UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

 

Commission File Number: 1-33338

 

 

American Eagle Outfitters, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

 

Registrant’s telephone number, including area code:

(724) 776-4857

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES þ     NO o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Sections 15(d) of the Act.  YES o     NO þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to the filing requirements for at the past 90 days.  YES þ     NO o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  YES o     NO þ

 

The aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant as of August 4, 2007 was $4,430,898,398.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 204,899,265 Common Shares were outstanding at March 14, 2008.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III — Proxy Statement for 2008 Annual Meeting of Stockholders, in part, as indicated.

 

 

AMERICAN EAGLE OUTFITTERS, INC. TABLE OF CONTENTS

 

 

 

General

 

American Eagle Outfitters, Inc., a Delaware corporation, is a leading retailer that operates under the American Eagle Outfitters^®, aerie^tm by American Eagle and MARTIN + OSA^tm brands.

 

American Eagle Outfitters designs, markets and sells its own brand of laidback, current clothing targeting 15 to 25 year-olds, providing high-quality merchandise at affordable prices. We opened our first American Eagle Outfitters store in the United States in 1977 and expanded the brand into Canada in 2001. American Eagle^® also operates ae.com, which offers additional sizes, colors and styles of favorite AE^® merchandise and ships to 41 countries around the world. AE’s original collection includes standards like jeans and graphic Ts, as well as essentials like accessories, outerwear, footwear, basics and swimwear under our American Eagle Outfitters, American Eagle and AE brand names.

 

During Fiscal 2006, American Eagle launched its new intimates brand, aerie by American Eagle (“aerie”). The aerie collection is available in aerie stores, predominantly all American Eagle stores and at aerie.com. The collection includes bras, undies, camis, hoodies, robes, boxers, sweats, leggings, fitness apparel and personal care for the AE girl. Designed to be sweetly sexy, comfortable and cozy, the aerie brand offers AE customers a new way to express their personal style everyday, from the dormroom to the coffee shop to the classroom.

 

We also introduced MARTIN + OSA during Fiscal 2006, a concept targeting 28 to 40 year-old women and men, which offers refined casual clothing and accessories, designed to be valuable, irresistible, inspiring, authentic and adventurous. In Fiscal 2008, MARTIN + OSA will begin offering merchandise online at martinandosa.com.

 

In January 2008, we announced plans to launch a new children’s apparel brand. 77kids by american eagle^tm (“77kids”) will offer on-trend, high-quality clothing and accessories for kids age two to 10. The brand will debut worldwide online at www.77kids.com during Fiscal 2008, with stores in the U.S. expected during 2010.

 

As used in this report, all references to “we,” “our,” and the “Company” refer to American Eagle Outfitters, Inc. and its wholly-owned subsidiaries. “American Eagle Outfitters,” “American Eagle,” “AE,” and the “AE Brand” refer to our U.S. and Canadian American Eagle Outfitters stores. “AEO Direct” refers to our e-commerce operations, ae.com, aerie.com, martinandosa.com and 77kids.com. “Bluenotes” refers to the Bluenotes/Thriftys specialty apparel chain which we operated in Canada prior to its disposition during Fiscal 2004.

 

As of February 2, 2008, we operated 929 American Eagle Outfitters stores in the United States and Canada, 39 aerie stand-alone stores and 19 MARTIN + OSA stores.

 

In December 2004, we completed the disposition of Bluenotes to 6295215 Canada Inc. (the “Bluenotes Purchaser”), a privately held Canadian company. As a result, our Consolidated Statements of Operations and Consolidated Statements of Cash Flows reflect Bluenotes’ results of operations as discontinued operations for all periods presented. See Note 11 of the Consolidated Financial Statements for additional information regarding this transaction.

 

In January 2006, we entered into an agreement to sell certain assets of National Logistics Services (“NLS”) to 6510965 Canada Inc. (the “NLS Purchaser”), a privately held Canadian company. The sale of these assets was completed in February 2006, at which time we exited our NLS operations. See Note 11 of the Consolidated Financial Statements for additional information regarding this transaction

 

Our financial year is a 52/53 week year that ends on the Saturday nearest to January 31. As used herein, “Fiscal 2010,” “Fiscal 2009” and “Fiscal 2008” refer to the 52 week periods ending January 29, 2011, January 30, 2010, and January 31, 2009, respectively. “Fiscal 2007” refers to the 52 week period ended February 2, 2008 and “Fiscal 2006” refers to the 53 week period ended February 3, 2007. “Fiscal 2005” and “Fiscal 2004” refer to the 52 week periods ended January 28, 2006 and January 29, 2005, respectively.

 

Information concerning our business segments and certain geographic information is contained in Note 2 of the Consolidated Financial Statements included in this Form 10-K and is incorporated herein by reference.

Growth Strategy

 

During Fiscal 2007, we continued to make significant progress on our key growth initiatives. As we enter Fiscal 2008, we remain focused on several well-defined strategies that we have in place to grow our business and sustain our financial performance. Our primary growth strategies are focused on the following key areas of opportunity:

 

Real Estate

 

We are continuing the expansion of our brands throughout the United States and Canada. At the end of Fiscal 2007, we operated in all 50 states, the District of Columbia, Puerto Rico and Canada. During Fiscal 2007, we opened 80 new stores, consisting of 27 U.S. AE stores, three Canadian AE stores, 36 aerie stores (including one Canadian aerie store) and 14 MARTIN + OSA stores. These store openings, offset by four U.S. AE store closings, increased our total store base by approximately 8% to 987 stores. Additionally, our gross square footage increased by approximately 10% during Fiscal 2007, with approximately 77% attributable to new store openings and the remaining 23% attributable to the incremental square footage from 53 store remodels.

 

In Fiscal 2008, we will continue the accelerated roll-out of aerie by American Eagle. We plan to open approximately 80 stores, all of which will be 3,500 to 4,500 gross square feet. Additionally, we plan to open approximately 40 new AE stores, 15 MARTIN + OSA stores, as well as remodel approximately 40 to 50 existing AE stores. Our square footage growth is expected to be approximately 10%. We believe that there are attractive retail locations where we can continue to open American Eagle stores and our other brands in enclosed regional malls, urban areas and lifestyle centers.

 

The table below shows certain information relating to our historical store growth in the U.S. and Canada:

 

 

 

 

Remodeling of our AE stores into our current store format is important to enhance our customer’s shopping experience. In order to maintain a balanced presentation and to accommodate additional product categories, we selectively enlarge our stores during the remodeling process to approximately 6,500 to 7,500 gross square feet, either within their existing location or by upgrading the store location within the mall. We believe the larger format can better accommodate our expansion of merchandise categories. We select stores for expansion or relocation based on market demographics and store volume forecasts. In 2007, we modified the design of our current store format to be more efficient and to freshen our brand.

 

During Fiscal 2007, we remodeled 53 stores in the U.S. to the current store design. Of the 53 remodeled stores, 26 stores were relocated to a larger space within the mall, 24 stores were expanded in place, and three stores were remodeled within their existing locations. Additionally, one store was refurbished as further discussed below.

 

We maintain a cost effective store refurbishment program targeted towards our lower volume stores, typically located in smaller markets. Stores selected as part of this program maintain their current location and size but are updated to include certain aspects of our current store format, including paint and certain new fixtures.

Destination AE

 

Under our Destination AE initiative, we believe that we can leverage the success we have had in making American Eagle the denim destination brand and increase market share in other brand-defining key categories. In Fiscal 2008, we expect to build upon this success by continuing to focus on our destination businesses, such as knits, denim, sweaters, and fleece. Additionally, we believe that our customer loyalty program, the AE All-Access Pass, helps us to continue making AE a destination for our customers. This program gives us a direct, one-on-one connection with our best customers and allows us to develop a relationship with these customers while rewarding brand loyalty.

 

aerie by American Eagle

 

In the fall of 2006, we launched our new intimates brand, aerie by American Eagle, which targets our core AE customers. The aerie collection includes bras, undies, camis, hoodies, robes, boxers, sweats, leggings, fitness apparel and personal care for the AE girl. It is intended to drive store productivity by expanding the product categories and building upon our experience. The aerie collection is offered in 39 stand-alone stores, predominantly all American Eagle stores and on aerie.com. Based on the positive customer response to aerie, in early Fiscal 2007 we decided to accelerate our real estate strategy for this brand. Our accelerated strategy included opening 36 stores during Fiscal 2007 compared to our original plan of 15 store openings during Fiscal 2007. The aerie brand remains a key focus in Fiscal 2008 with planned openings of approximately 80 stores.

