Taking Advantage of American Eagle’s Mishap of a Quarter (AEO)

Shares of American Eagle Outfitters AEO fell nearly 17% yesterday after the company reported that fiscal first-quarter earnings plunged by half on losses from its failed MARTIN+OSA chain, masking higher sales. The retailer forecast current-quarter earnings well below Street estimates. Though those headlines look quite bearish, I think the company deserves a second look. The company has essentially no debt, comp store sales were up 5% on the quarter, the stock is running at a forward P/E of 9.6x and a PEG Ratio of 0.78, and has a dividend yield of 3.16%. Those are facts, not conjecture about how the company has “lost its luster” as I am hearing from pundits. I think the stock is a buy very near this price; the technicals for the stock show support around the $12.00 and then around $10.00. In addition to that I am seeing bullish put selling on the name today with the November $10 strike sold on the bid 6,000 times; open interest on the strike is only 27 contracts, which signals new positioning. I tend to like that trade, but think that you can take better advantage of skew and volatility in the name. I believe that selling the January 2011 $10 put twice for a total of $1.60 and buying the November $15 call once for $0.80 is the way to play this. Net credit on the transaction is $0.80 (a 4% yield on the maximum capital allocation over the holding period; 8% yearly yield). This gives you upside potential, a cash yield, and the ability to buy shares at roughly a 23% discount to the current trade price.