One Person's Trash Is Another Person's Treasure Portfolio Selection: American Eagle Outfitters

Last November I announced my intention to create a portfolio composed of 10 companies that investors have unjustly cast aside. My goal in creating the One Person's Trash Is Another Person's Treasure portfolio is to highlight just how successful value investing and contrarian viewpoints can be, as well as uncover some great companies that have a good chance of turning their fortunes around. For a more thorough explanation of what I hope to accomplish and how I've been measuring my success, I encourage you to visit my portfolio mission statement as well as my most recent portfolio update.

Today we have a special selection since one of the 10 components within the portfolio, Dell, has officially gone private at the hands of a leveraged buyout by CEO Michael Dell and Silver Lake Partners. In other words, we need a new stock to take its place, and I've decided that company should be American Eagle Outfitters (NYSE: AEO  ) .

Why traders have given up on American Eagle Outfitters
Investors have kept their distance from teen apparel and accessories retailer American Eagle and much of the clothing sector since the summer because back-to-school sales were awful with a capital A!

Consumers were clearly not in a spending mood this summer, with American Eagle lowering its second-quarter outlook in early August on the heels of a 7% decrease in same-store sales (including its rapidly growing AE Direct website) on a 2% drop in total revenue.

But American Eagle wasn't alone. Abercrombie & Fitch (NYSE: ANF  ) reported a comparable-store sales decrease of 8% in the second quarter, and that was with the benefit of a 21% increase in sales from its online sales. Similarly, Aeropostale (NYSE: ARO  ) updated its second-quarter guidance just days after American Eagle and highlighted an expected 15% decline in comparable-store sales with the benefit of improving online sales.

Why the deluge of pessimism all of a sudden in the apparel sector? Some of it may have to do with growing skepticism about the state of the U.S. economy. Consumer confidence tanked in October as fears of another round of debt-ceiling debates still loomed large. You may not think about Congress' actions affecting our day-to-day lives or the stocks we hold, but consumers out there use this skepticism as all the more reason to hold on to their money rather than spend it.

The other issue here is that competition among these three retailers is getting fierce -- especially with department stores like Macy's (NYSE: M  ) attempting to carry clothing that would appeal to a younger crowd. Macy's wasn't immune, either, with its comparable-store sales falling 0.8% in August when a gain of 2.3% was projected by analysts, but it also possesses deeper pockets, a rich brand name, and a widely used charge card that it can use to attract consumers (which in this case is often parents) into its stores. In turn, this causes teen retailers like Aeropostale, Abercrombie & Fitch, and American Eagle to discount deeper than they'd like to in order to keep traffic heading into their stores.

Why investors should trust American Eagle Outfitters
The primary reason American Eagle Outfitters interests me and appears to be the clear choice among the teen retailers is its niche position with regard to pricing and fashion.

On the low end of the scale we have Aeropostale, which has never been very concerned with its gross margin and has instead focused on churning as much volume as possible. This is a game that works well for discount-seeking customers, but any disruption in buying habits can cause a monstrous inventory backup that yields to excessive discounting. Also, because of its low-end pricing, Aeropostale doesn't have a ton of brand power, and you won't see too many teens going out of their way to flash their Aeropostale-branded clothing.

On the other end of the spectrum we have Abercrombie & Fitch, whose CEO, Mike Jeffries, seems to stick his foot in his mouth at least once every two years, harming the company's image on a somewhat regular basis. Coupled with Abercrombie's edgy apparel is a price tag that's far and away higher than any of its peers save for a chain like True Religion. While implying higher perceived value with its lofty price points, A&F is also exposed to rapidly weakening sales anytime GDP growth prospects in the U.S. don't meet expectations. In addition, A&F is also making a big push into Europe at a time when most countries and citizens are trying to curb their spending.

Then we have American Eagle, whose price point fits perfectly in between Aeropostale and Abercrombie & Fitch. What's particularly intriguing about its product line is that it offers much of the same flair and branding as you'll find at A&F, but it's cheaper! I would also argue that its fashions are also considerably more in demand with teens than the designs at Aeropostale. American Eagle has also historically done a far better job at controlling its inventory relative to its peers and often resorts to far fewer discounts than either Aeropostale or A&F.

What you'd get here
If you were to jump into American Eagle here, you would be getting a company valued at 14 times forward earnings coming off one of its ugliest quarters since the recession. It's not uncommon for retailers to suffer for more than one quarter, so I wouldn't be surprised if its third-quarter report demonstrated only modest improvement from the second quarter.

But you would be getting a company whose management team has demonstrated an ability to control inventory and pricing better than the competition. American Eagle Outfitters also places a high emphasis on returning profits to its shareholders, paying out a $0.50 annual dividend that equates to a 3.5% annual yield -- an incredible figure in the retail sector.

American Eagle Outfitters is well capitalized, with $405 million in cash and no debt, and is able to use that leverage, as well as its operating cash flow, to open new locations and look for other business opportunities that its foes simply don't possess.

I will be adding American Eagle to the portfolio based on Thursday's closing price of $15.49 and will be allotting 63.91 shares into the portfolio (a purchase price totaling $989.97) as well as adding a $10 commission charge for the purchase.

The three retail game-changers you need to know
The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.


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