Ticker Symbol: AEO. Kevin Cooper - 1 -

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1 Ticker Symbol: AEO Jennifer Pfieffer Lisa Hase Michael Gerrish Carl Ebbern Kevin Cooper (kevin.cooper@ttu.edu)

2 Table of Contents Executive Summary 3 Company Overview 7 Five Forces Model 9 Formal Accounting Analysis 27 Financial Ratio Analysis 49 Forecasting 79 Regression Analysis 89 Valuation 91 Appendix Appendix Works Cited

3 Executive Summary Investment Recommendation: Overvalued, Sell 4/1/2007 Key Statistics Industry Members PPS (as of 4/1/07) Index NYSE Abercrombie and Fitch $75.68 PPS AEO (as of 4/1/07) $29.99 Aeropostale $ week range $ $34.80 Gap $17.21 Revenue (2006) $2.8 B Limited $26.06 Market Capitalization $6.6 B Shares Outstanding $221 M Comparables Valuations Enterprise Value $7 B P/E (trailing) $33.74 Undervalued Dividend Payout Ratio 15.9% P/E (forecast) $32.25 Undervalued 3 month Avg. Daily Trading Volume 3.2 mil. P/B $24.12 Overvalued Price/Earnings Dividends/Price $18.09 Overvalued Price/Earnings forecast P.E.G. $27.24 Overvalued Book value per share $8.98 P/EBITDA $31.85 Undervalued Return on Equity 33.5% P/(FCF per share) $16.27 Overvalued Return on Assets 24.10% Enterprise Value/EBITDA $34.92 Undervalued Cost of Capital Est. Beta R2 Ke Intrinsic Valuation 72 months % 1.9% Discounted Dividends $6.64 Overvalued 60 months % 3.6% Free Cash Flows $90.97 Undervalued 48 months % -0.8% Free Cash Flows (Cap. Leases) $ Undervalued 36 months % 2.1% Residual Income $11.90 Overvalued 24 months % 3.0% Abnormal Earnings Growth $19.78 Overvalued Published Beta 1.2 Ke 13% Altman Z-Score 3.75 Low Risk WACC 11% Altman Z-Score(Capitalized) 2.66 Moderate Risk

4 Analysts Recommendation Overvalued, Sell Company and Industry Overview and Analysis American Eagle Inc. was established in 1977 to offer affordable, quality clothing to the younger generation. American Eagle is in a sub-industry of the apparel industry, which consists of other competitors Gap Inc., Limited Brands, Abercrombie and Fitch Co., and Aeropostale. These companies sell denim, shirts, footwear, swimwear, accessories, and outerwear. Rivalry amongst existing firms is intensified by focusing on a smaller market, and competition is propelled by the industry s constant need to have the latest fashions when demanded. American Eagle and its direct competitors expand their economies of scope into sub-brands and a wider variety of merchandise in order to capture more market share. The current competition deters new entrants because it is hard for new entrants to secure channels of distribution in order to deliver to customers. Department stores pose a threat of substitution for cheaper clothes and a wider variety. Although department stores are more convenient, consumers of American Eagle are loyal to it and its competitors because these consumers are driven by brand names and logos. This helps eliminate the threat of substitutes of cheaper clothes. Consumers have low switching costs between the direct competitors because consumers alternate between the stores seamlessly. American Eagle sets itself apart in the specialty retail sub-industry by offering its products at a lower price and emphasizing a healthy brand image. Accounting Analysis American Eagle altered its accounting policies in 2003 in order to improve efficiency. The company did this by changing inventory policies and how they manage discounted merchandise. GAAP allows companies in the specialty retail sub-industry a wide range of flexibility when determining goodwill amortization, - 4 -

5 asset depreciation, classifying leases, and accounting for inventory. This flexibility enables the management to convey the workings of the company to shareholders with additional explanations to provide understanding for investors. When analyzing American Eagle, we considered many sales and expense manipulation diagnostics to investigate management s treatment of revenues and expenses. The only red flag raised was the operating leases which expenses only the current portion of the lease obligation instead of capitalizing the future lease holds on the balance sheet. This underestimates assets and liabilities and modifies a potential investor s view of the company. When the leases are capitalized we gain a better knowledge of American Eagle s true financial situation. Financial Ratio Analysis and Forecasting A firm s financial ratios are broken down into three categories: liquidity ratios, profitability ratios, and capital structure ratios. American Eagle presents average liquidity ratios in comparison to the industry. The current ratio is currently 2.6, which means $2.60 of current assets are available for every $1 of current liabilities. Therefore, American Eagle has plenty of liquidity that would appeal to lenders. According to our analysis, American Eagle has high profitability ratios and it leads the industry in gross profit margin and operating profit margin. This is because American Eagle is able to purchase its merchandise at a cheap rate from a variety of vendors. They are then able to turn the product around and sell in a high end market to gain a high gross profit. The capital structure ratios show that American Eagle is financed mostly by equity, which frees them from payments to bond holders who could hold leverage over the company. In order to forecast American Eagle s financial statements out for the next ten years, we created a common-size statement of the balance sheet and income statement. This helped us determine structural trends for the company to better forecast future growth. Since American Eagle changed accounting policies in - 5 -

