American Eagle Outfitters(AEOS)

Dan DeRoseMatthew McDonnell

14-November-2006

Presentation Outline• Company overview• RCMP Position• Macroeconomic/Market overview• Industry overview

– Porter’s 5 forces• Firm strategy/development• Stock performance• Portfolio “fit”• Firm financial performance

– Historical cycles and margin analysis– Relative ratio analysis– DuPont Decomposition

• Valuation– Margin, ratio & multiple analysis– Discounted cash flow (DCF)

• Recommendation

Part 1: Company overview

American Eagle Outfitters- The Business

• Business: Specialty clothing retail• Product: Casual clothing (tops, bottoms), intimates,

footwear, outerwear, accessories, and fragrances• Target customers:

– AEOS= 15-25yrs– Martin + Osa= 25-40

• Venues: Primarily mall-based stores with limited stand-alone stores and internet sales

• Geography: – Stores in all 50 states, Puerto Rico, and Canada– Limited online sales to locations outside USA

Company Overview• 1994:

– Incorporated as Natco Industries Inc.• 1999:

– Adopts present name • 2000:

– Bought 3 Canadian businesses• Thriftys/Bluenotes, Braemar, National Logistic Services• 3-2 Stock spit

• 2004: – Thriftys/Bluenotes sold– 2-1 Stock split– First ever dividends paid

• 2005: – Announces launch of Martin + Osa, Arie– Dividends raised

• 2006:– Much of National Logistic Services

Part 2: RCMP Position

RCMP Position

• Transaction history– 10-Dec-1999:

• BOT 200 shares at $44.00– 10-Jan-2000:

• BOT 200 shares at $27.00 – 3-May-2000:

• BOT 600 shares at $15.63– 23-Feb-2001:

• 3-2 split– 8-Mar-2005:

• 2-1 split– 25-Apr-2005

• SLD 600 shares at $26.28– 16-Nov-2005

• SLD 700 shares at $23.33

RCMP Position• Gains/losses

– Book value of holdings= $13,504– Realized capital gains= $21,842– Unrealized capital gains= $ 65,454 – Market value of holdings= $ 78,778

• Portion of portfolio MV= 22.70%

AEE6%

AEOS22%

CPRT9%

FR13%

JKHY5%

JPM13%

KMB6%

MS9%

MVSN2%

SRCL4%

SRZ5% WAG

6%

AEE

AEOS

CPRT

FR

JKHY

JPM

KMB

MS

MVSN

SRCL

SRZ

WAG

Part 3: Macroeconomic and Market Overview

Macroeconomic/Market Overview

• Macroeconomic overview– Economic growth in

Q2, Q3 2006 lower versus previous year

Macroeconomic/Market Overview

• Consumption spending– Weak y/y summer– Strong y/y fall

• Clothing and shoe spending steady since 2003• 2006 Q1, Q3 stronger y/y, 2006 Q2

significantly weaker

Real Annualized Change in Expendatures 2003-2006 Q3

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

2003

2005

2003:Q

1

2003:Q

3

2004:Q

1

2004:Q

3

2005:Q

1

2005:Q

3

2006:Q

1

2006:Q

3

% C

han

ge

Clothing and Shoes

Macroeconomic/Market Overview

Macroeconomic/Market Overview

• Clothing and shoe spending very non-cyclical– Although we do not have data for specialty clothing

retailers such as AEOS, we would likely expect much more sensitivity to changes in real GDP growth

Annualized Rates of Change 2003-2006 Q3: Real GDP and Clothing and shoes

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

Clothing and shoes

Real GDP

Part 4: Industry Overview

Industry Overview- Specialty Clothing Retailers

Power of Customers

MODERATE

Power of Customers

MODERATE

Industry RivalryHIGH

Industry RivalryHIGH

Threat of Substitutes

LOW

Threat of Substitutes

LOW

Power of SuppliersLOW

Power of SuppliersLOW

Threat of new entrants

HIGH

Threat of new entrants

HIGH

Overall Threat Level:

High

Overall Threat Level:

