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Updated daily. All values annualized from Jan. 2008.

Most Americans are familiar with American Eagle Outfitters. The company runs over 950 American Eagle mall-based clothing stores, primarily aiming for the teen and young adult market. More recently, the company has also started 3 new concepts: aerie (50 stores), which sells (as management says) "bras and undies", Martin + Osa, which focuses on sportswear for the 25-40 age range, and 77steps, a new concept aiming for the baby and youth market. AE only sells it's own proprietary brands instead of sourcing outside labels. Their niche is "affordable fashion". In shopping terms, this would be a step above Target and a step below Abercrombie & Fitch (ANF).

First, the positives. American Eagle is an extremely well run company. MFI return on capital levels have averaged about 69% since 2004, which is superb efficiency. Cash flow generation is similarly impressive, with free cash flow margin showing a 5-year 16% average. The company has compounded earnings per share at a 32% clip over that period. The balance sheet sparkles, with 370 million in cash versus no debt. Finally, management has been quite shareholder friendly, especially when compared to peers. American Eagle boasts a 3% dividend at today's prices, and payout ratio of free cash flow is only about 22%. The current dividend is quite safe and there is plenty of room for more dividend hikes. Any way you slice it, this is an effective company.

Even more exciting, American Eagle stock today boasts statistics that would make any value investor raise an eyebrow. Earnings yield is nearly 22%, or for old fashioned types, a 7.1 enterprise value (EV) to price ratio - insanely cheap. EV to sales is under 1. Free cash yield, my favorite valuation statistic, is huge at 15% (EV/free cash flow is 6.7). These are fire sale prices based on past levels of earnings and cash flow.

There is certainly a large amount of pessimism built into this stock - way too much, in the opinion of MagicDiligence. American Eagle's flagship stores are nearing saturation, but the aerie concept could have the potential to grow into a several hundred store chain. Also, slower expansion improves free cash flow generation, allowing more stock buybacks and dividend increases. A quick look at the Magic Formula screen shows a whole slew of clothing retailers being cheap... a clear sign that it's the industry, and not the company, being discounted. And when something is cheap solely because of short term macro-economic factors, it could be a good time to buy. American Eagle is a pretty good bet to bounce back strongly, and that's why MagicDiligence has a buy opinion.

Still, AE is not Top Buy material. Clothing retail, especially to teenagers, is a classic no moat business. There is a TON of competition in this space. Aeropostale (ARO), Abercrombie & Fitch (ANF), Gap (GPS), and PacSun (PSUN) are just a few of the competitors, to say nothing of the specialty stores as well as larger retailers such as Kohl's (KSS). Most all of these are well run companies with strong financial health and cash flow. The teen and young adult set are notoriously fickle on fashion. Ask Gap or PacSun shareholders about the pain when a teen clothier messes up it's product offering, even for just a few months. Compare this to a wide moat firm like Microsoft (MSFT), who has blown billions of dollars on sinkholes like MSN and the Zune, only to remain ludicrously profitable. All AE has is it's management, and there is little room for error.

In a nutshell, MagicDiligence loves American Eagle the company, but really and truly hates the business its in. It's a good buy for the do-it-yourself Magic Formula investor. But there are too many other Magic Formula entries with strong, built-in competitive advantages to recommend AEO as a Top Buy.

Steve owns no position in any stocks discussed in this article.

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