After Hanson's Resignation, Is American Eagle a Strong Buy?

"Be fearful when others are greedy and greedy when others are fearful." That is the mantra that Warren Buffett is best known by and the very same concept that helped propel him to riches. In the case of American Eagle, investors are more scared than ever now that the company's CEO has retired. But is this an opportune moment to buy in?

Jan 27, 2014 at 1:29PM

Last Thursday was a rough day for shareholders of American Eagle Outfitters (NYSE:AEO). After announcing that the company's CEO, Robert Hanson, would be leaving immediately, shares fell as much as 10.6% before closing down 7.8%.

While the abrupt departure of a CEO can be chalked up to any number of reasons, it usually serves as a warning sign that something bad is happening at a company. However, after announcing Hanson's resignation and reaffirming American Eagle's fourth-quarter forecast, is it possible that Mr. Market is overreacting to the news?

Fourth-quarter results are expected to be weak
For American Eagle's fourth quarter, the company has forewarned investors that it's risky to expect much out of it. If management's prediction turns out to be right, then earnings per share will likely come in around $0.26, which represents the lower end of the $0.26 to $0.30 range previously forecast by the company. If this weren't bad enough, when you compare these results to the $0.47 the company reported the same quarter a year earlier, the situation looks depressing.

In part, the lackluster forecast for the fourth quarter is attributable to a poor holiday season for the retailer. In its holiday season update, American Eagle's management announced that revenue fell 2.4% from $904 million to $882 million for the nine weeks ending Jan. 4. Although this doesn't look like a steep decline, the primary driver behind the fall in revenue came from a 7% drop in comparable- store sales.

American Eagle is flying into unknown territory
Declining sales and profits is something that isn't really known to American Eagle. For instance, over the past four years, the company has been growing at a nice clip and has benefited from the higher profitability that accompanied this growth. Over this time frame, revenue at the retailer rose 18.2% from $2.9 billion to about $3.5 billion. While this isn't as strong as the 54% leap in revenue experienced by Abercrombie & Fitch (NYSE:ANF), it puts the 7% rise reported by Aeropostale (NYSE:ARO) to shame.

In terms of profitability, American Eagle performed even better. Between 2009 and 2012, the company's net income rose an impressive 37.3% from $169 million to $232.1 million. In its most recent annual report, the company claimed that the primary driver behind increased sales was its rise in comparable-store sales. From 2010 to 2011, the retailer's comparable-store sales rose 4% followed up by a 9% rise in comparable-store sales between 2011 and 2012.

But yet again, American Eagle fell in the middle of the pack. Over the same time frame, Aeropostale saw its net income deteriorate significantly. From 2009 through 2012, Aeropostale's net income fell a jaw-dropping 84.8% from $229.5 million to $34.9 million. The precipitous fall in the company's net income was driven by a 29.9% jump in its cost of goods sold coupled with a 14.1% rise in selling, general, and administrative expenses. These two factors drove down profits even though revenue ticked up marginally.

On the other side of the coin we have Abercrombie. Between 2009 and 2012, net income skyrocketed from $0.3 million to $232.1 million (it's not even fair at that point to put it as a percentage increase because of how sad Aeropostale and American Eagle would feel). This improvement in Abercrombie's bottom line arose in spite of a 62.1% rise in revenue and was due to a much smaller 38.4% rise in the company's selling, general, and administrative expenses.

Historically, the situation at American Eagle has been nice but far from ideal. The business grew at a reasonable pace and posted continued improvements over the past few years, but this was all but washed away during 2013. During the first three quarters of the year, the business experienced a 4% decline in revenue and a 47.2% falloff in net income. This reversal of fortune is inexplicable but universal. Over this time frame, the company announced that the fall is sales was due to lower traffic, fewer transactions, and lower-priced transactions.

Foolish takeaway
Moving forward, American Eagle has a lot of work cut out for it. Obviously, for shareholders who are patient and who believe in the company's future, the upside could be huge, but it does carry certain risks with it. The primary risk on investors' minds is: what kind of problem or problems exist at the company that could cause its CEO to abruptly resign?

In theory, the explanation could be anything from fraud, to poor financials, to personal reasons, but until shareholders find out more about the matter, they have a right to be cautious. At this point in time, even the most adamant shareholders should be keeping an eye out for anything that could signal a further deterioration in business, but that shouldn't keep you away from investing in the company per se. Rather, for those who believe shares are significantly undervalued, now might be the best time to take advantage of Mr. Market's fear.

What other retailer are seeing success?
Right now, American Eagle looks to be on the precipice of prosperity and doom.  However, it is possible that business can improve, in which case it might earn shareholders a hefty return.  But, is it one of the best long-term retail plays on the market?  To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

Daniel Jones has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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