 

AEO Direct

 

We sell merchandise via our e-commerce operations, ae.com and aerie.com, which are extensions of the lifestyle that we convey in our stores. During Fiscal 2007, AEO Direct shipped internationally to 41 countries, providing an opportunity to grow in regions where we do not currently have store locations. We are continuing to focus on the growth of AEO Direct through various initiatives, including improved site efficiency and faster check-out, expansion of sizes and styles, unique online content and targeted marketing strategies. In Fiscal 2008, we plan on expanding AEO Direct through the addition of e-commerce operations for martinandosa.com and 77kids.com.

 

MARTIN + OSA

 

In the fall of 2006, we launched MARTIN + OSA, a concept targeting 28 to 40 year-old women and men. MARTIN + OSA offers refined casual clothing and accessories, designed to be valuable, irresistible, inspiring, authentic and adventurous. During Fiscal 2007, we opened 14 MARTIN + OSA stores and we expect to open approximately 15 MARTIN + OSA stores in the United States during Fiscal 2008. Additionally, in Fiscal 2008, MARTIN + OSA will begin offering merchandise online at martinandosa.com.

 

77kids by american eagle

 

In January 2008, we announced plans to launch a new children’s apparel brand. 77kids by american eagle will offer on-trend, high-quality clothing and accessories for kids age two to 10. The brand will debut worldwide online at www.77kids.com during Fiscal 2008, with stores in the U.S. expected during 2010.

Consolidated Store Locations

 

Our stores average approximately 5,800 gross square feet and approximately 4,700 on a selling square foot basis. As of February 2, 2008, we operated 987 stores in the United States and Canada under the American Eagle Outfitters, aerie and MARTIN + OSA brands as shown below:

 

United States, including the District of Columbia and the Commonwealth of Puerto Rico — 911 stores

 

 

Purchasing

 

We purchase merchandise from suppliers who either manufacture their own merchandise, supply merchandise manufactured by others, or both. During Fiscal 2007, we purchased a majority of our merchandise from non-North American suppliers.

 

All of our merchandise suppliers receive a vendor compliance manual that describes our quality standards and shipping instructions. We maintain a quality control department at our distribution centers to inspect incoming merchandise shipments for uniformity of sizes and colors, and for overall quality of manufacturing. Periodic inspections are also made by our employees and agents at manufacturing facilities to identify quality problems prior to shipment of merchandise.

 

Corporate Social Responsibility

 

We are firmly committed to the goal of using only the most highly regarded and efficient suppliers throughout the world. We require our suppliers to provide a workplace environment that not only meets basic human rights standards, but also one that complies with all local legal requirements and encourages opportunity for all, with dignity and respect.

 

For many years, we have had a policy for the inspection of factories throughout the world where goods are produced to our order. This inspection process is an important component of our comprehensive vendor compliance program that was developed with the assistance of an internationally recognized consulting firm. This program contractually requires all suppliers to meet our global workplace standards, including human rights standards, as set forth in our Vendor Code of Conduct. The Vendor Code of Conduct is required to be posted in all factories in the local language. The program utilizes third party inspectors to audit compliance by vendor factories with our workplace standards and Vendor Code of Conduct. Additionally, a copy of the Vendor Code of Conduct is posted on our website, www.ae.com. In Fiscal 2007, we opened a Compliance office in Hong Kong. The key functions

performed by the AE team there are to validate the inspection reporting of our third-party auditors, and to work with new and existing factories on issues of remediation. Also in Fiscal 2007, we instituted a process for pre-inspection of substantially all potential production facilities and expanded our annual re-audit program to include all primary existing facilities.

 

Security Compliance

 

During recent years, there has been an increasing focus within the international trade community on concerns related to global terrorist activity. Various security issues and other terrorist threats have brought increased demands from the Bureau of Customs and Border Protection (“CBP”) and other agencies within the Department of Homeland Security that importers take responsible action to secure their supply chains. In response, we became a certified member of the Customs — Trade Partnership Against Terrorism program (“C-TPAT”) during 2004. C-TPAT is a voluntary program offered by CBP in which an importer agrees to work with CBP to strengthen overall supply chain security. Our internal security procedures were reviewed by CBP during February 2005 and a validation of processes with respect to our external partners was completed in June 2005. We received a formal written validation of our security procedures from CBP during the first quarter of Fiscal 2006 indicating the highest level of benefits afforded to C-TPAT members. Additionally, we took significant steps to expand the scope of our security procedures during 2004, including, but not limited to: a significant increase in the number of factory audits performed; a revision of the factory audit format to include a review of all critical security issues as defined by CBP; a review of security procedures of our other international trading partners, including forwarders, consolidators, shippers and brokers; and a requirement that all of our international trading partners be members of C-TPAT. In Fiscal 2007, we further increased the scope of our inspection program by performing pre-inspections of substantially all potential production facilities and re-auditing all primary existing facilities.

 

Trade Compliance

 

We act as the importer of record for substantially all of the merchandise we purchase overseas from foreign suppliers. Accordingly, we have an affirmative obligation to comply with the rules and regulations established for importers by the CBP regarding issues such as merchandise classification, valuation and country of origin. We have developed and implemented a comprehensive series of trade compliance procedures to assure that we adhere to all CBP requirements. In its most recent review and audit of our import operations and procedures, CBP found no unacceptable risks of non-compliance.

 

Merchandise Inventory, Replenishment and Distribution

 

Purchase orders are entered into the merchandise system at the time of order. Merchandise is normally shipped directly from vendors and routed to our two US distribution centers, one in Warrendale, Pennsylvania and the other in Ottawa, Kansas, or to our third-party distribution provider in Canada. Historically, our stores in Canada received merchandise from NLS. Beginning in Fiscal 2006, our stores in Canada receive merchandise through logistics services provided under a transitional services agreement with the NLS Purchaser, which expires on July 31, 2008. During Fiscal 2007, we entered into a lease of a 294,000 square foot building to house our Canadian distribution center, which we plan to place into service in May 2008.

 

Upon receipt, merchandise is entered into the merchandise system, then processed and prepared for shipment to the stores or forwarded to a warehouse holding area to be used as store replenishment goods. The allocation of merchandise among stores varies based upon a number of factors, including geographic location, customer demographics and store size. Merchandise is shipped to our stores two to five times per week depending upon the season and store requirements.

 

During Fiscal 2007, we completed the first phase of expansion at our Ottawa, Kansas distribution center. The expansion of the distribution center enabled us to bring the fulfillment services for AEO Direct in house. Previously, AEO Direct utilized a third party vendor for its fulfillment services. The second phase of the expansion will be completed in Fiscal 2008 and is deigned to enhance our operating efficiency. Additionally, the expansion is central to our plans for supporting future growth, especially in areas such as AEO Direct, aerie, MARTIN + OSA and 77kids.

Customer Credit and Returns

 

We offer our AE customers in the U.S. an American Eagle private label credit card, issued by a third-party bank. We have no liability to the card issuer for bad debt expense, provided that purchases are made in accordance with the issuing bank’s procedures. We believe that providing in-store credit through use of our proprietary credit card promotes incremental sales and encourages customer loyalty. Our credit card holders receive special promotional offers and advance notice of all American Eagle in-store sales events. Our customers in the U.S. and Canada may also pay for their purchases with American Express^®, Discover^®, MasterCard^®, Visa^®, bank debit cards, cash or check.

 

AE and aerie gift cards can be purchased in our American Eagle and aerie stores, respectively. Both AE and aerie gift cards are available through ae.com. MARTIN + OSA gift cards are available in our MARTIN + OSA stores. When the recipient uses the gift card, the value of the purchase is electronically deducted from the card and any remaining value can be used for future purchases. As of July 2007, we no longer charge a service fee for inactive gift cards.

 

We offer our customers a hassle-free return policy. We believe that certain of our competitors offer similar credit card and customer service policies.

 

Competition

 

The retail apparel industry, including retail stores and e-commerce, is highly competitive. We compete with various individual and chain specialty stores, as well as the casual apparel and footwear departments of department stores and discount retailers, primarily on the basis of quality, fashion, service, selection and price.

 

Trademarks and Service Marks

 

We have registered AMERICAN EAGLE OUTFITTERS^®, AMERICAN EAGLE^®, AE^® and AEO^® with the United States Patent and Trademark Office. We have also registered or have applied to register these trademarks with the registries of many of the foreign countries in which our manufacturers are located and/or where our product is shipped. We have registered AMERICAN EAGLE OUTFITTERS^® and have applied to register AMERICAN EAGLE^tm with the Canadian Trademark Office. In addition, we are exclusively licensed in Canada to use AE^tm and AEO^® in connection with the sale of a wide range of clothing products.

 

In the United States and around the world, we have also registered, or have applied to register, a number of other marks used in our business, including aerie^tm, MARTIN+OSA^tm and 77kids by american eagle^tm.

