Comparison of the three months ended July 29, 2006 to the three months ended July 30, 2005

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

Net sales increased approximately 16% to $1.125 billion from $972.3 million. The sales increase was due to a 9% comparable store sales increase as well as a 6% increase in gross square footage. The gross square footage increase consisted primarily of the addition of 29 new stores, net of 9 closings. The comparable store sales increase was driven by strong customer acceptance of our assortments as well as positive store traffic. As a result, we experienced a high single-digit increase in the number of units sold per average store and a mid single-digit increase in the number of transactions per average store. Our average transaction value increased in the mid single-digits, due to a higher average unit retail price as well as a low single-digit increase in the number of units per transaction. A change in product mix as well as an improved markon contributed to a mid single-digit increase in our average unit retail price. Comparable store sales increased in the low double-digits in the men's business and in the high single-digits in the women's business.  

Gross profit as a percent to net sales improved by 70 basis points to 47.0% from 46.3%. The percentage increase was attributed to a reduction of buying, occupancy and warehousing costs as a percent to net sales. Our merchandise margin was flat for the period due primarily to an improved markon, offset by an increase in markdowns during the first quarter and an increase in the shrinkage reserve as a result of a physical inventory count during the second quarter. This increase in the shrinkage reserve reflects a return to a normal shrinkage rate, compared to last year when we experienced favorability in the rate. Buying, occupancy and warehousing costs declined as a percent to net sales due primarily to an improvement in rent expense as a percent to net sales.  Share-based payment expense included in gross profit increased to approximately $3.2 million compared to $2.8 million last year due to our adoption of SFAS No. 123(R) at the beginning of Fiscal 2006.

Selling, General and Administrative Expenses

Selling, general and administrative expenses as a percent to net sales increased to 24.9% from 24.8% due primarily to incremental planned expenses for MARTIN + OSA and an increase in store supplies as a percent to net sales. These increases were partially offset by improvements in store payroll, incentive compensation and payroll taxes as a percent to net sales. Share-based payment expense included in selling, general and administrative expenses increased to approximately $12.9 million compared to $8.5 million last year due primarily to our adoption of SFAS No. 123(R).

Depreciation and Amortization Expense

Depreciation and amortization expense as a percent to net sales decreased to 3.6% from 3.8% due primarily to the comparable store sales increase. Depreciation and amortization expense increased to $40.9 million compared to $36.7 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 $17.1 million from $8.4 million due primarily to increased investment income resulting from higher cash and investment balances this year compared to last year as well as improved investment returns. Included in other income, net for the six months ended July 29, 2006 is a $3.5 million realized capital gain related to investments that were classified as trading securities prior to being sold during the second quarter. These increases were partially offset by the realization of a $0.9 million foreign currency translation loss related to the final settlement of NLS, which had previously been recorded in accumulated other comprehensive income. 

Provision for Income Taxes

The effective tax rate increased to approximately 39% from approximately 37% last year. The increase in the effective tax rate is due primarily to state tax credits received during the last year, which had the effect of lowering the effective tax rate.

Net Income

Net income increased 20% to $136.3 million, or 12.1% as a percent to net sales, from $113.3 million, or 11.6% as a percent to net sales last year. Net income per diluted common share increased to $0.89 from $0.72 in the prior year. The increase in net income was attributable to the factors noted above.     

As of July 29, 2006, we had a deferred tax asset of $1.4 million relating to certain state tax credits that can be used to offset state income tax. The credits will expire over a period from July 2011 to July 2014. No valuation allowance has been provided against this deferred tax asset. Our management believes that it is more likely than not that the benefit of this asset will be realized prior to the expiration dates of the tax credits.

For the six months 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

Net cash provided by operating activities from continuing operations totaled $327.6 million for the six months ended July 29, 2006. Our major sources of cash from operations were proceeds from the sale of trading securities as well as merchandise sales. Our primary outflows of cash for operations were for the purchase of inventory and the payment of operational costs.

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Investing activities for the six months ended July 29, 2006 included $103.1 million for capital expenditures as well as $17.0 million for the net purchase of investments classified as available-for-sale, partially offset by $12.3 million of proceeds from the sale of NLS assets. Capital expenditures consisted primarily of $37.3 million related to investments in our stores, including 18 new stores in the United States and 32 remodeled stores in the United States and Canada. The remaining capital expenditures were primarily related to the purchase of our new corporate headquarters in Pittsburgh, Pennsylvania, construction of an addition to our Ottawa, Kansas distribution center and information technology upgrades at our home office, including the construction of a new data center.

