RTCrawford’s Weblog

Equities investing is an imprecise science, at best. No investor is immune to the vagaries of the marketplace or the inadequacies of the human mind (especially, the inadequacies that constitute self-inflicted injuries). My experience has included both. Early in my investing life, I purchased shares of several Fortune 500 companies (Dow 30 stocks, each) for all the wrong reasons — they were big, reputable, seemed cheap, and, most especially, they were designed to persuade my wife that I wasn’t about to lose the farm as I invested our relatively small savings. And then there was that investment in Sears Holdings, which was a maven-following exercise (Eddie Lambert), Alberto Culver (poor math and no moat), Duke Energy (unrecognized conflict of interest), and one or two others.

Despite these failures, my portfolio has significantly outperformed the various and appropriate indexes, using a value investment approach and philosophy. During this time, I have beaten the S&P 500 by roughly 8% per year, thereby, outperforming 70% of professional portfolio managers. Not bad for a scrawny academic living in Morrisville, North Carolina.

One of my favorite investments has been American Eagle — the clothier of my son and many of his friends at Enloe High School, to say nothing of a significant number of my students that the University of North Carolina at Chapel Hill. I mention this because Peter Lynch recommends identifying the stock of companies that, by self-observation, enjoy significant foot traffic and popularity. Lynch, however, urges the investor to perform their due diligence, above and beyond simple observation, before deploying hard-earned savings. Since American Eagle and its stock are down in value since I began posting comments on the Yahoo message board for the stock, it may be beneficial to do more than revisit the original investment decision — focusing, instead, on the fundamentals as they exist today, in comparison to that initial decision.

Before getting started, I should mention two relevant items. First, this posting is going to be graphics-heavy — providing more information than the average investor typically employs when making a purchasing decision. Second, having been so publicly supportive of the stock (I use no moniker to disguise my postings on Yahoo or elsewhere), I feel obliged to explain my decisions.

And, so, with that as predicate, let’s get into the analysis.

First, let’s consider the return on invested capital for the company.

The 2008 results, which came out long after the start of the new year, are clearly disappointing. In Late 2007, when I first purchased the stock, the prior results significantly exceeded the five-year and 10-year averages and were well above the range required by the original value investor, Benjamin Graham (the two horizontal lines). There are two items worth mentioning at this point. First, value investors do not deploy capital based on a single year’s results. One of the strongest forces in the marketplace is “reversion to the mean,” and I have every reason to believe that this will be the case with American Eagle. Short-term investors are notorious for assessing a stock’s valued based on short-term results, but stocks tend to revert to their intrinsic value over time. Second, my original investment decision was not based on the 2008 results. I will leave crystal ball reading to others, since, by self-report, they are so good at it.

The ability of the Company to convert its cash holdings in a net income is an important measure of management efficiency. On this front, the company performed significantly better than the first chart would imply.

At this point, it is important to note that no single metric of performance by a company and its management should be considered definitive. If basing your investment on the first chart, alone, you would have an incomplete picture. This is especially true if looking at American Eagle’s conversion of last year’s cash into this year’s cash.

The decline in cash, however, can be largely explained by the repurchase of shares in the company. Do not, therefore, view a single chart as uniquely important. Instead, view all the charts that follow as providing a holistic feel for the company and its character. Some graphs will suggest that the company is outstanding, while others will leave you uncertain. Taken in their totality, the original investment choice will make sense, as will the more recent reduction in my estimation of intrinsic value for American Eagle.

Next, let’s turn to “owner’s earnings” — which is a measure that Warren Buffett uses to identify that portion of the company that accrues to the owner/investor. With each of the graphs that follow, clicking on them will make them larger and easier to read.

