American Eagle Outfitters Battles Increased Costs

This review of American Eagle Outfitters' (NYSE: AEO  ) earnings quality is the second in a series of commentaries about specialty retailers listed in the S&P400 index -- specifically, retailers that have income statement and revenue issues. This group of retailers also includes ANN, INC. (NYSE: ANN  ) , Aeropostale (NYSE: ARO  ) , and Foot Locker (NYSE: FL  ) .

Earnings quality is reflected in the financial statements
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important for investors to understand before hard-earned money has been lost.

The EQ Score database assigns an index rank to the company from one (lowest quality) to five (highest quality). As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward.

EQ trends for specialty retailers with revenue recognition issues:

Retailer

EQ Score January 2012

EQ Score February 2012

EQ Score March 2012

Trend

Likely Issue

ANN 3 4 2 Down Revenue
American Eagle Outfitters 2 2 1 Down Revenue
Aeropostale Not ranked Not ranked Not ranked Flat Revenue
Foot Locker Not ranked Not ranked Not ranked Flat Revenue

Source: Fool EQ Score (week ending March 16, 2012).

ANN's and American Eagle Outfitters' EQ scores have trended down, and Aeropostale and Foot Locker have shown no trend. All exhibit income statement and revenue recognition issues. I have already provided commentary on ANN, and I'll discuss Aeropostale and Footlocker in future commentaries, but here is a brief look. ANN's revenues have increased year over year almost 10%, but the company's cost of goods sold has increased 16%, and the gross margin has decreased 5% year over year. Inventory levels have increased from $169.14 million in fiscal year 2010 to $213.45 million, or 26%. Revenue has not kept pace with increases in the cost of goods sold, and inventory remains on hand longer. I expect price reductions at the register to further depress margins and net income. Aeropostale's revenue was down 4% year over year, while its COGS was up 51% and its gross margin down 51% year over year. Gross profit was down 53% from the same period a year earlier, and net income and earnings per share were down 69% and 66%, respectively. Foot Locker saw its revenues rise 8% year over year, but its COGS increased markedly to 68% from 22% a year earlier, and its gross margin dropped from 78% to 32% year over year.

American Eagle's earnings quality -- mostly made in America
American Eagle Outfitters, together with its subsidiaries, operates as an apparel and accessories retailer in the U.S. and Canada for 15- to 25-year-old men and women under the American Eagle Outfitters and aerie brand names, and clothing and accessories for kids ages 2 to 14 under the 77kids brand name. As of Jan. 28, 2012, the company operated 911 American Eagle Outfitters stores, 158 aerie stand-alone stores, and 21 77kids stores, as well as 21 franchised stores through its franchise partners in 10 countries.

American Eagle Outfitters' revenue and gross margin for the last two years are charted above. The chart shows increasing revenue year over year, up 14%, with the understandable seasonal spikes during the first quarter of each year. The gross margin remained above revenue until the last quarter, but overall the gross margin is down 14%, while the company's cost of goods sold increased 24%. The chart suggests that revenue will be lower next quarter, as in the past. This data translates into decreasing gross profit levels, which have been negative the last six out of eight quarters, and net income that is down 41% year over year, from $87.04 million to $51.28 million.

A tactic often used by management to boost net income and EPS is to repurchase shares of stock to reduce the shares outstanding ("the float"). The second chart illustrates this effect, but it was temporary. Also note that EPS has been essentially flat at approximately $0.26 per share after smoothing the quarterly variations. Decline in EPS year over year was -42%, however.

The third chart shows the correlation between days sales in inventory, or DSI and inventory levels. Notably, last Christmas season's inventory level spiked much more than in previous years. DSI fourth-quarter average increased from 72 days to 82 days, and the cash conversion cycle fourth-quarter average increased from 43 to 51 days. These data indicate that the company took higher levels of post-Christmas discounts at the registers, thereby putting pressure on operating and profit margins.

As noted above, gross margin and net income have declined, and EPS has been flat despite the decreased float. In addition, free cash flow is down significantly from last year to $139.12 million from $318.34 million. Since Aug. 26, 2012, American Eagle shares have increased from $10.37 to $17.51 as of yesterday's close. As with other specialty retailers exhibiting poor earnings quality, you should review the underlying trend data and select a suitable entry price before taking a position in American Eagle Outfitters.

Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article. The Motley Fool owns shares of Aeropostale. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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