High

Part 5: Firm Strategy and Development

Firm strategy/development

• Open 45-50 stores per year • Remodel and/or relocate 45-50 stores per year

until all 160 stores in old format are updated– Renovated stores achieved an annual sales increase

of 46% on a 29% increase in square footage

• Sustain momentum and position brand– Jeans became number one specialty store brand

purchased – doubling market share since 2003– Focus on knit business such as polo's, graphic Ts and

tank tops

Firm strategy/development

• Product Mix– Product mix has remained constant last several years with slight

shifts toward women’s apparel and accessories at the expense of men’s apparel and accessories

AEOS Product Sales Mix 2000-2005

40% 39% 38% 35% 34% 35%

52% 54% 57% 60% 61% 60%

8% 7% 5% 5% 5% 5%

0%

20%

40%

60%

80%

100%

2000 2001 2002 2003 2004 2005

Footwear- men's andwomen's

Women's apparel andaccessories

Men's apparel andaccessories

Firm strategy and development

• Continue to develop aerie– Sub-brand of intimates (bras,

panties, dormwear, and personal care) that is consistent with the AE lifestyle

– Real estate strategy consists of integrated, side-by-side, and stand-alone stores

Firm strategy and development

• Develop Martin + Osa– New brand aimed at designing sportswear for

the 25-40 year old customer– Opened 4 stores in August, plan on opening 10-

15 in 2007

Firm strategy and development

• Expanding distribution centers in Kansas to support further growth of AE and Martin + Osa

• Recently, the firm has stressed expansion into the Southwest US

Firm strategy and development

2000 2002 2004 2005

Part 6: Stock Performance

Stock Performance

• Current Price : 47.50

• 52 Week Range: 19.45 – 47.48

• Stock price up 203% since January 3rd

• Dividends– Quarterly dividend increased to $0.113 from

$0.075 in 2nd quarter

Stock Performance

• AEOS has outperformed S&P and NASDAQ for 5 yr. and 6 mo. intervals

Stock Performance

• AEOS has outperformed competitors ANN, ANF, and LTD for 5 yr. and 6 mo. intervals

Part 7: Portfolio Fit

Portfolio Fit- Diversification

• AEOS, our largest holding, comprises 22% of market value of portfolio (November 7th)

• As shown in the graphs on the right, this concentration is due to high relative AEOS appreciation

• Our next largest holdings are JPM and FR at 13% each

Holdings as % of Total Market Value

AEE6%

AEOS22%

CPRT9%

FR13%

JKHY5%

JPM13%

KMB6%

MS9%

MVSN2%

SRCL4%

SRZ5%

WAG6%

AEE

AEOS

CPRT

FR

JKHY

JPM

KMB

MS

MVSN

SRCL

SRZ

WAG

Holdings as % of Total Book Value

AEE10%

AEOS7%

CPRT4%

FR12%

JKHY4%

JPM13%

KMB10%

MS12%

MVSN8%

SRCL2%

SRZ12%

WAG6%

AEE

AEOS

CPRT

FR

JKHY

JPM

KMB

MS

MVSN

SRCL

SRZ

WAG

Portfolio Fit – Correlation Matrix

AEE AEOS CPRT FR JKHY JPM KMB MS MVSN SRCL SRZ WAGAEE 1AEOS 0.155 1CPRT 0.226 0.2044 1FR 0.326 0.1321 0.3377 1JKHY 0.196 0.4141 0.2727 0.237 1JPM 0.338 0.3896 0.2462 0.231 0.498 1KMB 0.266 0.2115 0.2871 0.341 0.283 0.272 1MS 0.255 0.4217 0.2745 0.265 0.494 0.745 0.361 1MVSN 0.179 0.3539 0.226 0.106 0.397 0.422 0.194 0.489 1SRCL 0.151 0.21 0.0315 0.169 0.207 0.28 0.311 0.24 0.1317 1SRZ 0.09 0.2398 0.0847 0.171 0.28 0.269 0.172 0.342 0.2099 0.161 1WAG 0.239 0.3095 0.2281 0.175 0.31 0.325 0.323 0.434 0.2319 0.329 0.158 1

Note: Table assumes equal-weighted portfolio

Portfolio Fit – Appraisal Ratio

• Appraisal ratio: Risk-adjusted measure of excess returns provided by a security

= alpha/(std error^2)

• Suggests user add (short) the security if alpha is significant and appraisal ratio is greater than alternatives

Portfolio Fit – Appraisal Ratio

Note: All values are significant at 90% confidence

Source Data: Yahoo! Finance

Appraisal ratio= α/(std. error^2)Confidence interval= 90%AEOS 0.618477765ANF 0.742700604GPS -0.480556986LTD 0.429232178

Part 9: Firm Financial Performance

Firm Financial Performance- Cyclicality and Margin Response

AEOS Source of Sales Y/Y Sales Growth 2001-2005

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

2001 2002 2003 2004 2005

non-comparable stores

Δ in comparable store sales

• As shown in the right, AEOS went through a downturn in FY 2002 and 2003

•"Merchandise assortments not clearly focused on target customers" led to "higher markdowns and increased promotional activity” AEOS 2003 10-k p. 11

• What was margin response?

•2002: “We were also not able to leverage selling, general and administrative expenses as a result of the negative comp store sales” AEOS 2002 10-k p. 11

•2003: "The decline in our gross profit margin was primarily due to the deleveraging of rent expense as a result of weak comparable store sales…” 2003 10-K p. 11

AEOS Margins 2000-2005

1.00%

10.00%

100.00%

2000 2001 2002 2003 2004 2005

Gross margin

Operating margin

Net profit margin

Firm Financial Performance- Relative Ratios

• Profitability

• Financial Strength/Liquidity

AEOS ANF GPS LTD IndustryQuick ratio 2.65 1 1.52 0.8 1.03Current ratio 3.44 1.9 2.43 1.93 2.3Long term debt to equity 0 0 9.71 64.99 20.7Total debt to equity 0 0 9.71 64.99 24.1

AEOS ANF GPS LTD Industry% Gross margin 5 yr avg 42.83 57.9 35.68 36.16 36.9% Operating margin 20.09 19.1 9.36 10.84 10.63% Net profit margin 12.84 12.01 5.81 7.22 6.82%ROE - 5 yr avg 26.02 36.68 17.26 30.01 24.02% ROA - 5 yr avg 19.53 20.41 10.32 12 12.1

Financial Management- DuPont Breakdown

FY 2000 2001 2002 2003 2004 2005

Total assets over 543,046 672,721 741,339 932,414 1,328,926 1,605,649Total equity 367,695 496,792 571,590 637,377 963,486 1,155,552

=Equity multiplier 1.48 1.35 1.30 1.46 1.38 1.39

Sales over 1,093,477 1,371,899 1,382,923 1,435,436 1,881,241 2,309,371Total assets 543,046 672,721 741,339 932,414 1,328,926 1,605,649

=Total asset turnover 2.01 2.04 1.87 1.54 1.42 1.44

Net income over 116,958 147,370 141,469 119,587 281,616 368,731Sales 1,093,477 1,371,899 1,382,923 1,435,436 1,881,241 2,309,371

=Profit margin 10.70% 10.74% 10.23% 8.33% 14.97% 15.97%

EM*TAT*PM =Return on equity 31.81% 29.66% 24.75% 18.76% 29.23% 31.91%

• Increases in ROE due primarily to greater profit margins (positive).

Part 10: Valuation

Valuation Method 1: Trading Multiples

• Step 1: Establish list of comparable firms

• Criteria used for choosing comparables:

1. Similar size (market cap)

2. Similar capital structure (Debt/Assets)

3. Similar dividend policy (retention rate)

Ticker Company Name Price Maret Cap Debt/AssetsEBITDA Retention Rate Price/Sales Price/Earnings Price/FCF PEGForward: AEOS American Eagle Outfitters 47.06 6979 0 536 86% 17.63Trailing: AEOS American Eagle Outfitters 47.06 6979 0 536 86% 2.85 22.41 18.57 1.29

GPS The Gap Inc. 19.85 16,446 0 2,370 86% 1.07 18.73 18.39 1.72LTD Limited Brands Inc. 31.64 12,496 1/4 1,285 64% 1.26 17.78 21.22 1.51ANF Abercrombie & Fitch Co. 74.37 6,550 0 667 84% 2.19 18.5 32.88 0.99CHS Chicos's Fashions Inc. 23.55 4,135 0 347 100% 2.55 21.03 35.19 1.05FL Foot Locker Inc. 23.21 3,611 0 580 81.37% 0.64 14.88 18.09 1.21URBN Urban Outfitters Inc. 21.7 3,588 0 247 100% 3.02 31.45 166 1.39GES Guess? Inc. 63.57 2,904 1/9 134 100% 2.57 28.13 29.57 1.22ANN Ann Taylor Stores Corp. 38.81 2,823 0 235 100% 1% 19.7 22.45 1.14JCG J Crew Group Inc. 32.52 1,885 2/3 113 100% N/A N/A N/A N/APSUN Pacific Sunwear of California 18.76 1,301 0 260 100% 0.95 16.03 18.68 1.42

Trading Multiples

• Step 2: Calculate average multiples

• Step 3: Apply multiples for firm being valued

Average Multiples:Price/Sales= 1.77xPrice/Earnings= 20.03xPrice/FCF= 25.99xPEG= 1.3x

Applied to AEOS:AEOS Salesttm= 17 times 1.77 equals 29.14$ Low Value= 22.90$

AEOS Earningsforward= 2.67 times 20.03 equals 53.48$ High value= 65.86$

AEOS FCFttm= 2.53 times 25.99 equals 65.86$ Median Value= 41.31$

AEOS PEG= 17.37 times 1.32 equals 22.90$

Valuation Method 2: Discounted Cash Flow (DCF) Analysis- Base Case

• Step 1: Forecast FCF

• Step 2: Calculate WACC

we= 100% ke= 15% β= 1.71

wd= 0 kd= Tax= 38%MRP= 6.50%

FY 2006 E FY 2007 E FY 2008 E FY 2009 E FY 2010 E

Net Sales 2,646,219 3,032,830 3,475,013 3,982,633 4,567,265

Less: Operating Costs 2,090,708 2,351,839 2,599,467 2,982,486 3,351,337 Taxes Paid 170,395.31 191,433.35 221,181.58 252,508.83 314,672.72 Net Investment (215,000.00) (200,000.00) (15,000.00) (10,000.00) - Δ Working Capital 249,758.40 (102,562.95) (532,762.53) 108,708.61 - = FCF 419,873.98 186,994.74 106,601.96 846,346.77 901,255.34

Discounted Cash Flow (DCF) Analysis- Base Case

• Step 3: Calculate Terminal Value and Discount Cash Flows

L-T Growth Rate= 4%WACC= 16%

1 2 3 4 5FY 2006 E FY 2007 E FY 2008 E FY 2009 E FY 2010 E

FCF 419,873.98 186,994.74 106,601.96 846,346.77 901,255.34 Terminal 8,069,785.19 =PV FVF 363165.6591 139894.6239 68979.9145 473687.1551 4342820.715

Total Equity Value= 5,388,548.07

DCF Analysis- Base Case

• Step 4: Subtract debt and divide by shares outstanding to arrive at intrinsic value

Total Equity Value= 5,388,548.07 Less: L-T Debt 0

=Firm intrinsic value 5,388,548.07 Over: Common shares outstanding 145,931.00

+ 10% 40.62$ =Value per common share 36.93$

- 10% 33.23$

DCF Analysis- Base Case Sensitivity Analysis

2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00%11% 53.19 55.85 58.84 62.23 66.10 70.58 75.79 81.95 89.35 12% 47.05 49.11 51.41 53.97 56.86 60.13 63.87 68.18 73.21 13% 42.05 43.69 45.49 47.48 49.70 52.18 54.96 58.12 61.72 14% 37.91 39.23 40.68 42.26 44.00 45.93 48.07 50.46 53.14

15% 34.43 35.52 36.69 37.97 39.37 40.90 42.58 44.44 46.50 16% 31.47 32.37 33.34 34.39 35.53 36.76 38.11 39.59 41.21 17% 28.92 29.68 30.49 31.36 32.30 33.31 34.41 35.61 36.91 18% 26.70 27.35 28.03 28.76 29.55 30.39 31.30 32.28 33.34 19% 24.76 25.31 25.90 26.52 27.18 27.89 28.65 29.46 30.34

Long-term growth rate

WA

CC

However…

• The DCF value just presented assumes steady annual growth of approximately 15%– Although AEOS has demonstrated an ability

to grow at extremely high rates (over 15%), one cannot forget the firm’s susceptibility to shifts in consumer preference (fashion)

DCF Analysis- Downside Scenario

DCF Analysis- Downside Scenario

• Let’s assume that for whatever reason, AEOS experiences a 2-year downturn in comparable store sales similar to the one experienced in 2002-2003

Downside Sales Projections 2001-2010

-10.00%-5.00%0.00%5.00%

10.00%15.00%20.00%25.00%30.00%35.00%

FY

2001

FY

2002

FY

2003

FY

2004

FY

2005

FY

2006 E

FY

2007 E

FY

2008 E

FY

2009 E

FY

2010 E

% y/y new store sales

% y/y comp sales

DCF Analysis- Downside Scenario

• Under this downside scenario, we see that the DCF-generated stock price decreases significantly

Total Equity Value= 3,154,038.48 Less: L-T Debt 0

=Firm intrinsic value 3,154,038.48 Over: Common shares outstanding 145,931.00

+ 10% 23.77$ =Value per common share 21.61$

- 10% 19.45$

DCF Analysis- Downside Scenario Sensitivity Test

2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00%11% 30.77 32.26 33.94 35.85 38.02 40.53 43.46 46.93 51.08 12% 27.31 28.47 29.76 31.20 32.82 34.66 36.76 39.18 42.01 13% 24.50 25.42 26.44 27.56 28.80 30.19 31.75 33.53 35.55 14% 22.17 22.92 23.73 24.62 25.60 26.68 27.88 29.22 30.73

15% 20.21 20.82 21.49 22.20 22.99 23.85 24.79 25.83 26.99 16% 18.55 19.05 19.60 20.19 20.83 21.52 22.28 23.11 24.02 17% 17.11 17.54 17.99 18.48 19.01 19.58 20.19 20.87 21.60 18% 15.86 16.22 16.61 17.02 17.46 17.93 18.44 18.99 19.59 19% 14.77 15.08 15.40 15.75 16.12 16.52 16.95 17.41 17.90

Long-term growth rate

WA

CC

Valuation Methods Compared

22.90 $41.31 65.86

23.77 $33.89 44.00

- 20.00 40.00 60.00 80.00 100.00 120.00 140.00

Trading Multiples

DCF

Valuation Methods- DCF and Trading Multiples

Part 11: Recommendation

Recommendation• Firm direction

– Martin + Osa– Margins

• Diversification• Valuation

– Trading multiples• The trading multiples approach suggests a price similar to that at which AEOS is

currently trading• This price relies on the firm’s past sales, earnings, and free cash flow numbers and

thus, would be prone to overvaluation, especially when used in a long-term investment decision

– DCF• Although our DCF model is somewhat crude, we feel that the insight added by

accounting for a downturn in sales shows, in a very dramatic way, the downside risk inherent in the company

• In summary, we believe that American Eagle Outfitters’ strong performance in recent periods has caused unrealistic market expectations for the firm’s future performance, thus inflating the price

Recommendation

• Our recommendation, therefore is to sell approximately 24% or 400 shares of AEOS at the market– Realized capital gain approx.= $15,664

Holdings as % Total Market Value: Post-Sale

7%

18%

9%

14%5%

13%

6%

9%

2%

4%

6%7%

AEE

AEOS

CPRT

FR

JKHY

JPM

KMB

MS

MVSN

SRCL

SRZ

WAG

Questions?