American Eagle Outfitters Stock Upgraded Ahead of Earnings: What You Need to Know

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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American Eagle Outfitters (NYSE: AEO) plans to report its second-quarter 2017 earnings early next Wednesday, Aug. 23, then follow up that report with a call with investors at 9 a.m. EDT. Few analysts are optimistic about what the teen clothier will have to tell them, however, with estimates calling for a small increase in sales but a large drop in profits. Despite that, one analyst is breaking from the pack this morning and urging investors to buy American Eagle ahead of earnings.

Here are three things you need to know about that.

1. FBR calls an audible

This morning, analysts at FBR Capital announced it is upgrading American Eagle shares ahead of earnings, assigning the stock a buy rating and a $13 price target.

Now, issuing a buy recommendation just days before an earnings release is a pretty risky move. Roughly one week from now, FBR will either be proven really right about American Eagle stock -- or really wrong. If the latter happens, investors who heeded FBR's call to action may be (rightly) upset with the analyst. And yet, FBR seems pretty certain it is not wrong about American Eagle.

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2. What FBR doesn't hate about American Eagle Outfitters...

Why is that? As explained in a write-up on StreetInsider.com (requires subscription) this morning, there is a certain amount of "mall risk" in American Eagle stock. Malls are dying as more and more Americans do their shopping online. That's bad news for a mostly mall-based clothing retailer like American Eagle Outfitters.

But looking at the valuation, FBR argues that mall risk is baked into the company's stock price already. Moreover, analysts' low expectations for American Eagle's sales growth this quarter, and their even lower expectations for earnings, mean there's "lower risk" that American Eagle will do badly enough to actually miss sales or earnings expectations. There's really only so low a retailer can limbo, and since analysts have already cut their estimates for the company's sales and earnings "significantly," there's little downside left in American Eagle shares.

3. ...and what FBR absolutely loves

At the same time, FBR points out that American Eagle Outfitters stock sports "one of the highest FCF yields and dividend yields" in the retail industry today. In contrast to other retailers, FBR sees "little risk" that the clothing specialist will fail to continue producing free cash flow and dividends in the future.

Why is that?

Currently, American Eagle Outfitters is generating free cash flow at the rate of about $170 million a year. Operating cash flow has been coming in pretty steadily at present levels for the past three years, and capital spending has held firm for the past two years (and is down from three years ago). All of this suggests that while American Eagle may not be growing much right now, at least it's not shrinking, either.

With cash profits secure, FBR is probably right about American Eagle being able to maintain is generous 4.5% dividend yield. In fact, with dividends accounting for less than 50% of the company's profits at present, and cash flows steady, it's even reasonable to believe American Eagle might increase its dividend at some point.

Bonus thing: The big picture

Meanwhile, American Eagle Outfitter's rivals continue to struggle. This year already, we've seen more than 300 retailers file for bankruptcy, including such big-name chains as The Limited, rue21, Payless ShoeSource, and Wet Seal. J.C. Penney, Sears, Macy's, and Abercrombie are all closing stores.

FBR believes that as its competition withers and dies, American Eagle Outfitters is likely to "continue to take market share." Such a development should result in growing sales for the retailer -- competition from Amazon.com notwithstanding -- and growing profits as well. And FBR isn't alone in thinking this.

According to data from S&P Global Market Intelligence, analysts on Wall Street are on average predicting American Eagle Outfitters will grow earnings at about 9% annually over the next five years. Combined with a 4.5% dividend yield, and weighed against a stock price now below 10 times earnings, that's a cheap price for a pretty attractive stock.

Despite the risk FBR is taking in upgrading American Eagle stock so close to earnings -- and regardless of what news next week brings -- I think it's the right call for the long haul.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of and recommends AMZN. The Motley Fool has a disclosure policy.