I’ve taken the liberty of overlaying process control charts, which will be a recurring theme with many of the charts that follow. Allow me, therefore, to explain them. The first five years use standard process control charts to identify the upper and lower control limits, which are set at three standard deviations from the mean. Whenever future results exceed the upper or lower control limit for the first five years, a statistically significant change in performance has taken place. The center line is the mean, and the three lines above and below the mean reflect one, two, and three standard deviations. Any single data point that exceeds the three standard deviation line is an outlier on the order of 100-year flood (exceeding 99.98 percent of expected results). Over the first five years, I use a standard linear control chart, and, over the second five years, I use a trended control chart. Considering both with the chart above indicates that the most recent five-year results significantly exceed the first five years, and that, despite last year’s decline, the results are not outside of the expected range for the trend and it still exceeds the expected range from just four years earlier. That range, however, has expanded (the distance between the upper and lower control limits), which is to be expected since the mean has grown significantly.

This suggests that the most recent year’s figures were not entirely outside of the range that may be reasonably expected. Indeed, the most recent results fall within the one standard deviation lines (the first lines above and below the central mean line). The average investor, however, would get hot and bothered by such a short-term decline. It may be helpful, therefore, to look at the percentage change in growth from one year to the next.

This chart indicates that there was, indeed, growth in the previous year, but that the growth was not horrifically bad, in comparison with prior results over the past decade. In other words, some years are great, other years are going to be poor, but most years will be about average. Last year’s results were about average.

Owner’s earnings, however, are designed to, either, enriched the stockholder or profitably progress Company growth. To assess this, we need to look at the company’s book value.

With book value, the company’s performance can be put into its proper perspective as a growth enterprise. During the first five years, the results indicate consecutive growth. During the second five years, the results continue that prior trend (even with the marginal decline in 2008 — which is not outside of the expected range) …

Even though it represented a marginal decline. Here, again, it is important to recognize the historical growth rate, expect that there will be some reversion to the mean, and, most importantly, to consider last year’s results within a perspective provided by the previous nine years. In other words, there was negative growth in the most recent year but that the level of negative growth was small in comparison to the actual growth posted in prior years. Personally, I would be more alarmed if the reduction were more significant or the decline were on a par with prior growth.

How does all of this affect shareholders equity? The results are similar:

Indeed, the company’s cash posture has not changed significantly (i.e., its ability to drive future growth with deployable capital). The change in Cash from the statement of cash flows is tracked below:

Note how it hovers around the zero line, and even represents a small improvement in the most recent year.

Because most investors tend to focus on earnings, I would be remiss if not providing the appropriate charts. It is important, however, to note the deficiency of earnings per share as a measure of company performance. Earnings per share factor in depreciation and amortization, as well as changes in “goodwill.” For those who are wedded to this measure, here are the charts:

Next, we turn to the securities market line, which considers the performance of the company in comparison to that which is expected of the stock market, as a whole. It considers the volatility of the stock (it’s beta), as well as the company’s earnings. This is the risk / reward measure you’ve heard so much about. Companies that generate results that are above the securities market line tend to produce better results than similar stocks at the same beta and do so with less risk.

The market tends to favor companies that pay dividends, even though those funds should be deployed toward growing the company if the firm is able to generate a higher return on capital than the investor may expect to achieve if deployed elsewhere. In previous postings, we have covered the subject of earnings power value, which indicates that the company is able to generate returns on invested capital exceeding its cost of capital. (http://rcrawford.wordpress.com/aeo-april-9th-2008aeo-april-9th-2008/) Nevertheless, American Eagle does pay a dividend. So, it is appropriate to consider the payout ratio.

This, of course, looks exceedingly healthy, and, in general, the totality of the previous charts provide a general indication that the company is not on the verge of bankruptcy or imminent implosion — as some holding short positions and posting on the Yahoo message boards suggest.

The preceding charts, however, provide a macro view of the company. Next, we leave the ratios behind and look at the actual results from the company’s financial reports. First, we consider gross margins.

Lost in all the angst over the most recent results is the reality that American Eagle posted profits last year, driven by its gross profitability. In other words, the cost of goods sold failed to eclipse operating revenues. Personally, it is amazing to me how depressed some investors can get over varying degrees of profitability. Contrast this with those who purchase lottery tickets, lose from one week to the next, and head back to purchase more.

While operating expenses were presented in the previous graph, lets drill down to see whether there is anything worthy of alarm.