 

These trademarks are renewable indefinitely, as long as they are still in use and their registrations are properly maintained. We believe that the recognition associated with these trademarks makes them extremely valuable and, therefore, we intend to use and renew our trademarks in accordance with our business plans.

 

Employees

 

As of February 2, 2008, we had approximately 38,700 employees in the United States and Canada, of whom approximately 32,500 were part-time and seasonal hourly employees. We consider our relationship with our employees to be good.

 

Seasonality

 

Historically, our operations have been seasonal, with a large portion of net sales and net income occurring in the fourth fiscal quarter, reflecting increased demand during the year-end holiday selling season and, to a lesser extent, the third quarter, reflecting increased demand during the back-to-school selling season. During Fiscal 2007, the third and fourth fiscal quarters accounted for approximately 57% of our sales and approximately 60% of our net income. As a result of this seasonality, any factors negatively affecting us during the third and fourth fiscal quarters of any year, including adverse weather or unfavorable economic conditions, could have a material adverse effect on our financial condition and results of operations for the entire year. Our quarterly results of operations also may fluctuate based upon such factors as the timing of certain holiday seasons, the number and timing of new store

openings, the acceptability of seasonal merchandise offerings, the timing and level of markdowns, store closings and remodels, competitive factors, weather and general economic conditions.

 

Available Information

 

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports are available, free of charge, under the “About AE” section of our website at www.ae.com. These reports are available as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (the “SEC”).

 

Our corporate governance materials, including our corporate governance guidelines, the charters of our audit, compensation, and nominating and corporate governance committees, and our code of ethics may also be found under the “About AE” section of our website at www.ae.com. Any amendments or waivers to our code of ethics will also be available on our website. A copy of the corporate governance materials is also available upon written request.

 

Additionally, our investor presentations are available under the “About AE” section of our website at www.ae.com. These presentations are available as soon as reasonably practicable after they are presented at investor conferences.

 

Certifications

 

As required by New York Stock Exchange (“NYSE”) Corporate Governance Standards Section 303A.12(a), on July 1, 2007 our Chief Executive Officer submitted to the NYSE a certification that he was not aware of any violation by the Company of NYSE corporate governance listing standards. Additionally, we filed with this Form 10-K, the Principal Executive Officer and Principal Financial Officer certifications required under Sections 302 and 906 of the Sarbanes-Oxley Act of 2002.

 

 

Our ability to anticipate and respond to changing consumer preferences and fashion trends in a timely manner

 

Our future success depends, in part, upon our ability to identify and respond to fashion trends in a timely manner. The specialty retail apparel business fluctuates according to changes in the economy and customer preferences, dictated by fashion and season. These fluctuations especially affect the inventory owned by apparel retailers because merchandise typically must be ordered well in advance of the selling season. While we endeavor to test many merchandise items before ordering large quantities, we are still susceptible to changing fashion trends and fluctuations in customer demands.

 

In addition, the cyclical nature of the retail business requires that we carry a significant amount of inventory, especially during our peak selling seasons. We enter into agreements for the manufacture and purchase of our private label apparel well in advance of the applicable selling season. As a result, we are vulnerable to changes in consumer demand, pricing shifts and the timing and selection of merchandise purchases. The failure to enter into agreements for the manufacture and purchase of merchandise in a timely manner could, among other things, lead to a shortage of inventory and lower sales. Changes in fashion trends, if unsuccessfully identified, forecasted or responded to by us, could, among other things, lead to lower sales, excess inventories and higher markdowns, which in turn could have a material adverse effect on our results of operations and financial condition.

 

The effect of competitive pressures from other retailers and other business factors

 

The specialty retail industry is highly competitive. We compete primarily on the basis of quality, fashion, service, selection and price. There can be no assurance that we will be able to successfully compete in the future.

 

The success of our operations also depends to a significant extent upon a number of factors relating to discretionary consumer spending, including economic conditions affecting disposable consumer income such as employment, consumer debt, interest rates and consumer confidence. There can be no assurance that consumer

spending will not be negatively affected by general or local economic conditions, thereby adversely impacting our continued growth and results of operations.

 

Our ability to grow through new store openings and existing store remodels and expansions

 

Our continued growth and success will depend in part on our ability to open and operate new stores and expand and remodel existing stores on a timely and profitable basis. During Fiscal 2008, we plan to open approximately 40 new American Eagle stores in the U.S. and Canada, approximately 80 aerie stand-alone stores and approximately 15 MARTIN + OSA stores. Additionally, we plan to remodel or expand approximately 40 to 50 existing American Eagle stores during Fiscal 2008. Accomplishing our new and existing store expansion goals will depend upon a number of factors, including the ability to obtain suitable sites for new and expanded stores at acceptable costs, the hiring and training of qualified personnel, particularly at the store management level, the integration of new stores into existing operations and the expansion of our buying and inventory capabilities. There can be no assurance that we will be able to achieve our store expansion goals, manage our growth effectively, successfully integrate the planned new stores into our operations or operate our new and remodeled stores profitably.

 

Our ability to grow through the internal development of new brands

 

We launched our new brand concepts, MARTIN + OSA and aerie by American Eagle, during Fiscal 2006. Additionally, in January 2008, we announced the planned launch of 77kids. Our ability to succeed in these new brands requires significant expenditures and management attention. Additionally, any new brand is subject to certain risks including customer acceptance, competition, product differentiation, the ability to attract and retain qualified personnel, including management and designers, and the ability to obtain suitable sites for new stores at acceptable costs. There can be no assurance that these new brands will grow or become profitable. If we are unable to succeed in developing profitable new brands, this could adversely impact our continued growth and results of operations.

 

Our international merchandise sourcing strategy

 

Substantially all of our merchandise is purchased from foreign suppliers. Although we purchase a significant portion of our merchandise through a single foreign buying agent, we do not maintain any exclusive commitments to purchase from any vendor. Since we rely on a small number of foreign sources for a significant portion of our purchases, any event causing the disruption of imports, including the insolvency of a significant supplier or a significant labor dispute, could have an adverse effect on our operations. Other events that could also cause a disruption of imports include the imposition of additional trade law provisions or import restrictions, such as increased duties, tariffs, anti-dumping provisions, increased Custom’s enforcement actions, or political or economic disruptions.

 

We have a Vendor Code of Conduct that provides guidelines for all of our vendors regarding working conditions, employment practices and compliance with local laws. A copy of the Vendor Code of Conduct is posted on our website, www.ae.com. We have a factory compliance program to audit for compliance with the Vendor Code of Conduct. However, there can be no assurance that our factory compliance program will be effective in discovering violations. Publicity regarding violation of our Vendor Code of Conduct or other social responsibility standards by any of our vendor factories could adversely affect our sales and financial performance.

 

We believe that there is a risk of terrorist activity on a global basis, and such activity might take the form of a physical act that impedes the flow of imported goods or the insertion of a harmful or injurious agent to an imported shipment. We have instituted policies and procedures designed to reduce the chance or impact of such actions including, but not limited to, a significant increase in the number of factory audits performed; a strengthening of our factory audit protocol to include all critical security issues; the review of security procedures of our other international trading partners, including forwarders, consolidators, shippers and brokers; and the cancellation of agreements with entities who fail to meet our security requirements. In addition, U.S. Customs has recognized us as a validated, tier three member of the Customs — Trade Partnership Against Terrorism program, a voluntary program in which an importer agrees to work with Customs to strengthen overall supply chain security. However,

there can be no assurance that terrorist activity can be prevented and we cannot predict the likelihood of any such activities or the extent of their adverse impact on our operations.

 

Seasonality

 

Historically, our operations have been seasonal, with a large portion of net sales and net income occurring in the fourth fiscal quarter, reflecting increased demand during the year-end holiday selling season and, to a lesser extent, the third quarter, reflecting increased demand during the back-to-school selling season. During Fiscal 2007, the third and fourth fiscal quarters accounted for approximately 57% of our sales and approximately 60% of our net income. As a result of this seasonality, any factors negatively affecting us during the third and fourth fiscal quarters of any year could have a material adverse effect on our financial condition and results of operations for the entire year. Our quarterly results of operations also may fluctuate based upon such factors as the timing of certain holiday seasons, the number and timing of new store openings, the acceptability of seasonal merchandise offerings, the timing and level of markdowns, store closings and remodels, competitive factors, weather and general economic conditions.

 

Our reliance on key personnel

 

Our success depends to a significant extent upon the continued services of our key personnel, including senior management, as well as its ability to attract and retain qualified key personnel and skilled employees in the future. Our operations could be adversely affected if, for any reason, one or more key executive officers ceased to be active in our management.

