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American Eagle Poised to Fly After Summer Fashion Crash

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While its summer styles put a dent in profitability, the current stock price combined with proposed initiatives should get the Eagle back in flight.

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Editor's Note: Michael Brush is the editor of the stock newsletter Brush Up on Stocks and a weekly market columnist for MSN Money.

As anyone with children knows, you can't offer teens something they don't want and expect them to accept it anyway. There's little room for compromise. American Eagle Outfitters (AEO) found that out the hard way once again in the July-ending quarter when it went heavy on styles of shirts that turned out to be less than popular.

Despite solid strength in denim jeans, jewelry, and Internet sales, the retailer had to slash prices to clear inventories because of this fashion miss, and price cutting by a competitor, Abercrombie and Fitch (ANF). American Eagle sales and margins took a hit. So did its stock, tumbling as low as $12, from above $19 in March.

The stock recently traded at $14.40, and down here it looks like a Buy for the long term. Several initiatives plus a hot new brand should get the Eagle back in flight again.

Insiders certainly think so. Board chair Jay Schottenstein, who has a great record in this stock, was a big buyer about a week ago -- purchasing $6.7 million worth of stock at around $13.60. That was followed by a $1.3 million purchase at prices as high as $14.70 by a director who also has a decent record timing this stock.

Besides buying the stock, another way to play American Eagle's return to flight is to sell November puts with a strike price of $14, or January puts with a strike price of $12.50. You can either keep the cash as these puts expire worthless, or accept the stock at a lower price than those available right now, if it gets put to you.

I wouldn't have a problem accepting delivery of this stock after a naked short put sale because of all the positives in the mix here. Besides those insider buys, you have the power of American Eagle's brand, solid financial strength in all that cash on the balance sheet, zero debt, and decent cash flow, plus several initiatives to cut costs and improve efficiency. These positives seem to offer decent protection against big downside.

Part of American Eagle's problem is that about five years ago it invested for big growth -- which never happened. Now, it's trimming headcounts and closing weaker stores. And it's revamping inventory management systems to deliver the right styles to the right stores in a better manner. "We will be able to do more with less inventory and thus reduce risk," CEO James O'Donnell told investors in the company's most recent conference call. American Eagle is also streamlining sourcing and production to help it react more quickly to style shifts -- a key ability to have in teen and college fashion.

All of this is the basic block and tackle of retailing, boring stuff for outsiders. But American Eagle also has an exciting winner in a relatively new brand with big potential -- a popular line of intimate apparel for teens called Aerie. Sales at Aerie stores open more than a year have been growing 20% a quarter, for the past several quarters. Now, American Eagle hopes to build on this success by expanding the brand to other kinds of clothing and personal care products.

"Aerie is about having the assortment for these girls that are in that age category, to satisfy their needs with good, wholesome taste in bras in panties, but why not all of the sportswear that goes around it?" American Eagle executive creative director Roger Markfield said in the most recent conference call. He predicted the brand will expand considerably over the next few seasons. "We're giving it new attitude and refining apparel categories to complement the success we have in bras and undies."

Morningstar analyst Zoe Tan believes the popularity of the Aerie brand, plus better inventory management and product sourcing, should help American Eagle hold the line on operating profit margins for the full year this year, despite the recent hit this summer from clearance sales related to the fashion miss.

"We estimate that the full-year operating margin will be similar to the 8.5% margin posted in 2009," says Tan, who gives the retailer a four star rating, Morningstar's second highest rating. On average over the long term, Morningstar's four-star stocks tend to significantly outperform the market.

There are risks here, of course. As an economically sensitive retailer, American Eagle stock remains highly susceptible to weakness if fears about a double-dip recession in the US return. And teen unemployment remains high in the US, and probably will for a while. American Eagle is expanding into China, Hong Kong, Dubai, and Kuwait City, but not fast enough to offset US-related issues in the near term if the economy weakens.

But above all, American Eagle has the never-ending challenge of trying to keep teens happy. As parents and American Eagle fashion designers know, that's a difficult task and can bring about serious problems at any moment.

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No positions in stocks mentioned.

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