American Eagle Outfitters: Free Cash Flow Machine ($AEO, $ARO)

May 9th, 2011
Tags: AEO, ARO.

In the fall, I wrote about Aeropostale (NYSE: ARO) and its strong returns on capital and earnings yield, even after including off balance sheet operating leases. Another teen clothing retailer is American Eagle Outfitters (NYSE: AEO) which, despite the market run-up over the last six months, is trading below where it was for most of November. AEO has zero bank debt, substantial cash and strong free cash flows.

AEO trades at a P/E of 17, but has $734 million in cash on its books, resulting in a P/E ex-cash of ~13x. This isn’t as cheap as other companies I’ve profiled on this site, but AEO operates a relatively strong business and has sustained ROCE of around 25 – 30% over the last decade. The company trades at a P/B of 2.25x which is, in my opinion, too cheap for a company capable of earning returns at these levels. In my residual earnings valuation, I find the company to be undervalued by roughly 25%. This is similar to the valuation I arrived at with my EPV model.

The most attractive thing about AEO is its ability to generate free cash flows. Though the company does not break out what portion of capital expenditures are related to maintaining versus growing revenues, we can infer that the required maintenance capex is relatively low. By looking at the company’s cash flow statement over the last three years we see that capex has declined by roughly 2/3 as store growth has slowed. At the same time, cash flow from operations has risen from $345 million to $402 million. The net effect is free cash flow that has tripled since 2009, throughout a recession! If the previous level of capex was mandatory for the company’s continued operations (i.e. maintenance capex), management would not have had the flexibility to scale back.

The company is also shareholder friendly, paying a dividend for the last six years and actively repurchasing shares. In fact, the company reduced share count by more than 5% in the last year alone, and has substantial room left for more repurchases, which the company assures investors it plans to use if shares stay this cheap.

Finally, AEO has a potential catalyst in the form of new management. The firm’s 70 year old CEO retired in March and the company is currently searching for a replacement. Hopefully the new CEO won’t tinker too much, as the company’s formula has been sustaining such strong returns, but perhaps a shake-up in the corner office will help bring a fresh perspective.

Author Disclosure: Long AEO

Talk to Frank about American Eagle Outfitters