 

Our ability to successfully complete important infrastructure projects

 

We implemented multiple infrastructure projects in Fiscal 2007 and will continue to implement new projects in Fiscal 2008. The major projects in Fiscal 2008 include:

 

 

We rely upon our facilities and information systems to support the management of our operations. Any delays or difficulties in these important projects could have a material adverse impact on our business.

 

Our reliance on third-party distribution services for our Canadian stores

 

Our stores in Canada receive merchandise through logistics services provided under a transitional services agreement with the NLS Purchaser, which will expire in July 2008. Any significant interruption in the logistics services provided by the NLS Purchaser could have a material adverse effect on the operation of our stores in Canada and on our financial condition and results. During Fiscal 2007, we entered into a lease of a 294,000 square foot building to house our Canadian distribution center, which we plan to place into service in May 2008.

 

Failure to comply with regulatory requirements

 

As a public company, we are subject to numerous regulatory requirements. Our policies, procedures and internal controls are designed to comply with all applicable laws and regulations, including those imposed by the Sarbanes-Oxley Act of 2002, the SEC and the NYSE. Failure to comply with such laws and regulations could have a material adverse effect on our reputation, financial condition and on the market price of our common stock.

Negative conditions in global credit markets may impair our auction rate securities portfolio.

 

Auction rate securities (“ARS”) are long-term debt instruments with interest rates reset through periodic short-term auctions. Holders of ARS can either sell into the auction or bid based on a desired interest rate or hold and accept the reset rate. If there are insufficient buyers, then the auction fails and holders are unable to liquidate their investment through the auction. A failed auction is not a default of the debt instrument, but does set a new interest rate in accordance with the original terms of the debt instrument. The result of a failed auction is that the ARS continues to pay interest in accordance with its terms; however, liquidity for holders is limited until there is a successful auction or until such time as another market for ARS develops. ARS are generally callable at any time by the issuer. Auctions continue to be held as scheduled until the ARS matures or until it is called.

 

As a result of the recent conditions in the global credit markets, we have been unable to liquidate our holdings of certain ARS because the amount of securities submitted for sale has exceeded the amount of purchase orders for such securities and the auctions failed. For failed auctions, we continue to earn interest on these investments at the contractual rate. In the event we need to access these funds, we will not be able to do so until a future auction is successful, the issuer redeems the securities, a buyer is found outside of the auction process or the securities mature. If these ARS are unable to successfully clear at future auctions or issuers do not redeem the securities, we may be required to adjust the carrying value of the securities and record an impairment charge. If we determine that the fair value of these ARS is temporarily impaired, we would record a temporary impairment within other comprehensive income, a component of stockholders’ equity. If it is determined that the fair value of these securities is other-than-temporarily impaired, we would record a loss in our Consolidated Statements of Operations, which could materially adversely impact our results of operations and financial condition. Additionally, it may become necessary to classify failed ARS holdings as long-term investments in our Consolidated Balance Sheets in future periods.

 

As of February 2, 2008, we had approximately $418 million of investments in ARS. See Note 13 of the Consolidated Financial Statements for information on a subsequent event related to our auction rate securities.

 

Other risk factors

 

Additionally, other factors could adversely affect our financial performance, including factors such as: our ability to successfully acquire and integrate other businesses; any interruption of our key business systems; any disaster or casualty resulting in the interruption of service from our distribution centers or in a large number of our stores; any interruption of key services provided by third party vendors; any interruption of our business related to an outbreak of a pandemic disease in a country where we source or market our merchandise; changes in weather patterns; the effects of changes in current exchange rates and interest rates; and international and domestic acts of terror.

 

The impact of any of the previously discussed factors, some of which are beyond our control, may cause our actual results to differ materially from expected results in these statements and other forward-looking statements we may make from time-to-time.

 

Not applicable.

 

 

During Fiscal 2007, we completed construction and relocated our corporate headquarters to an 186,000 square foot building in an urban Pittsburgh, Pennsylvania location. Additionally, we began construction of a 152,000 square foot building on adjacent land, which will also be used for the relocation and expansion of our corporate headquarters. We lease three locations near our headquarters, which are used primarily for store and corporate support services, totaling approximately 68,000 square feet. These leases expire with various terms through 2022.

 

We own a 490,000 square foot building located in a suburban area near Pittsburgh, Pennsylvania, which houses our distribution center and contains approximately 120,000 square feet of office space. We also own a 45,000 square foot building, which houses our data center. We lease an additional location of approximately 18,000, which is used for storage space. This lease expires in 2010.

We rent approximately 131,000 square feet of office space in New York, New York for our designers and sourcing and production teams, as well as for the offices of MARTIN + OSA. The lease for this space expires in May 2016. We also lease an additional 5,000 square feet of office space in New York, New York, which expires in February 2014. During Fiscal 2007, we entered into a two additional leases for office space totaling approximately 55,000 square feet, with various terms expiring through 2018.

 

We own a distribution facility in Ottawa, Kansas consisting of approximately 940,000 square feet, including a 544,000 square foot expansion which was completed during Fiscal 2007. During Fiscal 2008, we have plans to further expand the facility by approximately 280,000 square feet. This expanded facility will be used to support new and existing growth initiatives, including AEO Direct, aerie, MARTIN + OSA and 77kids.

 

During Fiscal 2007, we entered into a lease of a 294,000 square foot building to house our Canadian distribution center. The lease expires in 2017.

 

We also entered into a lease in Fiscal 2007 for a new flagship store in the Time Square area of New York, New York. The 25,000 square foot location has an initial term of 15 years with three options to renew for five years each. We anticipate this store to open in late Fiscal 2009.

 

All of our stores in the United States and Canada are leased. The store leases generally have initial terms of 10 years. Certain leases also include early termination options, which can be exercised under specific conditions. Most of these leases provide for base rent and require the payment of a percentage of sales as additional contingent rent when sales reach specified levels. Under our store leases, we are typically responsible for tenant occupancy costs, including maintenance and common area charges, real estate taxes and certain other expenses. We have generally been successful in negotiating renewals as leases near expiration.

 

 

We are a party to litigation incidental to our business. At this time, our management does not expect the results of the litigation to be material to our financial position or results of operations.

 

 

Not applicable.

 

 

Effective March 8, 2007, our common stock began trading on the NYSE under the symbol “AEO.” Prior to that time, our stock was traded on the NASDAQ Stock Market LLC under the symbol “AEOS.” The following table sets forth the range of high and low sales prices of the common stock as reported on the NYSE and the NASDAQ Stock Market during the periods indicated. As of March 14, 2008, there were 774 stockholders of record. However, when including associates who own shares through our employee stock purchase plan, and others holding shares in broker accounts under street name, we estimate the stockholder base at approximately 90,000. The following information reflects the December 2006 three-for-two stock split.

 

 

During Fiscal 2007 and Fiscal 2006, we paid quarterly dividends as shown in the table above. The payment of future dividends is at the discretion of our Board of Directors (the “Board”) and is based on future earnings, cash flow, financial condition, capital requirements, changes in U.S. taxation and other relevant factors. It is anticipated that any future dividends paid will be declared on a quarterly basis.

 

Performance Graph

 

The following Performance Graph and related information shall not be deemed “soliciting material” or to be filed with the SEC, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that we specifically incorporate it by reference into such filing.

 

The following graph compares the changes in the cumulative total return to holders of our common stock with that of the NASDAQ Stock Market — U.S. Composite Index, S&P Midcap 400, the Dynamic Retail Intellidex and our former peer group as described below. The comparison of the cumulative total returns for each investment assumes that $100 was invested in our common stock and the respective index on February 1, 2003 and includes reinvestment of all dividends. The plotted points are based on the closing price on the last trading day of the fiscal year indicated.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN

Among American Eagle Outfitters, Inc., The NASDAQ Composite Index*

The S&P Midcap 400 Index*, The Dynamic Retail Intellidex** And Peer Group Index**

 

 

 

 

Issuer Purchases of Equity Securities

 

The following table provides information regarding our repurchases of our common stock during the three months ended February 2, 2008.

 

 

 

 

Equity Compensation Plan Table

 

The following table sets forth additional information as of the end of Fiscal 2007, about shares of our common stock that may be issued upon the exercise of options and other rights under our existing equity compensation plans and arrangements, divided between plans approved by our stockholders and plans or arrangements not submitted to the Company’s stockholders for approval. The information includes the number of shares covered by, and the weighted average exercise price of, outstanding options and other rights and the number of shares remaining available for future grants excluding the shares to be issued upon exercise of outstanding options, warrants, and other rights.

