do think AEO could do very well from today's stock price, but I currently have 26% of my portfolio in retailers so a big position in AEO is unlikely, but I may consider a small speculative position in AEO at around $6 based on a 50% discount to normalized EPS of $1.00 and a 12x P/E. I am completely guessing on the $1.00 - I am just using the sellside's average calendar 2010 EPS of $0.99 as a rough guidepost. If you can provide me with some detailed analysis regarding normalized earnings power, that would be very useful.

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