6 2003, the past five years has seen a dramatic alteration across the financials. Therefore, we used the past three years in order to determine trends to grow net sales and total assets. In the forecasted balance sheet, we compensated for the operating leases and capitalized the leases on a second balance sheet. American Eagle already grows in sales at about 14%, which is consistent with the industry. Intrinsic Valuation When calculating the intrinsic valuations, we first calculated the cost of debt and cost of equity to determine the weighted average cost of capital. We adjusted cost of debt when we capitalized leases. We then valued the company through the discounted dividends model, free cash flows model, residual income model, and abnormal earnings growth model. The discounted dividends, residual income, and abnormal earnings growth models all stated American Eagle is overvalued in the market. We based our recommendation on the residual income and abnormal earnings growth models because they presented the most accurate valuations. The two averaged a $15.84 value for American Eagle Stock compared to the observed April 1, 2007 price of $ We finally considered Altman s z-score to examine American Eagle s credit risk. The z-score revealed American Eagle to have minimal chance of going bankrupt with a 3.75 score considering operating leases. After converting the leases to capital leases, the z- score fell to 2.66, making the company an indeterminable risk. Ultimately, we believe American Eagle to be at moderate to low risk of going bankrupt. Our overall conclusion is the firm is overvalued by approximately $

7 Company Overview American Eagle Outfitters, Inc., also known as American Eagle or AE, was established in The corporate headquarters are currently located in Warrendale, Pennsylvania, but will soon be moving to Pittsburgh, PA. It is a specialty apparel retailer of fashionable clothing targeting people between the ages 15 and 25. American Eagle sells jeans, t-shirts, accessories, footwear, swimwear, and outerwear. It has expanded its operations from the United States, into Canada, and Puerto Rico. Currently there are a total of 911 stores, 839 in the U.S., and 72 in Canada. ( American Eagle considers itself to be a part of the competitive, brand name, specialty apparel industry. Its successes derive from its ability to adapt and offer the newest trends at a reasonable price. Other firms in this unique industry include the following: Abercrombie and Fitch Co., Gap Inc., Aeropostale Inc., and Limited Brands Inc. The following graph illustrates the market capitalization for each firm not only as a number but also as a percentage of this sub-industry. It is calculated by multiplying the price per share times the number of shares outstanding. Industry Market Cap (in billions of dollars) $10.37 $18.81 $6.64 $6.68 $2.39 American Eagle Abercrombie and Fitch Aeropostale Gap Limited

8 All members of this industry design, market, and sell their own lines of specialty apparel. American Eagle intends to increase its market share by continuing to promote brand loyalty through the customer loyalty programs. In addition, the company will provide the newest fashion the customers want, at the prices they can afford. They have also recently expanded its customer base by introducing the MARTIN + OSA, and aerie sub-brands. MARTIN + OSA consists of sportswear targeting 25 to 40 year olds, and aerie is a new collection of dorm wear and intimates for young women (AEO 10-K). Revenues for the 2006 fiscal year increased over 20 percent to the amount of $2,794,3409,000. The majority of the firms in this industry experienced similar increases in revenue. In addition to increasing revenue, total asset value has also increased. The chart below describes the percent change in total asset value for American Eagle over last five years. There has been a definite increase in asset value for each of the years with the largest increase from 2004 to Analyzing a firm s total asset value is another way to measure the size of a company. AEOS Asset Values Year Asset Value (in thousands) % Change from Previous Year 2006 $1,987, % 2005 $1,605, % 2004 $1,328, % 2003 $932, % 2002 $741,339 N/A The following graph, found on the yahoo website, illustrates American Eagle s stock price performance for the past five years. It experienced a 5-year low of $3.35 on October 9, 2002, and the 5-year high of %34.34 occurred on January 16, After adjusting for splits and dividends, the data shows that the stock price has tripled in the past five years. This graph also shows all of American Eagle s industry competitors and their stock price performances over - 8 -

9 the past five years. The firms in this industry seem to be following the same general stock price trends ( Splits:06-Jan-98 [3:2], 11-May-98 [3:2], 04-May-99 [2:1], 26-Feb-01 [3:2], 08-Mar-05 [2:1], 19-Dec-06 [3:2] Five Forces Model The five forces model details the extent of competition within an industry by analyzing factors such as rivalry among existing firms, threat of new entrants, threat of substitutes, buying power of buyers, and bargaining power of suppliers. When the competition level is properly assessed, a company can better determine its core competencies so it can best succeed in the industry. Rivalry Among Existing Firms Threat of New Entrants Threat of Substitutes Buying Power of Buyers Bargaining Power of Suppliers High Low Medium High Low - 9 -