 

 

 

 

 

The following Selected Consolidated Financial Data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included under Item 7 below and the Consolidated Financial Statements and Notes thereto, included in Item 8 below. Most of the selected data presented below is derived from our Consolidated Financial Statements, which are filed in response to Item 8 below. The selected Consolidated Statement of Operations data for the years ended January 29, 2005 and January 31, 2004 and the selected Consolidated Balance Sheet data as of January 28, 2006, January 29, 2005 and January 31, 2004 are derived from audited Consolidated Financial Statements not included herein.

 

 

 

 

The following discussion and analysis of financial condition and results of operations are based upon our Consolidated Financial Statements and should be read in conjunction with those statements and notes thereto.

 

This report contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which represent our expectations or beliefs concerning future events, including the following:

 

 

 

We caution that these forward-looking statements, and those described elsewhere in this report, involve material risks and uncertainties and are subject to change based on factors beyond our control, as discussed within Part I, Item 1A of this Form 10-K. Accordingly, our future performance and financial results may differ materially from those expressed or implied in any such forward looking statement.

 

Critical Accounting Policies

 

Our Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions that may affect the reported financial condition and results of operations should actual results differ. We base our estimates and assumptions on the best available information and believe them to be reasonable for the circumstances. We believe that of our significant accounting policies, the following involve a higher degree of judgment and complexity. See Note 2 of the Consolidated Financial Statements for a complete discussion of our significant accounting policies. Management has reviewed these critical accounting policies and estimates with the Audit Committee of our Board.

 

Revenue Recognition.  We record revenue for store sales upon the purchase of merchandise by customers. Our e-commerce operation records revenue upon the estimated customer receipt date of the merchandise. Revenue is not recorded on the purchase of gift cards. A current liability is recorded upon purchase, and revenue is recognized when the gift card is redeemed for merchandise.

 

Revenue is recorded net of estimated and actual sales returns and deductions for coupon redemptions and other promotions. The estimated sales return reserve is based on projected merchandise returns determined through the use of historical average return percentages. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our sales return reserve. However, if the actual rate of sales returns increases significantly, our operating results could be adversely affected.

 

During Fiscal 2007, we discontinued assessing a service fee on inactive gift cards. As a result, we estimate gift card breakage and recognize revenue in proportion to actual gift card redemptions as a component of net sales. We determine an estimated gift card breakage rate by continuously evaluating historical redemption data and the time when there is a remote likelihood that a gift card will be redeemed.

 

During Fiscal 2006, we reviewed our accounting policies related to revenue recognition and determined that shipping and handling amounts billed to customers, which were historically recorded as a reduction to cost of sales, should be recorded as revenue. Accordingly, these amounts are recorded within net sales. Prior year amounts were reclassified for comparative purposes.

 

During the three months ended October 28, 2006, we began recording sell-offs of end-of-season, overstock and irregular merchandise on a gross basis, with proceeds and cost of sell-offs recorded in net sales and cost of sales, respectively. Historically, we presented the proceeds and cost of sell-offs on a net basis within cost of sales. Amounts for prior periods were not adjusted to reflect this change as the amounts were deemed to be immaterial.

 

Merchandise Inventory.  Merchandise inventory is valued at the lower of average cost or market, utilizing the retail method. Average cost includes merchandise design and sourcing costs and related expenses.

 

We review our inventory in order to identify slow-moving merchandise and generally use markdowns to clear merchandise. Additionally, we estimate a markdown reserve for future planned markdowns related to current inventory. If inventory exceeds customer demand for reasons of style, seasonal adaptation, changes in customer preference, lack of consumer acceptance of fashion items, competition, or if it is determined that the inventory in stock will not sell at its currently ticketed price, additional markdowns may be necessary. These markdowns may have a material adverse impact on earnings, depending on the extent and amount of inventory affected.

We estimate an inventory shrinkage reserve for anticipated losses for the period between the last physical count and the balance sheet date. The estimate for the shrinkage reserve is calculated based on historical percentages and can be affected by changes in merchandise mix and changes in actual shrinkage trends. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our inventory shrinkage reserve. However, if actual physical inventory losses differ significantly from our estimate, our operating results could be adversely affected.

 

Asset Impairment.  In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”), we evaluate long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset might not be recoverable. Assets are evaluated for impairment by comparing the projected undiscounted future cash flows of the asset to the carrying value. If the future cash flows are projected to be less than the carrying value of the asset, we adjust the asset value to estimated fair value and an impairment loss is recorded in selling, general and administrative expenses.

 

Our impairment loss calculations require management to make assumptions and to apply judgment to estimate future cash flows and asset fair values, including forecasting useful lives of the assets and selecting the discount rate that reflects the risk inherent in future cash flows. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate long-lived asset impairment losses. However, if actual results are not consistent with our estimates and assumptions, our operating results could be adversely affected.

 

Other-Than-Temporary Impairment of Investments.  We record an investment impairment charge at the point we believe an investment has experienced a decline in value that is other-than-temporary. In determining whether an other-than-temporary impairment has occurred, we review information about the underlying investment that is publicly available, analyst reports, applicable industry data and other pertinent information, and assess our ability to hold the securities for the foreseeable future. The investment is written down to its current market value at the time the impairment is deemed to have occurred. Future adverse changes in market conditions, continued poor operating results of underlying investments or other factors could result in further losses that may not be reflected in an investment’s current carrying value, possibly requiring an additional impairment charge in the future. Any other-than-temporary impairment charge could materially affect our results of operations.

 

Share-Based Payments.  We account for share-based payments in accordance with the provisions of SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123(R)”). To determine the fair value of our stock option awards, we use the Black-Scholes option pricing model, which requires management to apply judgment and make assumptions to determine the fair value of our awards. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the “expected term”), the estimated volatility of the price of our common stock over the expected term and an estimate of the number of options that will ultimately be forfeited.

 

We calculate a weighted-average expected term using the “simplified method” as permitted by Staff Accounting Bulletin (“SAB”) No. 107, Share-Based Payment (“SAB No. 107”). The “simplified method” calculates the expected term as the average of the vesting term and original contractual term of the options. Expected stock price volatility is based on a combination of historical volatility of our common stock and implied volatility. We chose to use a combination of historical and implied volatility as we believe that this combination is more representative of future stock price trends than historical volatility alone. Estimated forfeitures are calculated based on historical experience. Changes in these assumptions can materially affect the estimate of the fair value of our share-based payments and the related amount recognized in our Consolidated Financial Statements.

 

Income Taxes.  Effective February 4, 2007, we adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return, including a decision whether to file or not to file in a particular jurisdiction. Under FIN 48, a tax benefit from an uncertain position may be recognized only if it is “more likely than not” that the position is sustainable based on its technical merits. See Note 12 of the Consolidated Financial Statements for further discussion of the adoption of FIN 48.

We calculate income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS No. 109”), which requires the use of the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on the difference between the Consolidated Financial Statement carrying amounts of existing assets and liabilities and their respective tax bases as computed pursuant to FIN 48. Deferred tax assets and liabilities are measured using the tax rates, based on certain judgments regarding enacted tax laws and published guidance, in effect in the years when those temporary differences are expected to reverse. A valuation allowance is established against the deferred tax assets when it is more likely than not that some portion or all of the deferred taxes may not be realized. Changes in our level and composition of earnings, tax laws or the deferred tax valuation allowance, as well as the results of tax audits may materially impact our effective tax rate.

 

The calculation of the deferred tax assets and liabilities, as well as the decision to recognize a tax benefit from an uncertain position and to establish a valuation allowance require management to make estimates and assumptions. Although we do not believe there is a reasonable likelihood that there will be a material change in the estimates and assumptions used, if actual results are not consistent with the estimates and assumptions, the balances of the deferred tax assets, liabilities and valuation allowance as well as net income could be adversely affected.

 

Key Performance Indicators

 

Our management evaluates the following items, which are considered key performance indicators, in assessing our performance:

 

Comparable store sales — Comparable store sales provide a measure of sales growth for stores open at least one year over the comparable prior year period. In fiscal years following those with 53 weeks, including Fiscal 2007, the prior year period is shifted by one week to compare similar calendar weeks. A store is included in comparable store sales in the thirteenth month of operation. However, stores that have a gross square footage increase of 25% or greater due to a remodel are removed from the comparable store sales base, but are included in total sales. These stores are returned to the comparable store sales base in the thirteenth month following the remodel.

 

Our management considers comparable store sales to be an important indicator of our current performance. Comparable store sales results are important to achieve leveraging of our costs, including store payroll, store supplies, rent, etc. Comparable store sales also have a direct impact on our total net sales, cash and working capital.

