Investing Club: Here's why we're reversing last month's downgrade of American Eagle

Published Tue, Apr 12 20224:11 PM EDT

Full disclosure: Club holding American Eagle was one of the portfolio's worst-performing stocks in the first quarter , and we have been pretty candid about how we got this so wrong and the lessons we have learned from owning shares in the retailer. Last month we even recognized that the market wanted to take this stock lower, which is why we downgraded our AEO rating to a 2 from a 1 on March 21 when the stock traded slightly above $18. We thought investors should use the market volatility to opportunistically pick up shares of higher-quality names. But with shares now trading at about $16.50, or roughly 9% below the price from where we recently downgraded it, the question we are asking ourselves is: Has the market gotten too negative on American Eagle? Let's first consider the retail sector. On Monday night's Mad Money, Jim Cramer sat down with JPMorgan retail analyst Matthew Boss to discuss his key themes from the 8 th annual Retail Round Up Conference. Boss' findings come at an important time because many department store and specialty retail names have been absolutely clobbered over the past few months. Since peaking in mid-November, the SPDR S & P Retail ETF has fallen roughly 27% on concerns about runaway inflation and high gas prices eating into discretionary spending, the possibility of a Fed-mandated recession, and general uncertainty related to the war in Ukraine. Despite the various macro headwinds, one theme from the conference that Boss wrote in a research note Monday morning was that the consumer today is "healthy." What's behind the healthy consumer and what has management teams expressing "cautious optimism" for the second half of the year is 3.6% unemployment, wage growth, and additional work-hour opportunities. Additionally, Boss cited consumer resilience to date, supported by JPMorgan's propriety Chase credit card data, which showed overall consumer spending in March increased 7.7% on a three-year compound annual growth rate (CAGR) basis, an acceleration of 90 basis points from February. Inflation may be rampant and a real problem, but the tight labor market and wage gains have supported spending, making us sanguine about the overall state of the consumer. With the macro picture now better understood, let's get down to company fundamentals. This brings us to American Eagle Outfitters (AEO). In Boss' research note, he provided several key takeaways from his group meeting with American Eagle CFO Mike Mathias and Judy Meehan, head of investor relations. The key point for us: CFO Mathias said the business has not experienced any slowdown related to the broader macroeconomic pressures on the consumer and that inventory positions today are "exactly where we want to be." And the momentum at Aerie, American Eagle's intimate apparel brand, does not sound like it's slowing down with management backing its 25 to 30% CAGR at Aerie through fiscal year 2023, implying that the brand is on a path to double in size every three years. Elsewhere, Boss noted that management said there has been no resistance to pricing actions and that product costs (like cotton) are not expected to be a headwind this year. Management also talked up the importance of its two logistics acquisitions: AirTerra and Quiet Logistics. Last but not least, unlocking value (through a spin-off) was part of the conversation based on what Boss wrote. He said management stated "strategic alternatives would be pursued should the macro-environment stabilize and AEO's valuation remains at ~$3B, which implies AE [American Eagle] worthless and Aerie only ~7.5x EBITDA" based on JPMorgan's sum-of-the-parts (SOTP) math. Why is this line notable? Finally, it sounds like management is fed up with how poorly the stock has traded over the past year and has begun to explore ways to bring out value for shareholders. Whether it be through a potential spin-off of Aerie (where the dis-synergies would be reasonable) or perhaps even a share repurchase program, we don't want to be so negative about a stock when management is actively looking to create value. So what are we doing with the stock? Based on the positive updates from Boss and our view that the stock was already very cheap to begin with, we are upgrading our rating to a 1 . (Here's how we rate stocks in our portfolio.) To be clear, we are not trying to call a bottom with this AEO upgrade. We expect the name to remain volatile as the market tries to figure out how substantial the Fed-mandated slowdown will be and how long supply chain challenges will last. But with shares trading at 8 times earnings with a 4.3% dividend yield and management finally acknowledging the low valuation of the company, suggesting value-creating opportunities could be in play, we simply are having a hard time continuing to be so pessimistic about this name. (Jim Cramer's Charitable Trust is long AEO. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. 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David Paul Morris | Bloomberg | Getty Images

Last month we even recognized that the market wanted to take this stock lower, which is why we downgraded our AEO rating to a 2 from a 1 on March 21 when the stock traded slightly above $18. We thought investors should use the market volatility to opportunistically pick up shares of higher-quality names.

But with shares now trading at about $16.50, or roughly 9% below the price from where we recently downgraded it, the question we are asking ourselves is: Has the market gotten too negative on American Eagle?

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