What American Eagle Outfitters Does With Its Cash

In the quest to find great investments, most investors focus on earnings to gauge a company's financial strength. This is a good start, but earnings can be misleading and incomplete. To get a clearer understanding of a company's ability to earn money and reward you, the shareholder, it's often better to focus on cash flow. In this series, we tear apart a company's cash flow statement to see how much money is truly being earned and, more importantly, what management is doing with that cash.

Step on up, American Eagle Outfitters (NYSE: AEO  ) .

The first step in analyzing cash flow is to look at net income. American Eagle Outfitters' net income over the last five years has been all over the place:

�	2011	2010	2009	2008	2007
Normalized Net Income	$161 million	$202 million	$194 million	$254 million	$403 million

Source: S&P Capital IQ.

Next, we add back in a few noncash expenses, like the depreciation of assets, and adjust net income for changes in inventory, accounts receivable, and accounts payable -- changes in cash levels that reflect a company either paying its bills, or being paid by customers. This yields a figure called "cash from operating activities" -- the amount of cash a company generates from doing everyday business.

From there, we subtract capital expenditures, or the amount a company spends acquiring or fixing physical assets. This yields one version of a figure called "free cash flow," or the true amount of cash a company has left over for its investors after doing business:

�	2011	2010	2009	2008	2007
Free Cash Flow	$139 million	$297 million	$259 million	$60 million	$214 million

Source: S&P Capital IQ.

Now we know how much cash American Eagle Outfitters is really pulling in each year. Next question: What is it doing with that cash?

There are two ways a company can use free cash flow to directly reward shareholders: dividends and share repurchases. Cash not returned to shareholders can be stashed in the bank, invested in other companies, or used to pay off debt.

Here's how much American Eagle Outfitters has returned to shareholders in recent years:

�	2011	2010	2009	2008	2007
Dividends	$86 million	$85 million	$83 million	$82 million	$81 million
Share Repurchases	$17 million	$234 million	--	$3 million	$451 million
Total Returned to Shareholders	$103 million	$319 million	$83 million	$86 million	$531 million

Source: S&P Capital IQ.

As you can see, the company has repurchased a decent amount of its own stock. That's caused shares outstanding to fall:

�	2011	2010	2009	2008	2007
Shares Outstanding (millions)	194	200	206	205	216

Source: S&P Capital IQ.

Now, companies tend to be fairly poor at repurchasing their own shares, buying feverishly when shares are expensive and backing away when they're cheap. Does American Eagle Outfitters fall into this trap? Let's take a look:

Source: S&P Capital IQ.

Sure enough, American Eagle bought back a lot of stock in 2007 when shares were fairly high, but none in 2009 when they plunged, only to come back with repurchases after shares rebounded. Whether this was a prudent way to save cash when it looked like the economy was about to implode, or a classic example of buying high and panicking low, is up for debate. In general, it doesn't appear management has been the most astute buyer of its own stock.

Finally, I like to look at how dividends have added to total shareholder returns:

Source: S&P Capital IQ.

Shares returned -38% over the last five years, which drops to -48% without dividends -- a small boost to top off otherwise poor performance.

To gauge how well a company is doing, keep an eye on the cash. How much a company earns is not as important as how much cash is actually coming in the door, and how much cash is coming in the door isn't as important as what management actually does with that cash. Remember, you, the shareholder, own the company. Are you happy with the way management has used American Eagle Outfitters' cash? Sound off in the comment section below.

• Add American Eagle Outfitters to�My Watchlist.