 

Gross profit — Gross profit measures whether we are optimizing the price and inventory levels of our merchandise. Gross profit is the difference between net sales and cost of sales. Cost of sales consists of: merchandise costs, including design, sourcing, importing and inbound freight costs, as well as markdowns, shrinkage, certain promotional costs and buying, occupancy and warehousing costs. Buying, occupancy and warehousing costs consist of: compensation, employee benefit expenses and travel for our buyers; rent and utilities related to our stores, corporate headquarters, distribution centers and other office space; freight from our distribution centers to the stores; compensation and supplies for our distribution centers, including purchasing, receiving and inspection costs; and shipping and handling costs related to our e-commerce operation. Any inability to obtain acceptable levels of initial markups or any significant increase in our use of markdowns could have an adverse effect on our gross profit and results of operations.

 

Operating income — Our management views operating income as a key indicator of our success. The key drivers of operating income are comparable store sales, gross profit, our ability to control selling, general and administrative expenses, and our level of capital expenditures.

 

Store productivity - Store productivity, including net sales per average square foot, sales per productive hour, average unit retail price, conversion rate, the number of transactions per store, the number of units sold per store and the number of units per transaction, is evaluated by our management in assessing our operational performance.

 

Inventory turnover — Our management evaluates inventory turnover as a measure of how productively inventory is bought and sold. Inventory turnover is important as it can signal slow moving inventory. This can be critical in determining the need to take markdowns on merchandise.

Cash flow and liquidity — Our management evaluates cash flow from operations, investing and financing in determining the sufficiency of our cash position. Cash flow from operations has historically been sufficient to cover our uses of cash. Our management believes that cash flow from operations will be sufficient to fund anticipated capital expenditures and working capital requirements.

 

Results of Operations

 

Overview

 

Fiscal 2007 marked another record year of financial performance for American Eagle Outfitters. We managed the business with discipline, achieving a 19.6% operating margin, while continuing to invest in critical growth initiatives. Our results were driven by our strong customer connection, well-positioned brands, leading operations and technology, as well as the talent within our teams.

 

Net sales for Fiscal 2007 increased 9% to $3.055 billion, and consolidated comparable store sales increased 1% compared to the corresponding 52 week period last year. Our comparable store sales increase was driven by a combination of higher units per transaction and a higher average unit retail price resulting in a higher transaction value.

 

Operating income as a percent to net sales was 19.6% for Fiscal 2007 compared to 21.0% for Fiscal 2006. The decrease was driven by a decline in gross profit and increased depreciation and amortization expense. This was partially offset by an improvement in selling, general and administrative expenses as a percent to net sales.

 

For Fiscal 2007, net income increased 3% to a record $400.0 million. As a percent to net sales, net income decreased to 13.1% during Fiscal 2007 from 13.9% during Fiscal 2006. Net income per diluted share increased 7% to $1.82 from $1.70 per diluted share last year.

 

We ended Fiscal 2007 with $785.7 million in cash, short-term and long-term investments. During the year, we continued to make significant investments in our business, including $250.4 million in capital expenditures. These expenditures related primarily to our new and remodeled stores in the U.S. and Canada, the expansion of our Ottawa, Kansas distribution center, the construction of our new Pittsburgh, Pennsylvania corporate headquarters, information technology upgrades at our home office and investments in our new aerie and MARTIN + OSA stores. Additionally, during Fiscal 2007, we repurchased 18.7 million shares of our common stock as part of our publicly announced repurchase programs for approximately $438.3 million, at a weighted average price of $23.38.

 

The following table shows, for the periods indicated, the percentage relationship to net sales of the listed items included in our Consolidated Statements of Operations.

 

 

Our operations are conducted in one reportable segment, which includes our 929 U.S. and Canadian AE retail stores, 39 aerie by American Eagle retail stores, 19 MARTIN + OSA retail stores and AEO Direct.

Comparison of Fiscal 2007 to Fiscal 2006

 

Net Sales

 

Net sales increased 9% to $3.055 billion from $2.794 billion. The sales increase resulted primarily from an increase in gross square feet due to new and remodeled stores, an increase in sales from our e-commerce operation, as well as a 1% increase in comparable store sales.

 

During the year, our AE Brand experienced a low single-digit increase in average transaction value, driven by a low single-digit increase in units per transaction and a slight increase in average unit retail price. Comparable store sales increased in the high single-digits in the men’s business and declined in the low single-digits in the women’s business over last year.

 

Gross Profit

 

Gross profit increased 6% to $1.423 billion from $1.340 billion in Fiscal 2006. Gross margin as a percent to net sales decreased by 140 basis points to 46.6% from 48.0% last year. The percentage decrease was attributed to a 50 basis point decrease in the merchandise margin rate and a 90 basis point increase in buying, occupancy and warehousing costs as a percent to net sales. Merchandise margin decreased for the period due primarily to increased markdowns and merchandise sell-offs partially offset by lower product costs. See Note 2 of the Consolidated Financial Statements for additional information regarding merchandise sell-offs. Buying, occupancy and warehousing expenses increased 90 basis points as a percent to net sales primarily due to higher rent, as well as delivery costs related to our AEO Direct business. Share-based payment expense included in gross profit increased to approximately $6.2 million compared to $5.8 million last year.

 

Our gross profit may not be comparable to that of other retailers, as some retailers include all costs related to their distribution network, as well as design costs in cost of sales. Other retailers may exclude a portion of these costs from cost of sales, including them in a line item such as selling, general and administrative expenses. See Note 2 of the Consolidated Financial Statements for a description of our accounting policy regarding cost of sales, including certain buying, occupancy and warehousing expenses.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased 7% to $715.2 million from $665.6 million. However, as a percent to net sales, selling, general and administrative expenses improved by 40 basis points to 23.4% from 23.8% last year. For the period, incentive compensation and supplies expense improved as a percent to net sales partially offset by increases in professional fees and advertising. Share-based payment expense included in selling, general and administrative expenses decreased to approximately $27.5 million compared to $30.8 million last year.

 

Depreciation and Amortization Expense

 

Depreciation and amortization expense increased 24% to $109.2 million from $88.0 million. As a percent to net sales, depreciation and amortization expense increased to 3.6% from 3.2%. These increases are primarily due to a greater property and equipment base driven by our level of capital expenditures.

 

Other Income, Net

 

Other income, net decreased to $37.6 million from $42.3 million. The decrease was primarily due to a $3.5 million realized capital gain last year and a decrease in our gift card service fee revenue due to the gift card program change that occurred in July 2007. These decreases were partially offset by increased investment income resulting from an overall increase in rates compared to last year. Additionally, we recorded a $1.2 million foreign currency transaction loss as a result of a stronger Canadian Dollar versus the U.S. Dollar compared to a $0.7 million loss last year.

 

Prior to July 2007, we recorded gift card service fee income in other income, net. As of July 8, 2007, we discontinued assessing a service fee on inactive gift cards and now record estimated gift card breakage revenue in net sales. In Fiscal 2007, we recorded gift card service fee income of $0.8 million compared to $2.3 million for the

Fiscal 2006. For Fiscal 2007, we recorded breakage revenue of $13.1 million in net sales. This amount included cumulative breakage revenue related to gift cards issued since we introduced the gift card program.

 

Provision for Income Taxes

 

The effective tax rate decreased to approximately 37% from 38% last year. The decrease in the effective tax rate is primarily related to a reduction in state income taxes and audit settlements.

 

Net Income

 

Net income increased 3% to a record $400.0 million, or 13.1% as a percent to net sales, from $387.4 million, or 13.9% as a percent to net sales last year. Net income per diluted share increased to $1.82 from $1.70 last year. The increase in net income was attributable to the factors noted above. The increase in net income per diluted share was attributable to the factors noted above, as well as a lower weighted average share count this year compared to last year.

 

Comparison of Fiscal 2006 to Fiscal 2005

 

Net Sales

 

Net sales increased 20% to $2.794 billion from $2.322 billion. The sales increase was due to a 12% comparable store sales increase compared to the corresponding 53 week period in Fiscal 2005, as well as an 8% increase in gross square feet, due primarily to the addition of new stores. The comparable store sales increase was driven by strong customer acceptance of our assortments, as well as positive store traffic. As a result, we experienced a high single-digit increase in our average transaction value, driven by a mid single-digit increase in units per transaction and a low single-digit increase in our average unit retail price. Comparable store sales percentages increased in the low double-digits in both the men’s and women’s businesses over Fiscal 2005.

