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Article by DailyStocks_admin    (12-22-08 07:34 AM)

The Daily Magic Formula Stock for 12/20/2008 is American Eagle Outfitters Inc. According to the Magic Formula Investing Web Site, the ebit yield is 26% and the EBIT ROIC is 25-50%.

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

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.

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:

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.


CEO BACKGROUND

Michael G. Jesselson, age 56, has served as a Director of the Company since November 1997. Mr. Jesselson is President of Jesselson Capital Corporation, a private investment corporation headquartered in New York City. He also serves on the Board of Directors of a number of nonprofit institutions.

Roger S. Markfield, age 66, is a non-executive officer employee of the Company and has served as a Director since March 1999. Prior to February 4, 2007, he served the Company as Vice-Chairman since November 2003, as President from February 1995 to February 2006, and as Co-Chief Executive Officer of the Company from December 2002 to November 2003. Mr. Markfield also served the Company and its predecessors as Chief Merchandising Officer from February 1995 to December 2002 and as Executive Vice President of Merchandising from May 1993 to February 1995. Prior to joining the Company, he served as Executive Vice President-General Merchandising Manager for the Limited Division of The Limited, Incorporated, a large national specialty retailer from May 1992 to April 1993. From 1969 to 1976 and from 1979 to 1992, he was employed by R.H. Macy & Co., a national retailer operating department and specialty stores, as a Buyer in Boys’ Wear rising to the office of President of Corporate Buying-Men’s. From 1976 to 1979, Mr. Markfield served as Senior Vice President of Merchandising and Marketing for the Gap Stores, Inc. He also serves on the Board of Directors of DSW, Inc.

Jay L. Schottenstein, age 53, has served as Chairman of the Company and its predecessors since March 1992. He served the Company as Chief Executive Officer from March 1992 until December 2002 and prior to that time, he served as a Vice President and Director of the Company’s predecessors since 1980. He has also served as Chairman of the Board and Chief Executive Officer of Schottenstein Stores Corporation, a private company owned by the Schottenstein-Deshe-Diamo nd families (“SSC”) since March 1992 and as President since 1991. Prior thereto, Mr. Schottenstein served as Vice Chairman of SSC from 1986 to 1992. He has been a Director of SSC since 1982. He has also served as Chairman since March 1992 and as Chief Executive Officer from July 1999 through December 2000 and from April 1991 through July 1997 of Retail Ventures, Inc. (“RVI”) a company that operates a chain of off-price department stores which is 50.1% beneficially owned by SSC, with the remaining shares publicly-held and traded on the New York Stock Exchange. Mr. Schottenstein has also served since March 2005 as Chairman of the Board and Chief Executive Officer of DSW, Inc. He has also served as an officer and director of various other corporations owned or controlled by members of his family since 1976. Jay L. Schottenstein is the brother-in-law of Jon P. Diamond.

Information Regarding Class II Directors with Terms Expiring in 2009

Janice E. Page, age 59, has served as a Director of the Company since June 2004. Prior to her retirement in 1997, Ms. Page spent 27 years in retailing holding numerous merchandising, marketing and operating positions with Sears Roebuck & Company, including Group Vice President from 1992 to 1997. Ms. Page is currently a private investor. She also serves on the Board of Directors of R.G. Barry Corporation.

J. Thomas Presby, age 68, has been a Director of the Company since December 2005. Mr. Presby has used his business experience and professional qualifications to forge a second career of essentially full-time board service since he retired in 2002 as a partner in Deloitte Touche Tohmatsu. At Deloitte he held numerous positions in the United States and abroad, including the posts of Deputy Chairman and Chief Operating Officer. He also serves as a Director and Audit Committee Chair of First Solar, Inc., Invesco Ltd., Tiffany & Co., TurboChef Technologies and World Fuel Services, Inc. As Mr. Presby has no significant business activities other than board service, he is available full time to fulfill his board responsibilities. He is a certified public accountant and a holder of the NACD Certificate of Director Education. He holds a BSEE from Rutgers University and a MBA from Carnegie Mellon University.

Gerald E. Wedren, age 71, has been a Director of the Company since November 1997. Mr. Wedren has served as President of Craig Capital Co., a Washington D.C. based merger and acquisition firm since 1973. Mr. Wedren was President of G.E.W. Inc., an owner of fast food restaurants, from 1981 to 1988. Mr. Wedren also serves on the Board of Directors of Advanced Technology Communications, Inc. and Westaff, Inc.

