Three months ago, I made a CAPScall on American Eagle Outfitters (NYSE: AEO), predicting a downfall in profits within the next six months to a year brought about by heavy markdowns on the mountain of inventory it had accumulated. Just a few weeks later, the stock price cratered 14% after a bad announcement from management, and I declared victory, noting that I would short the stock again if it recovered.

It has.

The deep discounts will not avail you
My principal objection before was that American Eagle was carrying an inventory that would be impossible to liquidate profitably. During the last holiday season, retailers of every stripe were offering enormous discounts, and American Eagle somehow expected to sell 40% more merchandise without having to sacrifice margins.

American Eagle did manage to get inventories down to a more reasonable level, boosting sales 14% in the process. But the company delved too greedily and too deep, and earlier this month we learned what it awoke in the darkness of the holiday season. For the full year, gross profit fell nearly 4 percentage points, continuing a long-term trend that has so far seen margins fall more than 12 points since 2007.

American Eagle's margin has fallen more than almost any of its competitors -- more than arch-competitor Abercrombie & Fitch (NYSE: ANF), and even Aeropostale (NYSE: ARO), whose deep discount business model has been severely hurt by high cotton costs recently. Some competitors, such as lululemon athletica (NYSE: LULU) and Limited Brands (NYSE: LTD), have even been able to significantly raise their margins, indicating that American Eagle isn't simply suffering from an industry slump that's beyond its control.

You cannot pass!
Despite all this, American Eagle's stock is up 30% since I ended my underperform call, much higher than it was even when I first made the call. What are investors so excited about?

Management's guidance for the year was far from optimistic. While we'll have to wait till May for the company's full-year EPS guidance, management expects $0.08 to $0.10 per share for the first quarter, a steep drop from last year's $0.14, mostly because of higher product costs and continued markdowns. For the year, the company is expecting a "modest" increase in sales and believes that margins will continue to weaken through the first half of the year and finally start to improve in the second half.

That makes sense, given the price of cotton and the cost dynamics of the apparel industry. Apparel companies aren't immediately affected by the price of cotton, so in the second half of last year, American Eagle would have been digesting the record high prices of the earlier spring. This year, it will experience a significant tailwind now that cotton has fallen. But cotton is still historically expensive, and there are no guarantees it will remain even this cheap.

The company also claims to have improved inventory management, but I don't see it. Inventories are 24% higher than they were last year. You might think that's due to higher product costs and that inventories are less worrisome on a per-unit basis, but that's not the case. Management noted that the increase is due only in part "to a high single-digit increase in the average unit cost" (emphasis mine). That leaves at least a 15% per-unit increase in inventory, meaning people simply aren't buying as many items from the stores. This reality will have to lead to increased markdowns, putting further pressure on margins.

This situation lies in stark contrast to competitor lululemon, a company that doesn't suffer from inventory buildup and the need to sell products at any price just to make room for the next season's pile of inventory.

It's a similar story at Limited Brands. A few years ago, inventory was growing far more rapidly than revenue. But since the recession, Limited has done a fantastic job of managing inventory more efficiently, bringing annual days in inventory down to 59 from a high of 80 in 2007, resulting in a 155-basis-point increase in gross margin.

Go back to the shadow!
I am not confident American Eagle will create enough demand to unload what is still too much inventory. I am also not confident it will learn from its continuing mistakes and run things more efficiently. I am confident it will disappoint investors, and I am reinitiating my underperform CAPScall.  

Don't let American Eagle's dour potential dissuade you from the broader retail space, though. There are incredible opportunities out there, including The Motley Fool's Top Stock for 2012. You can uncover this soon-to-be highflyer that Wall-Street is still aloof to in our special free report. Get your free copy now. Enjoy, and fool on!