10 The apparel industry consists of a wide variety of clothing, footwear, and accessories stores. Within this large industry is a smaller sub-industry of specialty retail. The specialty retail industry is made up of companies such as Abercrombie and Fitch Co., American Eagle Outfitters Inc., Gap Inc., Aeropostale Inc., and Limited Brands Inc. These stores are competitive in higher end retail and market to a narrower customer base. This customer base focuses on consumers from ages ( The key is to balance a different, yet trendy product and proved a price that suggests value to the customer while being affordable. Rivalry Among Existing Firms Rivalry among existing firms breaks down the competition level between the leading competitors in an industry. The competition is best depicted by analyzing the growth of the industry, concentration and balance of competitors, degree of differentiation and switching costs, ratio to fixed and variable costs, and exit barriers and excess capacity. The different degrees of competition determined by these factors affect how companies relate to one another in order to prove successful. INDUSTRY GROWTH Industry growth determines if companies must fight for their share of the market. If the industry is growing, there are plenty of consumers for each company to be profitable. In the specialty retail sector, the industry has been growing steadily which should lower competition. The sub-industry, specialty retail is encompassed by the apparel industry; competitors include American Eagle Outfitters Inc. Gap Inc., Aeropostale Inc., Abercrombie and Fitch Co., Limited Brands Inc. These companies make up a cluster of specialty retail stores that market quality clothing to a younger generation. The industry has shown a

11 steady increase in stock value over the past five years. The cyclical nature of this industry is created by quarterly fashion trends; this creates a constant demand for the latest product. These companies offer a differentiated product but they also compete heavily with each other. The industry strives by marketing higher end clothing to year olds. Although the industry is growing, limiting marketing to such a small portion of the population intensifies competition. The companies differentiate themselves with highly recognized brand names. The brand name and quality of clothes separate each company from the other, giving them a unique advantage over other general clothing shops such as department stores. In this portion of the industry, brand is everything and the customers pay a premium for it. The demand for these styles of clothing is limited to certain age groups, causing more stores to fight for the same market share and therefore increasing competition. Nevertheless, firms in this industry seem to be experiencing growth. Total Assets Total Assets (in thousands of dollars) 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000, Year American Eagle Abercrombie and Fitch Aeropostale Gap Limited Industry Average

12 As illustrated in the previous graph, the firms in this industry are steadily increasing their assets with the exception of Gap Inc. and the Limited Brands. By measuring changes in total assets, we can analyze the amount of growth within a firm or an industry. The growth trends of this industry are further evident in the following pie chart. The chart illustrates industry market share. Industry Market Share (based on net sales) 8% 7% 10% 6% 9% 31% 30% 7% 5% 31% 6% 4% 31% 3% 6% 3% 32% 5% 2% 55% % % 50% % % American Eagle Abercrombie and Fitch Aeropostale Gap Limited Market share is the portion of the market a particular firm controls as a percentage of the entire industry. This chart uses net sales as the determinate for market share of a firm. Net sales must increase at an equal or greater rate than the competition in order to maintain market share. According to the chart ANF, AEO, and ARO appear to be gaining market share, while GPS and LTD seem

13 to be losing market share over the last five years. Firm growth can also be examined by looking at the firm s net income. Net Income 1,400,000 1,200,000 1,000, , , ,000 American Eagle Abercrombie and Fitch Aeropostale Gap Limited 200, The previous graph represents the net incomes of each competitor in the specialty retail sub-industry for the past five years. Changes in net income help illustrate a firm s growth. Again, there is evidence that this sub-industry has grown as a whole. CONCENTRATION AND BALANCE OF COMPETITORS Concentration and balance of competitors focuses on the number of competitors and how they work together in competition in order to avoid destructive price competition (Palepu, 2-3). The apparel industry s retailers are most often found in malls and surrounded by some of their greatest competitors. Consumers of the specialty retail industry brands perceive high value of the clothing and expect to pay extra for it. Price competition is relatively low and any

14 discounts to the customer are considered bonuses. But, with so many direct competitors centrally located, the companies must fight to lure customers into their stores as opposed to the others. Additionally, companies are continuing to search for new mall to add locations, create sub-brands within their own stores, and remodel and update current stores to increase the concentration and consequently the competition. Therefore, this intense concentration of competitors stimulates a high degree of competition. DEGREE OF DIFFERENTIATION AND SWITCHING COST The degree of differentiation refers to the ability of a company to distinguish its products from other stores merchandise. By increasing differentiation, competition is decreased because people are willing to pay more for a unique product. Switching costs determine the customers likelihood to change their product preference. American Eagle s portion of the apparel industry is completely different than other clothing stores in the industry such as Kohl s or Dillard s. The clothes in the specialty retail industry are styled to have a more casual, laidback look that appeals to year olds. This different, specialized style is what separates the companies from other clothing stores in the apparel industry. Consumers of these products tend to switch quite frequently between the different direct competitors. The companies offer very similar clothing styles to the same targeted market. Therefore, the low switching cost year old buyers stimulates higher competition between the companies. Within this unique sector of the apparel industry, some firms offer more affordable clothing. It is within the specialized section that American Eagle, for example, uses price competition as a business strategy ( In addition to using price to attract consumers to American Eagle, the company launched the AE All-Access Pass in Fiscal 2005 to encourage brand loyalty. This pass rewards frequent customers by granting credits after buying

15 a certain amount of merchandise. The credits can be accumulated to purchase free merchandise from the American Eagle website ( Similarly, American Eagle, Gap, and Abercrombie and Fitch all have brand credit cards for purchases made in their stores and on their respective websites. Although gimmicks such as credit cards are used to sway the customer from switching between brands, it is not entirely effective. Since switching costs are low and the degree of differentiation between these specialty retail shops is low, competition for the targeted market remains high. RATIO OF FIXED TO VARIABLE COSTS If the ratio of fixed to variable costs is high, there is higher competition because fewer variable costs can be minimized to enhance profits. Firms can decrease prices to attract more consumers. The ratio of fixed to variable costs is low in the apparel industry. Fixed costs for American Eagle primarily consist of building leases for stores, offices, and two distribution centers. Abercrombie and Fitch, Aeropostale, and Limited Brands all lease their properties as well ( This is common in stores primarily located in malls or shopping centers. Variable costs consist of purchasing inventory and paying wages along with other selling and administrative expenses, which make up a large percentage of total costs. The costs are based on the quantity of inventory each store chooses to buy and its ability to sell it. This decreases competition because it allows the store to adjust to the economy or buying trends and can avoid burdening itself with excessive inventories. EXIT BARRIERS AND EXCESS CAPACITY Exit barriers occur when a specific product would be hard to liquidate or sell if the firm left the industry. In the apparel industry, inventory is easy to sell with a single sale or clearance. A firm in the apparel industry must turnover

16 most of its merchandise four times a year as the seasons change. Therefore, there are four times a year a firm in this industry could easily exit the apparel industry if it chooses not to replenish its inventory. The barriers to exit this industry are relatively low because of the frequent total inventory turnover. Companies in this industry will only buy enough merchandise it can sell in a single season to prevent discounts and receive optimal profits. Excess capacity is when supply surpasses consumer demand and there is unsold merchandise. Retail stores can easily prevent this by holding sales to move of the leftover seasonal inventory. Firms place clothes on sale at the end of each quarter before new shipments of clothes arrive. Low exit barriers and low excessive capacity leads to low competition because a firm can exit the industry whenever necessary without suffering heavy consequences. In conclusion, the degree of competition among existing firms is very high within the select specialty retail industry. Competitors market a similar clothing style to a very limited amount of people. This makes supply surpass demand and companies must work to stress the importance of brand loyalty to the customer. Threat of New Entrants If a company in the industry is earning abnormal profits, competitors are likely to enter because the potential profit is high and attainable. This threat can force firms already in the industry to keep prices low to discourage new entrants. In this industry, a competing firm must be differentiated from the industry, but in its sub-industry firms need to be a price leader. If the competing companies fail to become price leaders, there will be new entrants who will drive down profit margins and gain market share. ECONOMIES OF SCALE Economies of scale differ in every industry. An industry with large economies of scale is unlikely to see a substantial amount of new entrants

17 Economies of scale include brand advertising, research and development, and investment in physical assets. In this industry, there are large economies of scale in brand advertising. Although it is very easy to compete on price in the apparel industry, consumers are willing to pay for the label. The businesses already competing with each other are very well known among the target consumer. In order to enter this business a new company would have to put enormous capital into advertising to increase brand awareness and become the cool brand. A competitor could enter the industry by undercutting the competition in price, but face an obstacle if they wanted to compete with stores such as Gap and Abercrombie and Fitch. This industry is easy to enter because the cost of capital can be quite cheap relative to the price of goods sold, but hitting the target market can be quite difficult because of brand recognition. Because of the necessity brand recognition, the threat of new entrants is greatly reduced. LEARNING ECONOMIES Learning economies refer to industries that require an extra amount of skill or knowledge that makes it difficult for new companies to enter the field. Firms in the apparel industry focus on knowing the up and coming trends to produce clothing, footwear, and accessories in a timely fashion to meet customer expectations. If the company was unaware of popular fashions for youth, they would be left behind the style curve. The industry is able to advertise to the target market what is in style in several ways such as, ads seen industry-wide feature popular stars, and attractive people modeling the clothes found in the stores. The stores in this industry also have a visual appeal that is lacking from other retail chains. Young, good-looking employees are hired to work the retail side of the business. These employees are able to tell customers what looks best on them while focusing on what will make their store the most money. The learning economies in this industry reduce the threat of new entrants

