American Eagle Outfitters (AEO), The Gap Inc. (GPS): Is a Plunge in This Apparel Retailer’s Stock a Good Opportunity?

Being a long-term investor, a short-term plunge in the stock price caused by sluggish quarterly earnings could represent a good investment opportunity. Recently, American Eagle Outfitters (NYSE:AEO) dropped significantly, falling nearly 17.30% to only around $16.50 per share due to disappointing second quarter outlook. Let’s take a look to determine whether American Eagle is a good buy at its current price or if we should avoid this retailer for now.

Declining operating performance

American Eagle Outfitters (NYSE:AEO) has revised its second quarter earnings per share guidance to around $0.10, much lower than the earnings per share from continuing operations of $0.21 last year. The revenue is expected to experience a 2% decline, with a 7% drop in comparable store sales in the second quarter. CEO Robert Hanson was not happy with the company’s second quarter performance, saying that it was driven by “a disappointing performance of our AEO women’s assortment and weak traffic.”

Operating in a highly promotional retail environment, the company will increase the depth and breath of price markdowns for a clean inventory position. Hanson commented that while the domestic retail environment was facing headwinds, American Eagle Outfitters (NYSE:AEO)experienced a low double-digit increase in its direct business.

Growth potential

Looking forward, American Eagle Outfitters (NYSE:AEO) expects to grow its number of factory stores from 80 to more than 150, with sales increasing from $330 million to more than $500 million. Moreover, it will grow its 4-wall profit to more than 30%.

The company is also focused on growing its e-commerce segment by enhancing customer experience, launching personalization and expanding unique merchandise for online segment. The company plans to build a 1 million square feet distribution center in northeastern Pennsylvania, allowing it to directly ship to U.S. customers within just two days. American Eagle Outfitters (NYSE:AEO) long-term target is to grow its sales by 7% to 9% while its earnings before interest and taxes growth (EBIT) is in the range of 12%-15%.

The cheapest among its peers

American Eagle Outfitters (NYSE:AEO) is trading at $16.50 per share, with the total market cap of $3.18 billion. The market values American Eagle at 5 times its trailing earnings before interest, taxes, depreciation and amortization (EBITDA.) Income investors might like the company’s decent dividend yield of 3% as well. Competing against peers such as The Gap Inc. (NYSE:GPS) and Abercrombie & Fitch Co. (NYSE:ANF), American Eagle has the lowest valuation of the three.

The Gap Inc. (NYSE:GPS) is trading at $46.30 per share, with the total market cap of around $21.70 billion. The market values Gap at more than 8.1 times its trailing EBITDA. Gap has been moving its business to higher-return outlet channels and away from specialty stores. In the past six years, while the number of Gap outlet stores has increased from 193 to 226, its specialty store count dropped from 1,056 to 764.

At the end of 2013, the company expects to have around 700 specialty stores and 250 outlet stores. Its full year diluted earnings per share estimates to be in the range of $2.52 – $2.60. At the current trading price, The Gap Inc. (NYSE:GPS) offers lower dividend yield at 1.30%, but with the conservative payout ratio at only 25%. More cash will be returned to shareholders via its $1.3 billion share repurchase plan which will yield an additional 6% to shareholders.