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Article by DailyStocks_admin    (11-23-07 03:10 AM)

The Daily Magic Formula Stock for 11/23/2007 is American Eagle Outfitters Inc. According to the Magic Formula Investing Web Site, the ebit yield is 15% and the EBIT ROIC is 75 - 100%.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


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BUSINESS OVERVIEW

American Eagle Outfitters, Inc., a Delaware corporation, is a leading retailer that operates under the American Eagle Outfitters ® 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 distributes merchandise via its e-commerce operation (“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 sub-brand, aerie TM by American Eagle (“ aerie ”). The aerie collection of dormwear and intimates includes bras, undies, camis, hoodies, robes, boxers and sweats for the AE girl.
We also introduced MARTIN + OSA, a new sportswear concept targeting 25 to 40 year-old women and men, in the fall of 2006. MARTIN + OSA carries apparel, accessories and footwear, using denim and sport inspiration to design fun and sport back into sportswear.
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, including the aerie sub-brand and ae.com. “MARTIN + OSA” refers to our new sportswear concept launched during Fiscal 2006. “Bluenotes” refers to the Bluenotes/Thriftys specialty apparel chain which we operated in Canada prior to its disposition during Fiscal 2004.
As of February 3, 2007, we operated 906 American Eagle Outfitters stores in the United States and Canada (including three aerie stand-alone stores) and five 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 9 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. As a result, our Consolidated Balance Sheets reflect the assets subject to the agreement as held-for-sale for all periods presented. See Note 9 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 2008” and “Fiscal 2007” refer to the 52 week periods ending January 31, 2009 and February 2, 2008, respectively. “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 2006, we made significant progress on our key growth initiatives. As we enter Fiscal 2007, 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 2006, we operated in all 50 states, the District of Columbia, Puerto Rico and Canada. During Fiscal 2006, we opened 50 new stores, consisting of 41 U.S. AE stores, one Canadian AE store, three aerie stand-alone stores and five MARTIN + OSA stores. These store openings, offset by eight AE store closings, increased our total store base by approximately 5% to 911 stores. Additionally, our gross square footage increased by approximately 8% during Fiscal 2006, with approximately 5% attributable to new store openings and the remaining 3% attributable to the incremental square footage from 65 store remodels.
During Fiscal 2006, we continued to grow in the western and southeastern U.S. with 66% of our AE store openings in those regions. Approximately 50% of our U.S. AE store base is located in those two regions.
During Fiscal 2006, we increased our total Canadian AE store base to 72 stores. We remain pleased with the results of our American Eagle expansion into Canada and look to a long-term potential of approximately 80 AE stores across the country. In addition to the AE stores, we believe that there are opportunities to open aerie stand-alone stores in Canada.
In Fiscal 2007, we plan to open 45 to 50 new AE stores, at least 15 new aerie stand-alone stores and approximately 12 new MARTIN + OSA stores. Additionally, we plan to remodel approximately 45 existing AE stores. Our square footage growth is expected to be 10%. We believe that there are attractive retail locations where we can continue to open American Eagle stores in enclosed regional malls, urban areas and lifestyle centers.

We continue to remodel our older AE stores into our current store format. In order to maintain a balanced presentation and to accommodate additional product categories, we selectively enlarge our stores during the remodeling process, to approximately 6,000 to 6,500 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. During Fiscal 2006, we remodeled 63 stores in the U.S. and two stores in Canada to the current store design. Of the 65 remodeled stores, 32 stores were expanded in place, 32 stores were relocated to a larger space within the mall and one store was refurbished as further discussed below. As of February 3, 2007, approximately 88% of all American Eagle stores in the U.S. are in our current store format.
We maintain a 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. This program provides a cost effective update for our lower volume stores.
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 2007, we expect to build upon this success by continuing to focus on knit tops, including men’s and women’s polos and graphic Ts and women’s tank tops. 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 sub-brand, aerie by American Eagle, which targets our core AE customers. The aerie collection of dormwear and intimates includes bras, undies, camis, hoodies, robes, boxers and sweats 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 all American Eagle stores, including 18 side-by-side stores, three stand-alone stores and on ae.com. Based on the positive customer response to aerie , we are expanding our real estate strategy and plan to open at least 15 stand-alone stores during Fiscal 2007.
ae.com
American Eagle sells merchandise via its e-commerce operation, ae.com, which is an extension of the lifestyle that we convey in our stores. During Fiscal 2006, ae.com expanded its international shipping 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 ae.com through various initiatives, including improved site efficiency and faster check-out, expansion of sizes and styles, unique online content and targeted marketing strategies.
MARTIN + OSA
During Fiscal 2006, we opened five MARTIN + OSA stores. MARTIN + OSA, a new sportswear concept targeting 25 to 40 year-old women and men, carries apparel, accessories and footwear, designed using denim and sport inspiration. We expect to open approximately 12 MARTIN + OSA stores in premier shopping centers throughout the United States during Fiscal 2007.