 

Gross Profit

 

Gross profit increased 24% to $1.340 billion from $1.078 billion in Fiscal 2005. Gross profit as a percent to net sales increased by 160 basis points to 48.0% from 46.4% last year. The percentage increase was attributed to a 100 basis point improvement in the merchandise margin rate, as well as a 60 basis point reduction of buying, occupancy and warehousing costs as a percent to net sales. Merchandise margin improved for the period due primarily to lower markdowns, as well as a higher markon, partially offset by increased design costs and the impact of presenting the cost of merchandise sell-offs and the related proceeds on a gross basis. See Note 2 of the Consolidated Financial Statements for additional information regarding merchandise sell-offs. Buying, occupancy and warehousing expenses decreased as a percent to net sales due primarily to an improvement in rent expense as a percent to net sales. Share-based payment expense included in gross profit increased to approximately $5.8 million compared to $5.0 million in Fiscal 2005 due to our adoption of SFAS No. 123(R) at the beginning of Fiscal 2006.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased 23% to $665.6 million from $540.3 million, rising 60 basis points as a percent to net sales to 23.8% from 23.2% in Fiscal 2005. For the period, incentive compensation (including stock options), MARTIN + OSA expenses, and costs for branded packaging increased as a percent to net sales. These increases were partially offset by an improvement in store salaries as a percent to net sales. Share-based payment expense included in selling, general and administrative expenses increased to approximately $30.8 million compared to $14.6 million in Fiscal 2005, primarily due to our adoption of SFAS No. 123(R).

 

Depreciation and Amortization Expense

 

Depreciation and amortization expense as a percent to net sales decreased to 3.2% from 3.4% as a result of the positive comparable store sales increase. Depreciation and amortization expense increased 12% to $88.0 million from $78.7 million due primarily to the increase in our property and equipment base driven by our increased level of capital expenditures.

Other Income, Net

 

Other income, net increased to $42.3 million from $18.3 million due primarily to increased investment income resulting from higher cash and investment balances, as well as improved investment returns. Beginning in the second quarter of Fiscal 2006, we recorded gift card service fee income in other income, net. Prior to this time, these amounts were recorded as a reduction to selling, general, and administrative expenses. For Fiscal 2006, we recorded gift card service fee income of $2.3 million. For Fiscal 2005, we reclassified gift card service fee income of $2.4 million from selling, general and administrative expenses to other income, net.

 

Provision for Income Taxes

 

The effective tax rate remained unchanged for Fiscal 2006 at approximately 38% compared to Fiscal 2005.

 

Income from Continuing Operations

 

Income from continuing operations increased 32% to a record $387.4 million, or 13.9% as a percent to net sales, from $293.7 million, or 12.7% as a percent to net sales in Fiscal 2005. Income from continuing operations per diluted share increased to $1.70 from $1.26. The increase in income from continuing operations was attributable to the factors noted above.

 

Adoption of New Accounting Standard

 

Effective February 4, 2007, we adopted FIN 48. As a result of adopting FIN 48, we recorded a net liability of approximately $13.3 million for unrecognized tax benefits, which was accounted for as a reduction to the beginning balance of retained earnings as of February 4, 2007. See Note 12 of the Consolidated Financial Statements for a discussion of the FIN 48 adoption.

 

In December 2004, the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 123(R). SFAS No. 123(R) requires that companies recognize all share-based payments to employees, including grants of employee stock options, in the financial statements based on the fair value of the equity or liability instruments issued. On January 29, 2006, we adopted SFAS No. 123(R) using the modified prospective transition method. Prior to this adoption, we accounted for share-based payments to employees under the recognition and measurement provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and related interpretations, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). No share-based employee compensation cost related to stock options was recognized in the Consolidated Statement of Operations for Fiscal 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

 

As of February 2, 2008, we had $19.7 million and $1.9 million of unrecognized compensation expense related to nonvested stock option awards and nonvested restricted stock awards, respectively. This unrecognized compensation expense is expected to be recognized over the weighted average periods of 1.8 years for stock options awards and 8 months for restricted stock awards.

 

For additional information on our adoption of SFAS No. 123(R), see Note 9 of the Consolidated Financial Statements.

 

Income Taxes

 

The effective tax rate used for the provision of income tax approximated 37% and 38% in Fiscal 2007 and Fiscal 2006, respectively. The decrease in the effective tax rate is primarily related to a reduction in state income taxes and audit settlements.

 

Liquidity and Capital Resources

 

Our uses of cash are generally for working capital, the construction of new stores and remodeling of existing stores, information technology upgrades, distribution center improvements and expansion, the purchase of both short and long-term investments, the repurchase of common stock and the payment of dividends. Historically, these

uses of cash have been funded with cash flow from operations. Additionally, our uses of cash include: the purchase and construction of our new corporate headquarters; the construction of a new data center to support our information technology needs; development of MARTIN + OSA; and development of aerie by American Eagle. In the future, we expect that our uses of cash will also include new brand concept development, including development of 77 kids by american eagle.

 

Our growth strategy includes internally developing new brands and the possibility of acquisitions. We periodically consider and evaluate these options to support future growth. In the event we do pursue such options, we could require additional equity or debt financing. There can be no assurance that we would be successful in closing any potential transaction, or that any endeavor we undertake would increase our profitability.

 

The following sets forth certain measures of our liquidity:

 

 

Our current ratio increased to 2.71 as of February 2, 2008 from 2.56 last year due primarily to a decrease in accrued income and other taxes as well as a decrease in accounts payable. Accrued income and other taxes decreased in comparison to last year primarily due to the timing of income tax payments. Accounts payable decreased due to a change in payment terms and method with our foreign buying agent.

 

Cash Flows from Operating Activities

 

Net cash provided by operating activities from continuing operations totaled $464.3 million during Fiscal 2007 compared to $749.3 million during Fiscal 2006 and $480.4 during Fiscal 2005. Our major source of cash from operations was merchandise sales. Our primary outflows of cash for operations were for the purchase of inventory and operational costs.

 

The decrease in net cash provided by operating activities of $285.0 million from the prior year was primarily due to proceeds from the sale of trading securities of $184.0 million received during Fiscal 2006, as well as a $74.9 million increase in cash used for the payment of accrued income and other taxes, and a $47.9 million increase in cash used for the payment of accounts payable. The increase in cash used for the payment of accrued income and other taxes was due primarily to greater payments of accrued income taxes this year as well as the timing of the payments. The increase in cash used for the payment of accounts payable resulted primarily from a change in payment terms and method with our foreign buying agent, which also resulted in a reduction to the available amounts that we maintain under our unsecured letter of credit facility as discussed below.

 

Cash Flows from Investing Activities

 

Investing activities for Fiscal 2007 included $354.2 million from the net sale of investments classified as available-for-sale, partially offset by $250.4 million for capital expenditures. Investing activities for Fiscal 2006 primarily included $437.4 million for the net purchase of investments classified as available-for-sale as well as $225.9 million for capital expenditures. Investing activities for Fiscal 2005 included $81.5 million for capital expenditures and $311.4 million for the net purchase of investments.

 

We invest primarily in tax-exempt municipal bonds, taxable agency bonds, corporate notes and auction rate securities, with an original effective maturity of up to five years and an expected rate of return of approximately a 4.6% taxable equivalent yield. We place an emphasis on investing in tax-exempt and tax-advantaged asset classes and all investments must have a highly liquid secondary market at the time of purchase and an effective maturity not exceeding five years.

 

Cash Flows from Financing Activities

 

Cash used for financing activities resulted primarily from $438.3 million used for the repurchase of our common stock as part of our publicly announced repurchase programs and $80.8 million used for the payment of dividends during Fiscal 2007. During Fiscal 2006, cash used for financing activities resulted primarily from

$146.5 million used for the repurchase of our common stock as part of our publicly announced repurchase programs and $61.5 million used for the payment of dividends. During Fiscal 2005, cash used for financing activities from continuing operations resulted primarily from $161.0 million used for the repurchase of common stock as part of our publicly announced repurchase programs and $42.1 million used for the payment of dividends, partially offset by $48.2 million in proceeds from stock option exercises during the period.

 

Prior to the adoption of SFAS No. 123(R), we presented all tax benefits from share-based payments as operating cash flows in the Consolidated Statements of Cash Flows. SFAS No. 123(R) requires that cash flows resulting from the benefits of tax deductions in excess of recognized compensation cost be classified as financing cash flows. Accordingly, for Fiscal 2007 and 2006, the excess tax benefit from share-based payments of $6.2 million and $19.5 million, respectively, are classified as financing cash flows.

 

Auction Rate Securities

 

As of February 2, 2008, we had a balance of approximately $418 million of investments in ARS. Beginning February 12, 2008 through March 25, 2008, we have experienced failed auctions for 36 ARS issues representing principal and accrued interest in the total amount of $272.5 million. During this time, we have also sold nine ARS issues, at par plus accrued interest, for a total of $36.6 million. As of March 25, 2008 our ARS portfolio totaled approximately $373 million. We believe that the current lack of liquidity relating to our ARS investments will have no impact on our ability to fund our ongoing operations and growth initiatives.

 

See Note 13 of the Consolidated Financial Statements for information on a subsequent event related to our auction rate securities.

