This Retailer Is Shooting Itself in the Foot

American Eagle Outfitters (NYS: AEO) recently reported a bang-up quarter, but that bang you heard may have been the company shooting itself in the foot. While net income did grow by nearly 60% over the same quarter last year, revenues were only up 11%, highlighting a big disparity. Meanwhile, inventories grew by nearly 40%, a massive explosion compared to the last several years. That's especially huge compared to the relatively weak sales growth, which is far too low to justify such stockpiling.

'Tis the season?
Maybe American Eagle is just gearing up for a big holiday season. Well, it'll have to be one heckuva holiday. Over the last four years, inventories going into the holiday season have hovered around $400 million. This year they stand at $572 million. The past two quarters have involved two of the company's highest jumps in inventory in the last 15 years.

This represents a significant gamble. Apparel has a shelf life that barely lasts a single season, and if too much is remaining at the end of that season, a company can take steep losses trying to sell it at any price to make room for the new season.

Poor inventory management has been a thorn in Aeropostale's (NYS: ARO) side for several quarters now, as it struggles to offer products that are as trendy as higher-end stores like The Buckle (NYS: BKE) and Abercrombie & Fitch (NYS: ANF) , but cheap enough to appeal to its bargain-minded demographic. And as The Wall Street Journal notes, the epic 98% drop in Crocs (NAS: CROX) shares was similarly precipitated by a massive inventory buildup.

Deck the halls with financial shenanigans
There's little hope that American Eagle sales will pick up, either. Revenues have barely grown in five years. The reason net income grew so strongly this quarter is because the same quarter of last year was artificially depressed with massive losses in American Eagle's auction rate securities portfolio.

This strikes me as a big red flag for two reasons. The first is simple -- what is a clothing retailer doing with these kinds of investments? Auction rate securities are typically debt instruments, and it appears American Eagle mostly held state and local government debt and debt backed by student loans, choices fit more for a yield-chasing fund than a clothing retailer's cash pile.

The way the losses occurred is more troubling. The investments were originally meant to be highly liquid, short-term investments. When they began nose-diving, American Eagle reclassified the investments as long term with a weighted-average contractual maturity of 26 years.

How supposedly short-term investments can be reclassified as long term with a 26-year time horizon is beyond me. You don't need to be a forensic accountant to know something wasn't reported correctly, either initially when the investments were made or later when they were reclassified. After taking a $24 million bath liquidating the investments, the proceeds were converted to straight cash, but a glance at the most recent balance sheet shows the company has moved about $100 million from cash back into "highly liquid, short-term investments." Most of that is in Treasury bills, so it should be fine, but investments in corporate bonds and state and local debt have increased by about $11 million, so it's still something to keep an eye on.

Don we now our heavily discounted apparel
American Eagle's inventory bloat is going to be a huge problem. Last quarter saw large inventory growth as well, and all it got the company was 11% more sales and a 9% drop in operating income. Management wants to gloss it over with some accounting magic, but if you really think American Eagle can properly manage its cash this time around and somehow sell 40% more merchandise than last year, you should think about buying the stock. As for me, I wouldn't touch it with a 49-and-a-half-foot pole. Instead, I'll be making an underperform CAPScall for the next six months to a year. Add American Eagle Outfitters to My Watchlist to follow along.

At the time this article was published Fool contributor Jacob Roche owns calls on Aeropostale but otherwise holds no position in any of the stocks mentioned. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. The Motley Fool owns shares of Aeropostale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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