MANAGEMENT DISCUSSION FROM LATEST 10K

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:


• the planned opening of 45 to 50 American Eagle stores in the United States and Canada, at least 15 aerie stand-alone stores and approximately 12 MARTIN + OSA stores in the United States during Fiscal 2007;
• the selection of approximately 45 American Eagle stores in the United States for remodeling during Fiscal 2007;
• the completion of improvements and expansion at our distribution centers;
• the completion of the construction of our new corporate headquarters and data center;
• the success of our new brand concept, MARTIN + OSA;
• the success of our new intimates sub-brand, aerie by American Eagle;
• the expected payment of a dividend in future periods; and
• the possibility of growth through acquisitions and/or internally developing additional new brands.


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 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.

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. 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. 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.

Both the calculation of the deferred tax assets and liabilities, as well as the decision 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 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. 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.

Management considers comparable store sales to be an important indicator of our current performance. Comparable store sales results are important in achieving leveraging of our costs, including store payroll, store supplies, rent, etc. Positive comparable store sales contribute to greater leveraging of costs while negative comparable store sales contribute to deleveraging of costs. 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 appropriately 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 and certain senior merchandising executives; 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 - Management views operating income as a key indicator of our success. The key drivers of operating income are comparable store sales, gross profit and our ability to control selling, general and administrative expenses.

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 management in assessing our operational performance.

Inventory turnover - 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 - 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. Management believes that cash flow from operations will be sufficient to fund anticipated capital expenditures and working capital requirements.

Results of Operations

Overview

In Fiscal 2006, we delivered strong financial performance, marking the third consecutive year of record earnings. Our results were driven by our on-going customer focus, the depth of talent within our teams and a company-wide commitment to strong operating disciplines. During the year, we increased profitability and margins while investing in talent, new technology, infrastructure and new concepts to support future growth.
Net sales for Fiscal 2006 increased 20% to $2.794 billion, and consolidated comparable store sales increased 12% compared to the corresponding 53 week period last year. Sales growth reflected consistently on-trend merchandise assortments that were well received by our customers. Sales metrics were favorable, led by increased in-store traffic, higher transaction counts and greater transaction value, which were driven by the strength and appeal of the AE brand.

Operating income as a percent to net sales rose to a rate of 21.0% for Fiscal 2006 from 19.8% for Fiscal 2005. The increase was driven by an improvement in gross profit and depreciation and amortization expense as a percent to net sales, partially offset by an increase in selling, general and administrative expenses as a percent to net sales.

For Fiscal 2006, net income increased 32% to a record $387.4 million. As a percent to net sales, net income increased to 13.9% during Fiscal 2006, which is our highest historical rate to net sales. Net income per diluted share increased 35% to $1.70 from $1.26 per diluted share last year.

Cash flow was strong in Fiscal 2006 due to increased profitability. We ended Fiscal 2006 with $1.079 billion in cash, short-term and long-term investments, an increase of $181.5 million from last year. During the year, we continued to make significant investments in our business, including $225.9 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 purchase and construction of our new Pittsburgh, Pennsylvania home office, information technology upgrades at our home office and investments in our new MARTIN + OSA stores. Additionally, during Fiscal 2006, we repurchased shares of our common stock for approximately $146.5 million.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

omparison of the 13 weeks ended August 4, 2007 to the 13 weeks ended July 29, 2006

Net Sales

Net sales increased approximately 17% to $703.2 million from $602.3 million last year. The sales increase was primarily due to an increase in comparable store sales, a 9% increase in gross square feet due to new stores and remodels, as well as an increase in sales from our e-commerce operation.

During the second quarter, we experienced a low single-digit increase in our transaction value, driven by a mid single-digit increase in units per transaction and partially offset by a slight decrease in our average unit retail price. Comparable store sales increased in the high single-digits in our men’s business and decreased in the low single-digits in the women’s business over last year.

Gross Profit

Gross profit increased 15% to $316.4 million from $275.3 million last year. However, as a percent to net sales, gross profit declined by 70 basis points to a rate of 45.0%. Our merchandise margin declined by 50 basis points primarily due to an increase in markdowns partially offset by a strong initial mark-up. Buying, occupancy and warehousing costs increased by 20 basis points, as a percent to net sales, primarily due to rent expense relating to upcoming aerie store openings, as well as incremental costs associated with transitioning our e-commerce fulfillment in-house to our Ottawa, Kansas distribution center. Share-based compensation expense included in gross profit was $1.4 million both this year and 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 and others 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 17% to $166.4 million from $142.8 million, but remained flat as a percent to net sales at a rate of 23.7%. Improvements in store payroll and lower incentive compensation were offset by an increase in store supplies and professional services, as a percent to net sales. Share-based compensation expense included in selling, general and administrative expenses decreased to $5.8 million, compared to $6.3 million last year.


Depreciation and Amortization Expense

Depreciation and amortization expense, as a percent to net sales, increased to 3.9% for the second quarter, compared to 3.8% for the corresponding period last year. Depreciation and amortization expense increased to $27.4 million, compared to $23.2 million last year. The increase in expense is primarily due to an increase in our property and equipment base driven by our increased level of capital expenditures.

Other Income, Net

Other income, net decreased to $8.8 million from $9.0 million primarily due to a gift card program change that occurred in July 2007. Prior to July 8, 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. For the 13 weeks ended August 4, 2007 and July 29, 2006, we recorded gift card service fee income of $0.2 million and $0.5 million, respectively, in other income, net.

Provision for Income Taxes

The effective tax rate declined to approximately 38% from 39% last year. The decrease was primarily due to an increase in tax exempt interest income during the 13 weeks ended August 4, 2007.

Net Income

Net income increased 13% to $81.3 million, or 11.6% as a percent to net sales, from $72.1 million, or 12.0% as a percent to net sales last year. Net income per diluted common share increased to $0.37 from $0.31 in the prior year. The increase in net income was attributable to the factors noted above.

Comparison of the 26 weeks ended August 4, 2007 to the 26 weeks ended July 29, 2006

Net Sales

Net sales increased approximately 17% to $1.316 billion from $1.125 billion last year. The sales increase was primarily due to a 9% increase in gross square feet from new stores and remodels, a comparable store sales increase, as well as an increase in sales from our e-commerce operation.

We experienced a low single-digit increase in our transaction value, driven by a low single-digit increase in units per transaction. Our average unit retail price was flat, compared to the corresponding period last year. Comparable store sales increased in the high single-digits in our men’s business and in the low-single digits in the women’s business over last year.

Gross Profit

Gross profit increased 16% to $614.9 million from $529.6 million last year. However, as a percent to net sales, gross profit declined by 40 basis points to a rate of 46.7%. Our merchandise margin decreased by 20 basis points primarily due to an increase in markdowns and the impact of presenting the cost of merchandise sell-offs and the related proceeds on a gross basis in the current period (see Note 2 of the Consolidated Financial Statements), partially offset by an improved markon. Amounts for prior periods were not adjusted to reflect the change in the presentation of merchandise sell-offs as the amounts were determined to be immaterial. Buying, occupancy and warehousing costs increased by 20 basis points, as a percent to net sales, primarily due to incremental costs associated with transitioning our e-commerce fulfillment in-house to our Ottawa, Kansas distribution center. Share-based compensation expense included in gross profit increased to approximately $3.3 million, compared to $3.2 million last year.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 17% to $323.4 million from $277.4 million, but improved by 10 basis points, as a percent to net sales, to a rate of 24.5%. The improvement in the rate was primarily due to lower incentive compensation, as a percent to net sales, partially offset by an increase in professional services. Share-based compensation expense included in selling, general and administrative expenses increased to approximately $16.4 million, compared to $12.9 million last year.


Depreciation and Amortization Expense

Depreciation and amortization expense, as a percent to net sales, remained flat at a rate of 4.0%, compared to last year. However, depreciation and amortization expense increased to $52.9 million, compared to $44.7 million last year. The increase in expense is primarily due to an increase in our property and equipment base driven by our increased level of capital expenditures.

Other Income, Net

Other income, net increased to $20.1 million from $17.1 million primarily due to increased investment income resulting from improved investment returns. Additionally, we realized a $0.9 million foreign currency translation loss last year, related to the final settlement of National Logistics Services. These increases were partially offset by a $3.5 million realized capital gain last year, related to investments that were classified as trading securities prior to being sold during the 26 weeks ended July 29, 2006.

Provision for Income Taxes

The effective tax rate decreased to approximately 38% from approximately 39% last year. The decrease in the effective tax rate is primarily due to an increase in tax exempt interest income this year and the additional tax liability recorded during the 26 weeks ended July 29, 2006 related to the anticipated repatriation of unremitted Canadian earnings, which had the effect of increasing the effective tax rate last year.

Net Income

Net income increased 18% to $160.1 million, or 12.2% as a percent to net sales, from $136.3 million, or 12.1% as a percent to net sales last year. Net income per diluted common share increased to $0.71 from $0.60 in the prior year. The increase in net income was attributable to the factors noted above.

Income Taxes

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.

We placed the second phase of our Ottawa, Kansas distribution center into service in May 2007. As a result, we are eligible for approximately $2.5 million of nonrefundable incentive tax credits in Kansas. These credits can be utilized to offset future Kansas income taxes and will expire in 10 years. These available credits are not currently utilizable due to existing credit carryovers and the level of income taxes paid to Kansas. Additionally, use of these credits is dependent upon our meeting certain requirements in future periods. Due to the contingencies related to the future use of the credits, we believe that it is more likely than not that the benefit of this asset will not be realized within the carryforward period. Thus, a full valuation allowance of $2.5 million has been recorded as of August 4, 2007.

For the 26 weeks ended July 29, 2006, the remaining $0.5 million of a $1.4 million valuation allowance that had been previously recorded against a capital loss deferred tax asset was released. We were able to realize sufficient capital gains to fully utilize the capital loss carry forward prior to its expiration in July 2006.

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 our 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 construction of our new corporate headquarters and the development of MARTIN + OSA and aerie by American Eagle. In the future, we expect that our uses of cash will also include new brand concept development.

Our growth strategies include continued expansion of the American Eagle Brand, 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.

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