18 ECONOMIES OF SCOPE Economies of scope refer to the variety of business within a company. Some companies provide various goods and services to expand their customer base while other companies emphasize certain products. For example, in Fiscal 2005r American Eagle expanded by introducing two sub-brands, aerie and MARTIN + OSA. Aerie is a line of intimates and dormwear for young women, while MARTIN + OSA is a line of casual sports wear for men and women ages If successful, these sub-brands will expand the market share of the company to customers not in its original business model ( For the industry to stay competitive, the consumer is likely to see sub-brands being offered at all the major competitors in this industry. The expanded scope utilized by companies in this industry lead to an intense challenge for new entrants to overcome in order to be successful. FIRST MOVER ADVANTAGE In an industry that is dominated by brand recognition, there is a very apparent first mover advantage. The competitors in the high end retail industry all started competing around the late 1990s. These competitors wanted to offer a substitute to higher end department stores for the consumer in the mid teens to mid twenties. The target consumer takes pride in owning name brand products. To have a name brand the company must establish itself by being in the industry for a significant amount of time. There are exceptions to this rule, if a movie star finds a designer that they like, a first mover advantage can be attained by getting the designer to design for the company. If a start up company can grab the designer before one of the companies already in place, the new company will have a competitive advantage. This industry is filled with

19 brands that have been around for quite awhile, and with very few exceptions there are no new entrants. ACCESS TO CHANNELS OF DISTRIBUTION AND RELATIONSHIPS Access to channels of distribution and the relationships with suppliers plays a substantial role in an industry such as this. Fashion constantly changes with the seasons, so inventory turnover is continually happening. Without good reliable relationships with suppliers, the stores in this industry would not be able to provide the current season s line of clothing in stores when demanded. Poor channels of distribution lead to poor quarterly sales and force stores to discount merchandise to move it off the shelves. This industry thrives on having the latest fashion. Even the most prestigious firm will fail if it can not keep up with the ever changing pace. This means that one late shipment from the companies suppliers can be devastating for bottom line profits. This pressure will discourage new entrants. LEGAL BARRIERS Because of the nature of retail, there are not many legal barriers to entry in the industry. The largest legal barrier that new entrants face is trademarks. The new entrant must differentiate its brand logo and their clothing enough so that it is not exactly like the competition, but keep the same basic ideas to appeal to the targeted market. Legal barriers do exist in the form of credit/debit sales, but this is a risk that should be calculated for on the financial statements of the company. Legal barriers also exist for high end retail stores that offer there own credit cards. A final legal issue that every retail store faces is the possibility of lawsuits from consumers who injure themselves at the stores. The small number of legal barriers leads to an increase in the likelihood of new entrants

20 CONCLUSION In conclusion, the threat of new entrants is relatively low in this industry because this industry has large economies of scale, large learning economies, large economies of scope, a large first mover advantage, and access to distribution channels is well set. Legal barriers pose less of a threat as the other categories, but they still will discourage new entrants on a smaller scale than the other categories. Threat of Substitutes The threat of substitutes refers to products that potentially replace other products due to changes in the economy or consumer preferences. The apparel industry does not need to worry about the threat of a physical product substituting the need for clothing. Companies worry about preserving their brand name and work to make their name the must-have. If the brand name looses its significance, consumers are likely to substitute the specialty retail shops with something more convenient like a department store. Department stores expand past casual comfortable wear and sell casual, formal, and professional clothes for all ages. They also sell jewelry, makeup, furniture, and other products making the department store a big time saver for consumers. If a customer does not value a brand name but does value their time, they are more likely to shop at the department store to get everything they need at once. Firms in the specialty retail industry tend to locate their stores close to department stores. This helps to eliminate the threat of department stores being too far from specialty retail stores. Therefore, it is not too much of a burden to go to one of these specialty retail stores to find the desired brand name. This way most of the family can shop at department stores and youth from ages 15 to 25 can shop at a specialty retail store. As long as these companies can

21 preserve the significance of brand names, the threat of substitute products is low. Power of Buyers Buyers hold the ultimate power in deciding which companies within the specialty retail industry succeed because they determine demand. Price sensitivity and bargaining power are forums on which buyers base their purchasing decisions. Many of these specialty stores are located in shopping malls. Abercrombie and Fitch, Gap, Aeropostale, and American Eagle are usually located close to each other in malls and shopping centers. The majority of the industry s buyers shop at more than one of the specialty stores which make switching costs for customers within the specialty retail apparel industry almost non-existent and could lead to direct competition between all industry competitors. However, buyers are usually willing to pay the industry s premium prices as long as a firm maintains relatively high levels of design and quality. Power of Suppliers In an industry with few suppliers, buyers are forced to pay the demanded price for supply. They also increase their demand by supplying at a lower cost than their competitors. However, the suppliers in this specialized retail industry have very little bargaining power over the companies they supply. Cheap manufacturing labor is abundant throughout the world. Though each company uses different purchasing methods, no one in the industry relies heavily on a specific supplier. For example, Abercrombie & Fitch has no more than 5% of its apparel coming from a single supplier. ( Though the majority of the firms merchandise is purchased from lone venders, the firms are under no contractual obligation to continue to purchase merchandise from the said vendor. Because these companies are not held to a contract with their

22 suppliers, the cost of switching vendors would be low. The vast majority of materials and product manufacturing in the industry are purchased from overseas (mainly in Southeast Asia and Central America). The merchandise is shipped to the distribution centers (located in Warrendale, Pennsylvania and Ottawa, Kansas in American Eagle s case) where it is inspected for quality and consistency. Due to the nature of foreign shipping, imports can be affected by trade laws, increased taxes or changes in foreign economies or political systems. This volatility increases the risk of receiving merchandise late or at an increased price. This is another reason why the retailers are hesitant to put responsibility and power into the hands of the suppliers ( Industry Classification The five forces model indicates that this is a competitive sub-industry that differentiates itself from the larger retail clothing industry. As shown, this is a mixed industry with competition ranging from high to medium and even to low. More work exists for a firm in order to remain a major competitor in such a mixed industry. It is this mixed industry that gives companies within the industry the opportunity to increase their market shares fairly easily because the threat of new entrants remains low. Value Chain Analysis The value chain is how a firm derives value from its every day operating policies and procedures. Because we have classified this industry as a mixed competition industry, there are many things a business can do to gain the most value out of its activities. This industry requires competitors to differentiate and keep manufacturing costs low. To be successful in this sub-industry, competitors must be able to keep costs low and provide merchandise that consumers are willing to pay a premium for. To do this, firms spend money on their brand

23 image and find additional places to cut costs. Each firm in the industry chooses how to achieve its optimum balance of differentiation and cost efficiency. Because this is a higher end retail industry, if a company does not differentiate; the consumer will see it as a substitute to low-end clothing brands. Having a product that is different is not enough though because consumers can easily switch between companies. In order to stay profitable, a company must engage in cost leadership practices. Corporate strategies in this sub-industry can be costly. Each firm uses its corporate strategies to attempt to add value to the firm. Examples of corporate strategies that derive value in this industry are consumer benefits though discount cards and credit cards, maintaining low manufacturing costs, expanding world-wide through the use of the internet, and being innovative when introducing new lines ( Industry-wide, a competitive company must both be a cost leader and be differentiated. All the firms in this industry sell very similar products; they are produced with superior quality. This industry produces quality products efficiently. It also exercises tight const control over production and shipping. Within each of the firms in the sub-industry, there is a very high degree of customer service. The customer service draws a consumer to buy more products. Every store in this industry has spent considerable money on their brand image. Consumers shopping in this industry know their preferred brands. Money must also be invested in research and development, to determine the up and coming fashions for each season. The nature of the fashion industry requires that each company anticipate what is going to be in style the next season so that they can start production and meet the demand of consumers. American Eagle: Differentiation or Cost Leadership or Both? American Eagle has had to both differentiate itself and be a cost leader in the industry. To start with differentiation, American Eagle has selected a specific

24 target consumer. According to their 10-K, also provide high quality merchandise. During the 2005 fiscal year, American Eagle spent $53.3 million on advertising (AEO 10-K). This shows just a small portion of its investment into brand image. American Eagle states in its 10-K that it relies heavily on personnel in upper management positions as well in retail sales positions to move the products it sells off the shelves and into the hands of consumers. Although American Eagle has a strategy of differentiation, this only propels it to the high end retail sub-industry. Within this sub-industry, American Eagle is a cost leader. The 10-K states that it will not only provide high quality goods, but they will be at affordable prices. The economies of scale and scope mentioned earlier also help American Eagle be a cost leader. Specifically, manufacturing of the goods that American Eagle sells in its stores has been outsourced all over the world. In order to enforce quality standards, American Eagle has a strict program that requires factories to comply with global workplace standards and their code of conduct (AEO 10-K). American Eagle offers a private label credit card. The credit card is issued through a third party bank, so American Eagle recognizes no bad debt on its income statement. Although there are undisclosed expenses associated with this service, the benefit of not having bad debt far outweighs those expenses. This helps American Eagle be a cost leader because it does not have to set money aside for an allowance for bad debt. In conclusion, American Eagle succeeds in the specialty retail sub-industry because it is able to differentiate itself from department stores, while remaining a cost leader among its direct competitors. American Eagle s Corporate Strategies Corporate strategy is how a firm sets itself apart based on its infrastructure as a business. This includes differentiation and cost leadership techniques. American Eagle uses the following techniques to improve customer loyalty and relationships, minimize costs, and maximize market share