Information Regarding Nominees for Class III Directors with Terms Expiring in 2010

Jon P. Diamond, age 50, has been a Director of the Company since November 1997. Since 1996, Mr. Diamond has served as President and Chief Operating Officer of Safe Auto Insurance Company, a property and casualty insurance company and as Executive Vice President and Chief Operating Officer from 1993 to 1996. Mr. Diamond served as Vice President of SSC, from March 1987 to March 1993 and served in various management positions with SSC since 1983. He also serves on the Board of Directors of RVI.

Alan T. Kane, age 66, has been a Director of the Company since January 2007. Mr. Kane has served as Dean of the School of Business and Technology at the Fashion Institute of Technology (FIT) since 2005. Mr. Kane also served as Professor of Retailing at the Columbia University Graduate School of Business from 1997 to 2006. Before joining the faculty at Columbia, Mr. Kane spent 28 years in the retailing industry with Federated Department Stores, The May Company, Grossman’s Inc. and a privately held retailer. He also serves on the Board of Directors of Circuit City Stores Inc.

Cary D. McMillan, age 50, has served as Chief Executive Officer of True Partners Consulting, LLC, a professional services firm providing tax and other financial services, since December 2005. From October 2001 to April 2004, he was the Chief Executive Officer of Sara Lee Branded Apparel. Mr. McMillan served as Executive Vice President and on the Board of Directors of Sara Lee Corporation, a branded consumer packaged goods company, from January 2000 to April 2004. From November 1999 to December 2001, he served as Chief Financial and Administrative Officer of Sara Lee Corporation. He also serves on the Board of Directors of McDonald’s Corporation and Hewitt Associates, Inc.

James V. O’Donnell, age 67, has served as Chief Executive Officer of the Company since November 2003 and prior thereto as Co-Chief Executive Officer of the Company since December 2002 and as Chief Operating Officer for the Company since December 2000. Mr. O’Donnell became a member of the Board in December 2000. Prior to joining the Company, since December 1999, he served as President and Chief Operating Officer of Lyte, Inc., a retail technology services company. From 1997 to 2000, Mr. O’Donnell served as Director of Merchant Banking for Colmen Capital Advisors, Inc., and as a Project Consultant for the C. Everett Koop Foundation. From 1992 to 1997, Mr. O’Donnell was an owner and Chief Executive Officer of Computer Aided Systems, Inc. From 1980 to 1992, Mr. O’Donnell held various executive positions at The Gap Inc., and from 1987 to 1992, he was a member of the Board of Directors and was Executive Vice President. From 1989 to 1992, he served as Chief Operating Officer of The Gap Inc. Mr. O’Donnell is also a member of the Advisory Board to the Villanova School of Nursing.

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 approximately 40 American Eagle stores in the United States and Canada, approximately 80 aerie stand-alone stores and approximately 15 MARTIN + OSA stores in the United States during Fiscal 2008;

• the selection of approximately 40 to 50 American Eagle stores in the United States for remodeling during Fiscal 2008;

• the online launch of our new children’s apparel brand, 77kids by american eagle during Fiscal 2008 with the opening of U.S. stores expected during 2010;

• the completion of improvements and expansion at our distribution centers;

• the success of MARTIN + OSA and martinandosa.com;

• the success of aerie by american eagle and aerie.com;

• the expected payment of a dividend in future periods;

• the possibility of growth through acquisitions and/or internally developing additional new brands; and

• the possibility that future auctions of our ARS holdings will not be successful and that we may be required to take impairment charges relating to our ARS investments.

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.