As indicated in the previous chart, operating expenses have increased at a rate commensurate with gross profits. The “other” category has not evidenced a spike up or down but, instead, has remained within the expected range. In other words, there is nothing alarming here.

While we will not give serious consideration to depreciation and amortization or goodwill, it is necessary to consider the management of taxes (the next significant item leading to net income).

Last year, taxes decreased marginally, even though earnings before taxes increased . In the past decade, taxes have increased on a par with earnings before taxes.

While we considered earnings-per-share previously, it is necessary to take into account diluted earnings per share as reported versus diluted earnings per share from operations.

With rare exceptions, the two are precisely the same.

Next, let’s drill down into the cash flows from operations.

Cash flows declined as income from operations marginally increased. The most significant cause of this is listed under the “other” category. In the most recent yearly filings, management explains this, as follows:

Other Income, Net

Other income, net decreased to $37.6 million from $42.3 million. The decrease was primarily due to a $3.5 million realized capital gain last year and a decrease in our gift card service fee revenue due to the gift card program change that occurred in July 2007. These decreases were partially offset by increased investment income resulting from an overall increase in rates compared to last year. Additionally, we recorded a $1.2 million foreign currency transaction loss as a result of a stronger Canadian Dollar versus the U.S. Dollar compared to a $0.7 million loss last year.

Prior to July 2007, we recorded gift card service fee income in other income, net. As of July 8, 2007, we discontinued assessing a service fee on inactive gift cards and now record estimated gift card breakage revenue in net sales. In Fiscal 2007, we recorded gift card service fee income of $0.8 million compared to $2.3 million for the Fiscal 2006. For Fiscal 2007, we recorded breakage revenue of $13.1 million in net sales. This amount included cumulative breakage revenue related to gift cards issued since we introduced the gift card program.

As for cash from investments, performance in the prior year was better than in previous years and, given the company’s exposure to auction rate securities, better than may be expected in the coming year. Here’s the chart:

Cash Flows from Investing Activities

Investing activities for Fiscal 2007 included $354.2 million from the net sale of investments classified as available-for-sale, partially offset by $250.4 million for capital expenditures. Investing activities for Fiscal 2006 primarily included $437.4 million for the net purchase of investments classified as available-for-sale as well as $225.9 million for capital expenditures. Investing activities for Fiscal 2005 included $81.5 million for capital expenditures and $311.4 million for the net purchase of investments.

We invest primarily in tax-exempt municipal bonds, taxable agency bonds, corporate notes and auction rate securities, with an original effective maturity of up to five years and an expected rate of return of approximately a 4.6% taxable equivalent yield. We place an emphasis on investing in tax-exempt and tax-advantaged asset classes and all investments must have a highly liquid secondary market at the time of purchase and an effective maturity not exceeding five years.

As before, the previous quote is taken from the company’s yearly filings.

While the company has disclosed its exposure to the recent liquidity crisis with its investments in auction rate securities, here is the description provided in the yearly filing:

Auction Rate Securities

As of February 2, 2008, we had a balance of approximately $418 million of investments in ARS. Beginning February 12, 2008 through March 25, 2008, we have experienced failed auctions for 36 ARS issues representing principal and accrued interest in the total amount of $272.5 million. During this time, we have also sold nine ARS issues, at par plus accrued interest, for a total of $36.6 million. As of March 25, 2008 our ARS portfolio totaled approximately $373 million. We believe that the current lack of liquidity relating to our ARS investments will have no impact on our ability to fund our ongoing operations and growth initiatives.

Next, we turn to cash from financing activities.

The decline in cash from financing is attributable to the significant repurchase of shares with available cash, which the company describes as follows:

Cash Flows from Financing Activities

Cash used for financing activities resulted primarily from $438.3 million used for the repurchase of our common stock as part of our publicly announced repurchase programs and $80.8 million used for the payment of dividends during Fiscal 2007. During Fiscal 2006, cash used for financing activities resulted primarily from $146.5 million used for the repurchase of our common stock as part of our publicly announced repurchase programs and $61.5 million used for the payment of dividends. During Fiscal 2005, cash used for financing activities from continuing operations resulted primarily from $161.0 million used for the repurchase of common stock as part of our publicly announced repurchase programs and $42.1 million used for the payment of dividends, partially offset by $48.2 million in proceeds from stock option exercises during the period.

It goes without saying that the purchase of equity shares represents a significant benefit for current stockholders, and that this reduction should not represent a negative in the mind of the investor — unless the company were borrowing (i.e., undertaking debt) to repurchase shares. Indeed, the willingness of the company to repurchase shares at recent price levels indicates management’s view that the stock is/was undervalued.

Turning to cash flows:

As previously noted, cash flows decline in the most recent year. This is commensurate with a reduction in cash from operations. There was, as well, a small reduction in capital expenditures from the prior year. While this may be explained by the company’s investments in infrastructure upgrades (described earlier), the yearly filings provide the following:

Capital Expenditures

We expect capital expenditures for Fiscal 2008 to be approximately $250 million to $275 million, which will relate primarily to approximately 40 new and 40 to 50 remodeled American Eagle stores in the United States and Canada, approximately 80 new aerie stand-alone stores, information technology upgrades, the purchase and construction of the second phase of our new corporate headquarters, investments in MARTIN + OSA, including approximately 15 new stores, and distribution center expansion/improvement, including the completion of the second phase of our Ottawa, Kansas distribution center expansion. We plan to fund these capital expenditures through existing cash and cash generated from operations.

Fiscal 2007 capital expenditures of $250.4 million included $129.9 million related to investments in our stores, including 80 new and 53 remodeled stores in the United States and Canada. Additionally, we continued to support our infrastructure growth by investing in the expansion and improvement of our distribution centers ($47.6 million), construction of our new corporate headquarters in Pittsburgh, Pennsylvania ($37.3 million), information technology upgrades at our home office ($22.1 million), and the purchase of a corporate jet ($13.5 million).

Current Assets:

The decline in net current assets is attributable to the change in short-term investments (mentioned earlier), which the company describes in the yearly filings as follows:

Proceeds from the sale of available-for-sale securities were $2.127 billion, $916.0 million and $876.1 million for Fiscal 2007, Fiscal 2006 and Fiscal 2005, respectively. These proceeds are offset against purchases of $1.773 billion, $1.353 billion and $1.188 billion for Fiscal 2007, Fiscal 2006 and Fiscal 2005, respectively. For Fiscal 2007, Fiscal 2006 and Fiscal 2005, net realized losses related to available-for-sale securities of $0.4 million, $0.6 million and $0.2 million, respectively, were included in other income, net.

Total Assets:

The change in short-term assets has already been described (above). There was, as well, a slight decline in other long-term assets, which the company described as a shifting of assets between categories:

During Fiscal 2006, the Company transferred certain investment securities from available-for-sale classification to trading classification (the “trading securities”). As a result of this transfer, during Fiscal 2006 a reclassification adjustment of $(0.3) million was recorded in other comprehensive income related to the gain realized in net income at the time of transfer. As a result of trading classification, the Company realized $3.5 million of capital gains, which were recorded in other income, net during Fiscal 2006. The trading securities were sold during Fiscal 2006, at which time the Company received proceeds of $184.0 million. As of February 2, 2008, the Company had no investments classified as trading securities.

Current Liabilities:

The decline in current liabilities was in line with the decline in operating income. This indicates that management was responsive to changing market conditions. There was, as well, a significant decline in accrued liabilities (which is of benefit to the investor).

Total Liabilities:

The decline in total liabilities was not as pronounced as the reduction in short-term liabilities. This was attributable to the category shift (described earlier). In general, it is preferable to shift short-term liabilities into long-term liabilities, if possible, during market declines, especially, if there are better uses for short-term capital — such as repurchasing shares or investing for future growth. The company did both in the prior year (described previously).