25 AE ALL ACCESS PASS The AE All Access Pass rewards customers for purchasing American Eagle products by granting credits that are redeemable at The purpose of this program, according to is to increase switching costs and provide incentive for customer loyalty towards American Eagle. The All Access Pass gives the holder access to exclusive American Eagle music. Customers are entitled to sales and contests that only All Access Pass members are privileged to attend. There are also other incentives, such as computer wallpapers, based online for All Access Pass members. AE CREDIT CARD The American Eagle Credit Card also encourages customer loyalty through small purchases. In addition, the credit card provides special promotional information and advance notice of sales and other events. This increases customer relations because customers are better informed of events and are more likely to participate in said events. The credit card also benefits American Eagle because they outsource the bad debt through a private third party bank. This relieves American Eagle of potentially unrecoverable accounts receivable ( COST OF MANUFACTURING American Eagle minimizes costs by outsourcing the majority of production. In order to maintain low costs, the company uses a variety of suppliers so no single supplier can control American Eagle s production. In addition to outsourcing, American Eagle participates in the Customs-Trade Partnership Against Terrorism program, where they work with the United States Customs Agency to ensure the security of the safety chains. By securing the safety

26 chains, American Eagle minimizes their potential liabilities and reduces excessive insurance rates that protect their merchandise (AEO 10-K). EXPANSIONARY SUB-BRANDS In the 2005 fiscal year, American Eagle started to expand past their previous targeted market group by establishing a sub-brand MARTIN + OSA. This sub-brand is a line that combines the traditional sport, classic, and denim clothing but is geared towards year old men and women. In addition to expanding their market share, American Eagle is broadening their scope for younger women by introducing the sub-brand aerie. Aerie is a line that specializes in dormwear and intimates. By expanding through sub-brands, American Eagle is making itself more competitive with the leaders in the industry ( EXPANSION TO CANADA In 2000, American Eagle purchased three Canadian businesses: Bluenotes, which was recently discontinued, Braemar, and National Logistics Services (NLS). Bluenotes is a previously established Canadian retail store. By acquiring a well known clothing chain, Canadian consumers were able to maintain confidence in the firm s products. Braemar is similar to American Eagle with premier mall locations. NLS is a 400,000 square foot distribution center located near Toronto, and it enables American Eagle to ship products to the growing Canadian market (AEO 10-K) ( By expanding into Canada, American Eagle has created a competitive advantage by being on the forefront of Canadian expansion within the industry. This creates barriers for entry for American Eagle s competitors because consumers are more likely to trust the brand that they have been around the longest

27 THE FUTURE OF AMERICAN EAGLE American Eagle is expected to continue expansion in Canada and the United States. Currently, there are no disclosed plans for expansion into Europe; however, e-commerce allows people worldwide to purchase American Eagle products. By expanding through e-commerce, American Eagle has unlimited potential for future growth ( Formal Accounting Analysis Companies often distort financial statements to produce numbers more appeasing to shareholders and reflect a better picture of the company. This bias clouds the true value of the company and therefore the firm must be reevaluated. The purpose of analyzing companies accounting policies is to undo the accounting distortions to better assess the financial infrastructure of the company (Palepu, 3-4). Bias can come from three different sources: noise from accounting rules, forecast errors, and managers' accounting choices. Accounting rules sometimes create noise because "it is often difficult to restrict management discretion without reducing the information content of accounting data" (Palepu, 3-4). Forecast errors occur because it is difficult to predict what is going to happen and how much inventory to have on hand for the future. It is also difficult to accurately predict bad debt expense and write-offs. GAAP allows managers to choose to be more aggressive or conservative when implementing certain accounting policies. Ideally, the manager will aim for an accounting policy somewhere between the two extremes. Managers also hold freedom to a level of disclosure in regards to the firm s financial statements. When a firm improves its disclosure level, an analyst has a better chance of valuing the company accurately

28 Key Accounting Policies In identifying key accounting policies, we consider the key success factors of the industry and how American Eagle deals with and accounts for those success factors. It is also important to analyze the level of disclosure with regards to these success factors. In the retail industry, we analyze how American Eagle manages its inventory and then compare it to the rest of the industry. We should also review the way American Eagle deals with their leases and gift cards. We need to look at the firm s benefit and retirement plans and how they account for goodwill impairments. The final two things we should examine are how they handle expenses related to marketing and branding. American Eagle leases both its retail spaces and the warehouses used to store their merchandise. This makes them a cost leader because it allows for tight cost control. GAAP flexibility allows many firms in this niche industry to use the operating leases. American Eagle tends to establish contractual five to ten year leases with set annual rental payments. The firm accounts for these rental expenses though the use of operating leases. These operating leases could in fact be revalued at a more applicable level though the use of capital leasing. This is possible because American Eagle holds the future rights to these rental properties with lease holding rights. Since American Eagle has acquired the future use of the properties through contracts, they could list it as an asset on the consolidated balance sheet to show a more accurate representation of the company. The subsequent chart compares the estimated present value of capital leases to the present value of operating leases based on an industry mortgage rate of 8%. Most retail firms prefer operating leases to capital leases simply because operating leases will minimize liabilities and keep these contractual obligations off of the balance sheet. American Eagle and its competitors have true capital leases however, because stores are found in malls. The corporation that owns the mall leases space to retail stores. By capitalizing American Eagle s

