Fly Like An American Eagle, Avoid This Stock

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Backing consumer stocks, especially in the clothing industry, is highly unpredictable. Consumer preferences change without notice, and competitors often replicate one another's popular lines with little patent protection. That said, there are some solid companies out there that have meaningful growth prospects ahead that you can buy into at a cheap valuation. There are others that have seen their days of glory and unreasonably trade at a premium. To which categories do American Eagle and Nike belong?

Why You Should Fly Like An American Eagle (NYSE: AEO)

Apparel producer American Eagle has been on a roll in recent months with profits soaring and outperformance against peers. The company's success has been credited to execution in differentiating products from the competition. In the recent quarter, revenue of $910 million came out $37 million ahead of expectations and capex fell from $30 million to $23 million.  But, in an industry where consumer preferences are fickle, is this sustainable? Does it make sense to invest after shares have risen ~82% from the 52-week low.

I recommend exposure. Though the company has delivered double-digit same-store growth (10%), this has caused plenty of mall-based peers to irrationally outperform the market. Put differently, American Eagle has not gotten enough exclusive credit as its corporate achievement has been unreasonably connected to broader and more general industry trends. As the industry fails to keep up with American Eagles' growth, we can expect multiples to continue to expand. At 13.2x forward earnings and no debt, American Eagle is attractive at the current valuation.

To put American Eagle's performance into perspective, consider it relative to competitor Gap (NYSE: GPS). The former has seen free cash flow rise 79.2% over the last 5 years while the latter has seen its free cash flow decline -2.9%. This outperformance has continued into the last year where American Eagles' free cash flow growth of 176% was 2.6x the amount experienced by Gap. Yet its competitor still trades fairly close at 12.3x forward earnings with weaker growth prospect ahead (a rate of nearly 100 bps less over the next 5 years). So, again, I recommend buying shares--the same strategy recommended by 75% of reporting analysts.

Why You Should Avoid Nike (NYSE: NKE)

For exposure to the sports apparel market, Nike is an obvious possibility. While its FQ2 performance beat expectations on both the top- and bottom-lines, China's softness continues to depress my outlook. Gross profit margins are at a historical low and may come to represent a new normal. Right now, the firm trades at a respective 22.9x and 17.6x past and forward earnings. The growth rate of 10.3% is below American Eagle's and, hence, you would do much better investing in American Eagle with a larger margin of safety.

Assuming Nike meets expectations, 2016 EPS will come out to $8.03, which, at a multiple of 16x, translates to a future stock value of $128.50. This provides for only a 6% annual average return when you factor in dividends--not nearly enough to merit an active investment. On the other hand, management has showcased a strong commitment to returning free cash flow to shareholders. It recently increased its dividend by around 17% recently. This was above expectations and maintains the history of double-digit increases.

At a time when Chinese orders declined 6% sequentially from changing consumer styles and a decelerating economy (we knew trends were softer bad, but this bad?), Nike is a stock to avoid. It has been selling off some of its brands--Umbro to Brand Group for $225 million and Cole Haan to Apex for $570 million--and, to its credit, has generated better-than-expected liquid injection in the process. Further, the company's clout in Oregon was enough to get the state Legislature to hold a special meeting to discuss whether to fully disclose whether it would retroactively change its tax treatment for the shoe maker (something industry lobbyists argue all companies should have a right to know in an already uncertain market). So, though the company carries a powerful brand name that enables it to sell lines and its stock at a premium, investors should not get in now with the upside limited.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Nike. Motley Fool newsletter services recommend Nike. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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