MANAGEMENT DISCUSSION FOR LATEST QUARTER

The following discussion and analysis of financial condition and results of operations should be read in conjunction with our Fiscal 2007 Management’s Discussion and Analysis of Financial Condition and Results of Operations which can be found in our Fiscal 2007 Annual Report on Form 10-K.
In addition, 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 these 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 approximately 12 new American Eagle stores and 17 new aerie stores in the United States and Canada during Fiscal 2009;

• the selection of approximately 25 to 35 American Eagle stores in the United States and Canada for remodeling during Fiscal 2009;

• the future opening of 77kids by american eagle stores;

• the completion of improvements and expansion at our distribution centers;

• the success of MARTIN + OSA and martinandosa.com;

• the success of aerie by american eagle and aerie.com;

• the expected payment of a dividend in future periods;

• the possibility of growth through acquisitions and/or internally developing additional new brands;

• the possibility that we may be required to take additional temporary or other-than-temporary impairment charges relating to our ARS investments; and

• the possibility that the amounts drawn on our demand borrowing agreements will be called for repayment and that the facilities may not be available for future borrowings.
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 Item 1A of this Quarterly Report on Form 10-Q and Item 1A of our Fiscal 2007 Annual Report on Form 10-K. Accordingly, our future performance and financial results may differ materially from those expressed or implied in any such forward-looking statements.
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 and achieving an optimal level of sales. 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. The inability to obtain acceptable levels of sales, 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 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 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
During the 13 weeks ended November 1, 2008 (“the third quarter”), the retail environment proved to be challenging. A slowing economy and decreased consumer demand led to a decline in store traffic and sales transactions per store, leading us to implement a stronger promotional strategy than last year. Total sales increased 1% to $754.0 million for the third quarter, compared to $744.4 million in the prior year, while comparable store sales declined 7% to last year.
Our operating margin was 12.6% in the third quarter, compared to 20.3% for the 13 weeks ended November 3, 2007. The decrease was largely due to increased promotions during the third quarter as well as the 7% decline in comparable store sales.
Net income for the third quarter decreased 57% to $42.6 million, or 5.6% as a percent of net sales. Net income per diluted common share also decreased 53% to $0.21 versus $0.45 last year. The decline in net income per share is attributed to the decline in operating margin as well as the OTTI charge of $19.9 million relating to our ARS.
We ended the third quarter with $615.5 million in cash and cash equivalents, short-term and long-term investments. During the period, we continued to make significant investments in our business, including $69.2 million in capital expenditures. These expenditures related primarily to new and remodeled stores in the U.S. and Canada, as well as headquarters, point-of-sale and distribution center projects.

Comparison of the 13 weeks ended November 1, 2008 to the 13 weeks ended November 3, 2007
Net Sales
Net sales for the 13 weeks ended November 1, 2008 increased 1% to $754.0 million compared to $744.4 million for the 13 weeks ended November 3, 2007. The decline in net sales was a result of a decline in traffic and lower transactions per store, which led to third quarter comparable store sales decreasing 7%, compared to a 2% increase last year. American Eagle Brand men’s comparable store sales increased 7% to last year while women’s decreased 16% to last year.
Gross Profit
Gross profit for the third quarter was $309.4 million, or 41.0% as a rate to sales, compared to $352.9 million, or 47.4% as a rate to sales last year. Merchandise margin declined by 470 basis points, primarily due to higher markdowns, and an increase in the cost of merchandise. Buying, occupancy and warehousing costs increased by 170 basis points, due to de-leveraging of rent related to new store openings and the third quarter comparable store sales decline. There was $1.3 million of share-based payment expense included in gross profit for the period compared to $1.4 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 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 approximately 4% to $181.7 million from $174.2 million, and increased by 70 basis points, as a percent to net sales, to 24.1% from 23.4% last year. The higher rate is primarily due to the negative comparable store sales. There was $2.7 million of share-based payment expense included in selling, general and administrative expenses compared to $5.7 million last year.
Depreciation and Amortization Expense
Depreciation and amortization expense as a percent to net sales increased to 4.3% for the third quarter compared to 3.7% for the corresponding period last year. Depreciation and amortization expense increased to $32.8 million compared to $27.9 million last year. These increases are primarily due to a greater property and equipment base driven by our level of capital expenditures related to new stores, point-of sale system, distribution centers, and our corporate headquarters.
Other Income, Net
Other income, net decreased to $4.5 million from $6.9 million compared to last year primarily due to lower interest income as a result of lower investment balances, lower interest rates and increased interest expense related to our demand line borrowings.

Other-than-Temporary Impairment
Other-than-temporary impairment relating to our auction-rate securities was $19.9 million for the 13 weeks ended November 1, 2008. There was no other-than-temporary impairment recorded during the 13 weeks ended November 3, 2007.
Refer to the auction-rate securities caption under our Liquidity and Capital Resources discussion included in the Management’s Discussion and Analysis of Financial Condition and Results of Operations for additional information.
Provision for Income Taxes
The effective income tax rate for the 13 weeks ended November 1, 2008 was 46.4% compared to 37.0% for the 13 weeks ended November 3, 2007. The higher effective income tax rate during Fiscal 2008 is primarily the result of the impairment charge recorded in connection with the valuation of certain auction-rate securities and preferred stock in which no income tax benefit was recognized.
Net Income
Net income decreased approximately 57% to $42.6 million, or 5.6% as a percent to net sales, from $99.4 million, or 13.4% as a percent to net sales last year. Net income per diluted common share decreased to $0.21 from $0.45 in the prior year. The decrease in net income was attributable to the factors noted above.

Comparison of the 39 weeks ended November 1, 2008 to the 39 weeks ended November 3, 2007
Net Sales
Net sales for the 39 weeks ended November 1, 2008 increased 1% to $2.083 billion compared to $2.060 billion for the 39 weeks ended November 3, 2007. Increased net sales were a result of a 12% increase in square footage as well as an increase in sales from our e-commerce operation partially offset by a 7% comparable store sales decline.
Gross Profit
Gross profit decreased approximately 11% to $862.5 million from $967.8 million last year. As a percent to net sales, gross margin declined 560 basis points to a rate of 41.4% compared to 47.0% last year. The primary cause of the reduced margin was increased markdowns as a result of lower than expected sales. In addition, rent increased as a percent to net sales due to new store openings. There was $4.1 million of share-based payment expense included in gross profit for the period compared to $4.7 million last year.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased approximately 4% to $519.3 million from $497.5 million, and increased by 80 basis points, as a percent to net sales, to 25.0% from 24.2% last year. The higher rate this quarter is primarily due to the comparable store sales decline. Other factors include increases in total compensation and benefits as a percent to net sales. There was $12.8 million of share-based payment expense included in selling, general and administrative expenses compared to $22.1 million last year.
Depreciation and Amortization Expense
Depreciation and amortization expense as a percent to net sales increased to 4.5% for the 39 weeks ended November 1, 2008 compared to 3.9% for the corresponding period last year. Depreciation and amortization expense increased to $94.4 million compared to $80.7 million last year. These increases are primarily due to a greater property and equipment base driven by our level of capital expenditures related to new stores, point-of-sale system, distribution centers and our corporate headquarters.
Other Income, Net
Other income, net decreased to $14.9 million from $27.0 million compared to last year primarily due to lower interest income as a result of lower investment balances, lower interest rates and increased interest expense related to our demand line borrowings.
Other-than-Temporary Impairment
Other-than-temporary impairment relating to our auction-rate securities was $19.9 million for the 39 weeks ended November 1, 2008. There was no other-than-temporary impairment recorded during the 39 weeks ended November 3, 2007.
Refer to the auction-rate securities caption under our Liquidity and Capital Resources discussion included in the Management’s Discussion and Analysis of Financial Condition and Results of Operations for additional information.
Provision for Income Taxes
The effective income tax rate for the 39 weeks ended November 1, 2008 was 40.0% compared to 37.7% for the 39 weeks ended November 3, 2007. The higher effective income tax rate during Fiscal 2008 is primarily the result of the impairment charge recorded in connection with the valuation of certain auction-rate securities and preferred stock in which no income tax benefit was recognized offset by state income tax settlements and other changes in income tax reserves.
Net Income
Net income decreased approximately 44% to $146.3 million, or 7.0% as a percent to net sales, from $259.5 million, or 12.6% as a percent to net sales last year. Net income per diluted common share decreased to $0.70 from $1.17 in the prior year. The decrease in net income was attributable to the factors noted above.

Impact of Current Market Conditions
Our sales performance for the 13 weeks ended November 1, 2008 reflects the slowing overall economy and the challenging retail environment. The third quarter results are also reflective of a highly promotional sales environment across the retail sector. The ongoing weakness in the economy and credit market uncertainty continue to negatively impact consumer confidence and spending.
As a result, during the 13 weeks ended November 1, 2008, store traffic declined 5% leading to comparable store sales decline 7% compared to the prior year. These declines have resulted in the Company being more promotional. We anticipate market conditions to remain challenging through the end of Fiscal 2008 and into early 2009.
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.
There were no material adjustments to our recorded liability for unrecognized tax benefits during the 13 weeks ended November 1, 2008. Over the next twelve months the Company believes that it is reasonably possible that the liability for unrecognized tax benefits may decrease by approximately $15 million due to settlements, expiration of the statute of limitations or other changes in unrecognized tax benefits.
Due to the completion of the second phase of our Ottawa, Kansas distribution center in 2007, we remain eligible for approximately $3.7 million (net of federal taxes) of nonrefundable incentive tax credits in Kansas. These credits can be utilized to offset future Kansas income taxes and will expire in 2017 and 2018. Due to the uncertainties related to the future use of the credits, a valuation allowance of $2.9 million (net of federal taxes) remains as of November 1, 2008.
The Company has recorded a valuation allowance against the deferred tax assets arising from the other than temporary impairment of certain auction-rate securities and preferred stock, the temporary impairment of certain auction-rate securities included in other comprehensive income, and the Kansas income tax credit carryforward (discussed above). As of November 1, 2008 the valuation allowance totaled $21.9 million (of which $11.4 million is recorded in other comprehensive income). No other valuation allowances have been recorded against deferred tax assets because management believes it is more likely than not that the full amount of the deferred tax assets will be realized in the future.
Fair Value Measurements
Our auction-rate securities were measured at fair value using both Level 2 and Level 3 inputs as of November 1, 2008. See Notes 3 and 4 to our Consolidated Financial Statements for additional information on our auction-rate securities, including a description of the securities and a discussion of the uncertainties relating to their liquidity.

CONF CALL

Judy Meehan

Good morning, everyone. Joining me today are Jim O'Donnell, Chief Executive Officer, and Joan Hilson, Executive Vice President, Chief Financial Officer.

If you need a copy of our third quarter press release, it is available on our website, AE.com.

Before we begin, I need to remind everyone that during this conference call members of management may make certain forward-looking statements based upon information which represents the company's current expectations or beliefs. The results actually realized may be materially different from those expectations or beliefs based on risk factors included in our quarterly and annual reports filed with the SEC.

And now I'll turn the call over to Jim.

James V. O'Donnell

Thanks, Judy. Good morning, everyone.

As you are well aware, we continue to face a number of challenges which impacted third quarter results. We experienced lower store traffic, weak consumer demand, primarily in women's. As a result, earnings per share excluding the impairment charge decreased 33%, driven by a 7% comp store sales decline.

Certainly, the times are uncertain; however, I'm confident in the strength of our organization and believe that we are well positioned to weather the storm. Now here's why:

This is a seasoned management team, one that has experienced difficult times before. We've not only survived, but we emerged a stronger company.

Our company is highly profitable and we have consistently generated strong cash flow. Although the third quarter earnings declined, we achieved a 12.6% operating margin, and so far this year we've generated $320 million in EBITDA. Our balance sheet is strong. Currently, we have $616 million in cash and cash equivalents, with $333 million of cash and liquid Treasury funds.

Looking forward, we expect the near-term environment to remain challenging and we're planning accordingly. To that end, we are reducing costs and tightly managing inventory [inaudible].

Also, we significantly lowered our 2009 capital spending plans, driven by our decision to open fewer new stores next year. We now expect to add a total of 29 stores versus our original plan of 90. Capital expenditures are expected to be in the range of $110 to $135 million. That compares to $250 to $270 million this year. Longer term, we see continued new store opportunities for all of our brands; however, given the current state of the economy, I believe conserving capital and lowering our cost structure takes precedence.

American Eagle is an established and leading brand of 15 to 25-year-olds, with a long heritage of quality merchandise offered at great value. Right now consumers are seeking lower prices and trusted value more than ever before. Within the AE brand, we are responding with affordable pricing and promotional events while maintaining our strong tradition of great quality. We are highly committed to protecting our market share and doing so profitability.

We can achieve this through appropriate inventory investments, building value into our initial pricing plans, and lowering indices and markdowns. For example, in the spring season we have planned and purchased a higher portion of our assortment to be value priced and on promotion compared to last year.

Like many others, we've experienced soft demand in women's. Strengthening this important business is our number one priority and opportunity. Over the past several months, we've improved our process to be more effective. We are making critical decisions more quickly and importantly, we've appointed a new head of AE women's design. And going into 2009, I believe we're in a stronger position, with increased customer connectivity and a more streamlined organization.

Although the women's business remains weak, we see improvements in certain areas. We are making progress with an increased selection of unique fashion items at great prices. For example, accessories, jewelry and new fashion tops are showing modest improvement. Our teams are enthusiastic about the spring lines, where we have a higher mix of value priced and new fashion items along with our AE core essentials. Needless to say, however, we are maintaining a conservative inventory position until business turns around.

Aerie. Aerie continues to emerge as a promising new business. We now have a solid base of 114 stores, with excellent upside potential. The merchandise margins in this business are very good; essentially, they're equal to the AE brand. We've reduced our operating expense base and our store build out costs. We have seen excellent brand acceptance and loyalty. An example - our A list loyalty program is gaining momentum, with growing members and high redemption rates. Over the next few years, the opportunity is to increase store productivity and we recently hired additional merchandising talent into our aerie team to drive ongoing category development and growth.

MARTIN + OSA. MARTIN + OSA is showing solid progress. We are pleased by the customers' response to the latest assortments, especially in light of the current retail climate. Consistent with our lower 2009 capital spending plan, we are not opening any new stores next year in MARTIN + OSA. We will continue to strengthen our operating model with the 28 existing stores and look for ongoing progress in merchandising and building consumer awareness.

Last month we launched 77kids online to an extremely positive customer response, which well exceeded our plans. We will continue to learn about this new business and we hope to open retail stores some time over the next few years.

But before I conclude, one final comment about the strength of our operational organization. Very simply, I feel it's the best in class. Over the past several years we've made significant investments in our data center, systems and distribution facilities. We are realizing the benefits of those investments in cost leverage and the effectiveness of our overall supply chain. In fact, despite the increase in fuel costs, our transportation and processing cost per unit declined from the third quarter of last year. We've been industry leaders in the use of technology and we will continue to implement new systems that deliver a meaningful return on investment with real productivity improvements.

In early November, our team completed the U.S. rollout of our new point of sale system. I'm very pleased that the implementation was on schedule and seamless, positioning us well for the holiday season. I believe that we have the most comprehensive system in our space, providing real-time multichannel visibility to customers, transactions and inventory. We've just begun to utilize the system's capabilities and have further projects planned to enhance the shopping experience, regardless of where and how the customers choose to shop our brands.

Now I'll turn the call over to Joan.

Joan Hilson

Thanks, Jim, and good morning, everyone.

Our third quarter earnings were the result of a decline in top line sales and increased promotional activity compared to last year. Third quarter comparable store sales declined 7% compared to a 2% increase for the same period last year. Total sales increased 1%.

A challenging retail climate contributed to lower traffic and transactions per store. The average dollar sale was essentially flat. More promotional activity resulted in a lower average unit retail price and drove an increase in units per transaction.

Turning to gross margin, our rate of 41% was 640 basis points below last year. Here's how this breaks down: 470 basis points for merchandise margin and 170 basis points from buying, occupancy and warehousing costs. Within the merchandise margin, markdowns were higher and experienced an increase in the cost of merchandise. Looking forward, we expect IMU pressure to continue in the fourth quarter due to higher product costs.

Rent was the primary factor within buying, occupancy and warehousing cost. New store openings and negative comparable store sales were the cause of the higher rate.

SG&A expense increased 4% to $181.7 million or 24.1% of the rate to sales. That compared to 23.4% in the third quarter last year. The higher rate was due primarily to the negative comp in the third quarter. Nearly all operating expenses were flat to last year as the rate to sales with the exception of professional services. Store payroll was well managed, with a slight deleverage on a negative 7% comp. As a result of our expense reductions, SG&A per foot declined by 9% over last year. This is our best rate since 2005.

Cost savings initiatives remain a primary focus. We expect SG&A dollar growth in the fourth quarter to be approximately 2%.

Other income was affected by an impairment charge of $19.9 million related to the valuation of auction rate securities.

The effective tax rate for the quarter was 46.4% compared to 37% last year. The higher tax rate was due to the affect of the ARS impairment charge.

Now turning to the balance sheet, average third quarter weekly inventory per square foot was consistent with our expectations of down low double-digit. Clearance inventory at quarter end was also down in the low double-digits. Looking forward, our fourth quarter average weekly inventory is planned down in the low double-digits at cost per foot, with a more conservative plan in women's.

Capital expenditures in the quarter totaled $69.2 million. This was related to store growth and renovation, headquarters and distribution centers. Our 2008 CapEx guidance continues to be in the range of $250 to $275 million.

As Jim mentioned, we significantly lowered our 2009 capital spending plans to a range of $110 to $135 million. Our plans include 12 new and 25 to 35 remodeled AE stores and 17 new aerie stores. Our plans also include the completion of our headquarters, information technology, and distribution center projects.

Now, regarding our fourth quarter outlook, November sales continue to be challenging. Through the first two weeks of the month, comparable store sales were down 17%. With onethird of the month still ahead and the importance of the Thanksgiving weekend to gauge holiday selling, we will provide fourth quarter earnings guidance next week, along with our November sales announcement.

Now I'll turn the call back over to Jim.

James V. O'Donnell

In closing, let me simply say this: We're a strong organization, with a trusted and enduring brand. We'll manage through these uncertain times and I'm confident that we'll emerge a stronger organization, ready to continue our growth plans.

Now we'll take questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from [Rick Patel] - Merrill Lynch.

Rick Patel - Merrill Lynch

Just a question on your inventory. Can you just give us some color on just how much of the inventory came from which brand and just some granularity on men's versus women's product?

Joan Hilson

Well, with respect to the inventory, as I said, it came in as expected, on the average down low double-digit. At the end of the month, the way the inventory positioned in terms of percentage decline, it was essentially consistent across men and women's categories.

When you look at our overall inventories, what contributes to the difference between the average and the end of the month, of course, is in transit as well as our AE Direct business, which is not included in the cost per foot calculation or the average weekly calculation.

Rick Patel - Merrill Lynch

And then in light of just the trends that you're seeing in November, have you been able to pull back on your inventory numbers for the spring?

Joan Hilson

We are managing inventory, so the answer's yes. And we are managing inventory consistently for spring '09 as we have for the third and fourth quarter of this year. But what I would ask you to keep in mind is the comment that Jim made in his prepared remarks and that is that our promotions and our inventory plans include a value offering that is planned for as opposed to what's occurring in the third and fourth quarter of this year, which is somewhat reactive to the traffic that we're seeing in the malls.

Operator

Your next question comes from Kimberly Greenberger - Citigroup.

Kimberly Greenberger - Citigroup

I was hoping that you might be able to expand on your comments on the SG&A cost cutting initiatives that you're undertaking as you're looking out to 2009. Is it possible you could give us maybe some major categories you're looking at for cost cuts and any sort of quantification just to help us understand what the magnitude of the opportunity is?

Joan Hilson

As we've said, we are looking at all areas of our organization for efficiency. But with that in mind, specifically, our first half of 2009 we will be able to continue to see benefit from the cost cutting initiatives of '08 because those largely began at the end of the second quarter.

We also are looking at our marketing expenses and look to position marketing at roughly 2% of sales as opposed to roughly 2.5% of sales for 2008. So that's an area that we can focus on.

We also can continue to drive the payroll at the store level. Because of efficiencies in terms of store operations, we're able to bring down some of our payroll costs at the store level as well as our payroll matrix, we can continue to evaluate based on the traffic in sales that we're seeing in the store. So it's a strong flex model for us.

Some of the other areas that we can go after and are doing so are in our non-merchandise procurement, so we can continue to drive efficiencies in packaging as we leverage the needs across all of our concepts and really drive a shared service approach there.

And, again, just the operation of the stores, we're able to get efficiencies in the facilities management of our stores.

And one of the significant initiatives that has been driven as well is capital expenditures, and we're pulling overall capital costs down, but also just the cost to build a store, we're able to drive some efficiencies there as well.

Kimberly Greenberger - Citigroup

On the product cost increases, is this, you know, fuel surcharges that are sort still lagging through your merchandise margin or are you continuing to see product cost inflation around the world?

Joan Hilson

The product cost, the higher costs really are in a couple of specific categories, Kimberly. And as we move into spring '09, as we developed the inventory plans and have costed out the product, we're seeing less pressure, in fact, and it's really about the categories that we have positioned in the fourth quarter. It's a bit about mix.

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