29 leases we will gain an insight to their balance sheet that can show issues within their liabilities and assets. Operating & Capital Lease Present Values Present Values (thousands) $1,000,000 $900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $ , Year Operating Lease PV Capital Lease PV American Eagle evaluates their goodwill every year; however, the number has not changed in the past two years. Goodwill for the past fiscal year was nearly one million while assets were 1.6 billion. Therefore only.6% of American Eagle s assets are based on goodwill. This is a.1% drop from the previous year's goodwill. Previously, the goodwill decreased at an accelerated rate due to impairment. In 2003 American Eagle approximated its goodwill decreased value by an approximated $14.1 million due to the "continued weak performance of the Bluenotes segment" (AE K). Although American Eagle properly recognized goodwill impairment, it failed to amortize the goodwill over a given amount of time. If the goodwill held a greater portion of the company s assets, it would be considered an aggressive accounting strategy if the firm failed to amortize it on an annual basis. By disclosing the amortization of the goodwill, an analyst can better value the company s true total asset value. American Eagle increased inventory and the number of store locations over the past five years. Sales have increased along with inventory. Inventory as a

30 percentage of sales is approximately 9.07% for the 2004 fiscal year. This percentage stayed at about 9.13% for the 2005 fiscal year, and in fiscal 2006 this ratio increased to 9.4%. This shows the company is attempting to maintain a steady ratio between sales and inventory. American Eagle efficiently outsources production, and is able to better maintain a low cost of production which leads to a greater profit margin. Although American Eagle outsources production, it holds rigorous standards for the quality of its clothing. These higher standards help American Eagle differentiate from the competition. These disclosures in the 10-K allows analysts to place additional value on the high standard for quality clothing and therefore determine a more relevant value. American Eagle participates in a 401(K) plan and a stock purchase plan. Both of these plans include company matches up to a certain percent. This falls under customer service because both of plans require employees to stay employed in order to optimize their potential benefits. The benefit plans attract higher quality employees, which in turn improves customer service in the long run. It also reduces training costs for new employees by encouraging current employees to work diligently and increase employee loyalty to American Eagle. The disclosure in the annual report reveals American Eagle puts a high emphasis on taking care of their employees through the use of these benefit plans. Gift cards are a means to increase the switching costs for customers, which guarantees American Eagle a liability that they will later expense within the next two years when the cards are redeemed or expired. American Eagle had a more than 10 million dollar increase in unredeemed store value cards and gift cards from fiscal years 2005 to This number reflects the value of gift cards that are over two years old and can legally be counted as revenue. American Eagle defines and utilizes gift cards as a key success factor (AE 10-K). American Eagle established itself by initially creating the brand name and then advertising the logo. This was accomplished through purchasing a trademark and also implementing extensive advertisements. By creating a demanded brand, the company then allows the customers to continue the

31 advertisements with a simple eagle logo found on the bottom of an American Eagle shirt to set it apart from other clothing brands. These things come at a cost, with trademark expenses and advertising expense. Advertising expenses made up $53.3 million of Fiscal 2005's budget. Trademark costs are included in intangible assets and are amortized over five to fifteen years. Although these costs must be expensed, they also create true value for future cash flows with potential customers. Accounting Flexibility Financial Statements for publicly traded companies must follow Generally Accepted Accounting Principles (GAAP). GAAP attempts to set accounting standards which will allow consistent evaluations of each firm within an industry on a level field. GAAP allows for quite a bit of flexibility in certain areas. The flexibilities are there to ensure truer valuations on the different financial statements. However, some aspects of GAAP severely limit firms abilities to properly value their company. Assessing the degree of accounting flexibility of a particular firm s key accounting policies will allow us to properly identify where a firm might biasly report its worth instead of presenting a true value. These discrepancies might come from limitations or flexibilities in GAAP. American Eagle utilizes the flexibilities in GAAP to report different aspects of its key accounting policies. Leases can be classified operating leases or capital leases, but most of the firms in the specialty retail industry, including American Eagle, choose to record leases as operating leases. GAAP allows for this flexibility because not all leases are the same, and the different types require different accounting measures. American Eagle chose operating leases because it can reduce liabilities. This flexibility allows for these firms to manipulate their values to shareholders. American Eagle also utilizes the flexibilities of GAAP with respects to estimating depreciation and amortization rates and schedules. GAAP will let the