 

Credit Facilities

 

During Fiscal 2007, we reduced the amount available under our unsecured credit facility (the “facility”) to $100.0 million and eliminated a $40.0 million unsecured demand line of credit (the “line”) under the facility. The interest rate on the facility is either at the lender’s prime lending rate minus 1.00% or at LIBOR plus a negotiated margin rate. At February 2, 2008, $6.6 million was outstanding on the facility, leaving a remaining available balance of $93.4 million. No direct borrowings were required against the line for the current or prior periods. We also have an uncommitted letter of credit facility for $100.0 million with a separate financial institution. At February 2, 2008, $28.0 million was outstanding on this facility, leaving a remaining available balance of $72.0 million.

 

Subsequent to Fiscal 2007, we reinstated the $40.0 million demand line and increased the amount available to $75.0 million as part of the facility. Additionally, we borrowed $75.0 million on this line and used the proceeds to increase our cash position to add financial flexibility. The interest rate on the borrowing is at the lender’s prime lending rate minus 1.00%.

 

See Note 13 of the Consolidated Financial Statements for information on a subsequent event related to credit facilities.

 

Capital Expenditures

 

Fiscal 2007 capital expenditures of $250.4 million included $129.9 million related to investments in our stores, including 80 new and 53 remodeled stores in the United States and Canada. Additionally, we continued to support our infrastructure growth by investing in the expansion and improvement of our distribution centers ($47.6 million), construction of our new corporate headquarters in Pittsburgh, Pennsylvania ($37.3 million), information technology upgrades at our home office ($22.1 million), and the purchase of a corporate jet ($13.5 million).

 

We expect capital expenditures for Fiscal 2008 to be approximately $250 million to $275 million, which will relate primarily to approximately 40 new and 40 to 50 remodeled American Eagle stores in the United States and Canada, approximately 80 new aerie stand-alone stores, information technology upgrades, the purchase and construction of the second phase of our new corporate headquarters, investments in MARTIN + OSA, including approximately 15 new stores, and distribution center expansion/improvement, including the completion of the second phase of our Ottawa, Kansas distribution center expansion. We plan to fund these capital expenditures through existing cash and cash generated from operations.

Stock Repurchases

 

During Fiscal 2005, we repurchased 10.5 million shares of our common stock under various repurchase authorizations made by our Board. During Fiscal 2006, we repurchased the remaining 5.3 million shares of our common stock under the November 15, 2005 authorization for approximately $146.5 million, at a weighted average share price of $27.89. As of February 3, 2007, we had no shares remaining authorized for repurchase.

 

During Fiscal 2007, our Board authorized a total of 60.0 million shares of our common stock for repurchase under our share repurchase program with expiration dates extending into Fiscal 2010. During Fiscal 2007, we repurchased 18.7 million shares as part of our publicly announced repurchase programs for approximately $438.3 million, at a weighted average price of $23.38 per share. As of April 2, 2008, we had 41.3 million shares remaining authorized for repurchase. These shares will be repurchased at our discretion. Of the 41.3 million shares that may yet be purchased under the program, the authorization relating to 11.3 million shares expires in 2009 and the authorization relating to 30.0 million expires in 2010.

 

During both Fiscal 2007 and Fiscal 2006, we repurchased 0.4 million shares from certain employees at market prices totaling $12.3 million and $7.6 million, respectively. During Fiscal 2005, we repurchased 0.5 million shares from certain employees at market prices totaling $10.5 million. These shares were repurchased for the payment of taxes in connection with the vesting of share-based payments as permitted under the 2005 Stock Award and Incentive Plan and the 1999 Stock Incentive Plan.

 

The aforementioned share repurchases have been recorded as treasury stock.

 

Dividends

 

During the first quarter of Fiscal 2005, our Board authorized a quarterly cash dividend of $0.033 per share. Additionally, a $0.05 per share dividend was paid during each of the second, third and fourth quarters of Fiscal 2005 and the first quarter of Fiscal 2006. A $0.075 per share dividend was paid during each of the second, third and fourth quarters of Fiscal 2006 and the first quarter of Fiscal 2007 and a $0.10 per share dividend was paid during each of the second, third and fourth quarters of Fiscal 2007.

 

Subsequent to the fourth quarter of Fiscal 2007, our Board declared a quarterly cash dividend of $0.10 per share, payable on April 11, 2008 to stockholders of record at the close of business on March 28, 2008. The payment of future dividends is at the discretion of our Board and is based on future earnings, cash flow, financial condition, capital requirements, changes in U.S. taxation and other relevant factors. It is anticipated that any future dividends paid will be declared on a quarterly basis.

 

Cash Flows from Discontinued Operations

 

Cash flows from discontinued operations, including operating, investing and financing activities, are presented separately from cash flows from continuing operations in the Consolidated Statements of Cash Flows. The absence of the cash flows from discontinued operations will not materially affect our future liquidity or capital resources.

 

Obligations and Commitments

 

Disclosure about Contractual Obligations

 

The following table summarizes our significant contractual obligations as of February 2, 2008:

 

 

 

Disclosure about Commercial Commitments

 

The following table summarizes our significant commercial commitments as of February 2, 2008:

 

 

 

 

Off-Balance Sheet Arrangements

 

We are not a party to any off-balance sheet arrangements.

 

Recent Accounting Pronouncements

 

Recent accounting pronouncements are disclosed in Note 2 of the Consolidated Financial Statements.

 

Certain Relationships and Related Party Transactions

 

See Part III, Item 13 of this Form 10-K for information regarding related party transactions.

 

Impact of Inflation/Deflation

 

We do not believe that inflation has had a significant effect on our net sales or our profitability. Substantial increases in cost, however, could have a significant impact on our business and the industry in the future. Additionally, while deflation could positively impact our merchandise costs, it could have an adverse effect on our average unit retail price, resulting in lower sales and profitability.

 

 

We have market risk exposure related to interest rates and foreign currency exchange rates. Market risk is measured as the potential negative impact on earnings, cash flows or fair values resulting from a hypothetical change in interest rates or foreign currency exchange rates over the next year.

Interest Rate Risk

 

Our earnings are affected by changes in market interest rates as a result of our short-term investments in tax-exempt municipal bonds, taxable agency bonds, corporate notes, variable rate demand notes (“VRDNs”) and auction rate securities, which have long-term contractual maturities but feature variable interest rates that reset at short-term intervals. We also invest in long-term agency bonds. Due to the fact that our investments are primarily fixed rate instruments, the effects of interest rate changes are limited to VRDNs and auction rate securities. If our current portfolio average yield rate decreases by 10% in Fiscal 2008, our income before taxes will decrease by approximately $2.9 million. Comparatively, if our current portfolio average yield rate decreased by 10% in Fiscal 2007, our income before taxes would have decreased by approximately $4.6 million. These amounts are determined by considering the impact of the hypothetical yield rates on our cash, short-term and long-term investment balances. These analyses do not consider the effects of the reduced level of overall investments that could happen in such an environment. Further, in the event of a change of such magnitude, management would likely take actions to further mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no changes in our investments structure.

 

Foreign Exchange Rate Risk

 

We are exposed to the impact of foreign exchange rate risk primarily through our Canadian operations where the functional currency is the Canadian dollar. We do not hedge against foreign currency exchange risks. We believe our foreign currency translation risk is minimal as a hypothetical 10% change in the Canadian foreign exchange rate would not materially affect our results of operations or cash flows.

 

 

To the Board of Directors and Stockholders of American Eagle Outfitters, Inc.

 

We have audited the accompanying consolidated balance sheets of American Eagle Outfitters, Inc. (the Company) as of February 2, 2008 and February 3, 2007, and the related consolidated statements of operations, comprehensive income, stockholders’ equity, and cash flows for each of the three fiscal years in the period ended February 2, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Eagle Outfitters, Inc. at February 2, 2008 and February 3, 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended February 2, 2008, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 9 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Shared-Based Payment,” effective January 29, 2006. As discussed in Note 12 to the consolidated financial statements, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,” effective February 4, 2007.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Eagle Outfitters, Inc.’s internal control over financial reporting as of February 2, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 26, 2008 expressed an unqualified opinion thereon.

 

 

Pittsburgh, Pennsylvania

March 26, 2008

AMERICAN EAGLE OUTFITTERS, INC.

 

CONSOLIDATED BALANCE SHEETS

 

 

See Notes to Consolidated Financial Statements

AMERICAN EAGLE OUTFITTERS, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

See Notes to Consolidated Financial Statements

AMERICAN EAGLE OUTFITTERS, INC.

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

 

See Notes to Consolidated Financial Statements

AMERICAN EAGLE OUTFITTERS, INC.

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY