Geoff Gannon December 23, 2005

On American Eagle

Generally, I don’t like investing in retailers, because it is nearly impossible to find one with a durable competitive advantage. I do, however, like to invest in companies generating tons of truly free cash flow and consistently earning good returns on invested capital while maintaining a pristine balance sheet. When one such company is priced at less than a dozen times earnings (and a part of that price is attributable to the cash in its coffers) my heart begins to patter.

The object of my affection: preppy teen retailer American Eagle (AEO). AE recently reported dismal numbers, and there is no reason to believe things will get better; in fact, they’ll probably get worse. But, at this price, the issue is not whether sales growth is slowing. In fact, at this price, the issue is not even whether sales are declining. Even If AE’s sales do decline, the stock could still be cheap. The issue is whether AE can, on a continuing basis, generate enough truly free cash flow to justify the current price. If, in the long – run, AE can throw off cash at a rate similar to that of the recent past, its shares are cheap. Of course, if AE’s ability to generate free cash has been permanently and materially impaired, its shares are wildly overpriced. Which is it? If you know, tell us by commenting below.

Otherwise: start your homework by reading another blogger’s take on American Eagle , and a fool’s takeRequesting an investor’s kit , and/or by checking out AE’s last 10-K right now. You can also hear more of my thoughts on American Eagle Outfitters on Thursday’s upcoming value investing podcast.

Until then, happy hunting!