Shareholders Equity In Comparison to Liabilities:

In this chart, the bolded green line indicates shareholders equity, which is contrasted with liabilities and shareholders equity in combination with liabilities. This provides the viewer a sense of the degree to which shareholders equity accounts for the totality of the company’s holdings. Recall that shareholders equity and liabilities equal total assets. While shareholders equity posted a marginal decline in the most recent year, that decline represented a small portion of the increase over the prior two years. This should put the company’s viability and strength into something approaching its proper perspective.

As we will see shortly, the stock price has declined by over 50% from its highs in January of 2007. There is nothing in the shareholder’s equity line to justify such a significant decline, unless the investor expects that shareholder’s equity will continue to drop to a level that is one half the pinnacle results achieved in 2007. The only other possible justification for the decline is to argue that the stock was overvalued before his recent reduction. While this is been addressed in previous postings, which consider the intrinsic value of the company based on discounted cash flow analysis, replication value, and earnings power value, let’s consider the company’s intrinsic value using another tool.

Sometime back, I worked with Joe Ponzio, the CEO of Meridian Capital and the brain behind FWallStreet.com, on a small number of projects related to automating identification of undervalued firms using discounted cash flow analysis. Here is one of the tools Joe created (applied to American Eagle). We start with identifying our free cash flow assumptions in future years.

The discount rate is set at 15%, which, in itself, represents the equivalent of a 50% margin of safety in comparison to the more normal 10% discount rate. The choice of 18% for the first three years is based on the cash return on invested capital rate, which, for American Eagle is a median of 18.5% over the past decade and 26.1% over the past five years. In general, a company cannot grow faster than its cash return on invested capital. For the next three years, I’ve used a 15% growth rate, which is in line with management’s declared medium-term projection for earnings. Thereafter, I’ve reduced this growth rate more severely, in order to achieve a more significant margin of safety.

Given these assumptions, historical calculations for intrinsic value in comparison to the stock’s price are:

There are a number of items from this chart that are worth noting. Without getting into the technical details, the Red line represents the recommended approach of, both, Monish Pabrai and John Burr Williams, while the Green line represents the marginally less conservative approach of Joe Ponzio. Both are more conservative than when identifying intrinsic value based on discounted cash flow analysis (due to the intrinsic value multipliers used to factor the continuing value of a company beyond the next 20 years). The pink line, as indicated, represents the book value of the company.

In reading the chart, it is worth noting that the significant decline in intrinsic value for the most recent year was not predictable based on the prior results. In fact, there is nothing in the fundamentals analysis for the company (provided above) to support such a change. Simply put, the economy went into a cyclical recession.

Looking forward, holders of the stock are compelled to ask whether this single year decline is likely to remain at this level in the future, decline further, or revert to the prior mean. While I believe that last year’s results represent a single-year blip (expecting expansion of the brand internationally, full roll-out of 77 Kids and M&O, and grow of the women’s lingerie line), other investors may view things differently and prefer to calculate the intrinsic value of the company based on some multiple of book value. This chart (above) provides the reader with a graphical means by which to do this.

As one who has advocated the value investing approach, the recent results may suggest that it lacks utility. So, let’s take a look at my purchasing decisions starting in October of 2007. Here are the dates and the prices at which I bought shares:

And here is the sequence on the pricing chart:

Given the strong run-up in price prior to January of 2007, the trend-following investor would consider the stock a golden opportunity, just as the stock was about to fall off a cliff. Having bought the stock with a 50% margin of safety, fully expecting to make no less than five purchases if the stock declined further, I feel like my good friend Joe Adelsberger on a parachute jump. Now retired, Joe was an A-Team operations Sergeant with the special forces. Weighing in excess of 300 pounds, Joe easily exceeded the maximum capacity of the standard parachute (with or without full combat load), and he frequently had to rely on his reserve chute — using the first to slow his decent.

By purchasing at a significant discount to its intrinsic value, even if the company performs no better than expected in the future, I have not overpaid. I anticipate, however, that the recession will end, the economy will rebound, and that American Eagle grow in the future. And that is why, despite the recent financial results, I remain invested in the stock and prepared to buy more if it should decline to my next target — which is around $15 a share.