We invest primarily in tax-exempt municipal bonds, taxable agency bonds, corporate notes and auction rate securities with an original maturity up to five years and an expected rate of return of approximately a 5.5% taxable equivalent yield.  We place an emphasis on investing in tax-exempt and tax-advantaged asset classes and all investments must have a highly liquid secondary market. 

Cash used for financing activities resulted primarily from $28.1 million used for the payment of dividends and $7.6 million used for the repurchase of common stock, partially offset by $10.3 million in proceeds from stock option exercises during the period and a $5.9 million excess tax benefit from the exercise of stock options.

Prior to the adoption of SFAS No. 123(R), we presented all tax benefits from the exercise of stock options as operating cash flows in the Consolidated Statements of Cash Flows. SFAS No. 123(R) requires that cash flows resulting from the benefits of tax deductions in excess of recognized compensation cost be classified as financing cash flows. Accordingly, for the six months ended July 29, 2006, the $5.9 million excess tax benefit from the exercise of stock options is classified as a financing cash flow. 

During the second quarter, we received temporary increases in the amounts available for letters of credit under our two letter of credit facilities. These increases will remain in place until December 31, 2006 and will be used to support commitments for merchandise inventory purchases. We currently have a $130.0 million unsecured letter of credit facility for letters of credit and a $40.0 million unsecured demand line of credit (the "line") which can be used for letters of credit and/or direct borrowing, totaling $170.0 million (the "facility"). The interest rate is at the lender's prime lending rate (8.25% at July 29, 2006) or at LIBOR plus a negotiated margin rate. No direct borrowings were required against the line for the current or prior periods. At July 29, 2006, letters of credit in the amount of $129.1 million were outstanding on this facility, leaving a remaining available balance of $40.9 million. We also have an uncommitted letter of credit facility for $100.0 million with a separate financial institution. At July 29, 2006, letters of credit in the amount of $83.9 million were outstanding on this facility, leaving a remaining available balance of $16.1 million.

During the second quarter of Fiscal 2006, our Board of Directors (our "Board") voted to raise our cash dividend to an annual rate of $0.45 per share from $0.30 per share. As a result, a quarterly cash dividend of $0.1125 was paid on July 7, 2006. Subsequent to the second quarter of Fiscal 2006, our Board declared a quarterly cash dividend of $0.1125 per share, payable on October 6, 2006 to stockholders of record at the close of business on September 22, 2006. The payment of future dividends is at the discretion of our Board and is based on earnings, cash flow, financial condition, capital requirements, changes in U.S. taxation and other relevant factors. It is anticipated that any future dividends paid will be declared on a quarterly basis.

During Fiscal 2005, we repurchased 7.0 million shares of our common stock under various repurchase authorizations made by our Board. At the beginning of Fiscal 2006, 3.5 million shares remained authorized for repurchase under the November 15, 2005 authorization. We did not repurchase any shares as part of our stock repurchase program during the six months ended  July 29, 2006 or July 30, 2005. The repurchase of the remaining shares will occur at our discretion. Subsequent to the second quarter of Fiscal 2006, we repurchased approximately 1.4 million shares of our common stock under the November 15, 2005 repurchase authorization.  These shares were repurchased for approximately $51.3 million, at an average share price of $37.31. As of August 30, 2006, we had approximately 2.1 million shares remaining authorized for repurchase.

During the six months ended July 29, 2006 and July 30, 2005, we repurchased 295,000 shares and 361,000 shares, respectively, from certain employees at market prices totaling $7.6 million and $10.5 million, respectively, for the payment of taxes in connection with the vesting of share-based payments as permitted under the 2005 Stock Award and Incentive Plan and the 1999 Stock Incentive Plan. The aforementioned share repurchases have been recorded as treasury stock.

Cash flows of discontinued operations, including operating, investing and financing activities, are presented separately from cash flows from continuing operations in the Consolidated Statements of Cash Flows. The absence of the cash flows from discontinued operations is not expected to materially affect our future liquidity or capital resources.

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We expect capital expenditures for Fiscal 2006 to be approximately $215 million, which will relate primarily to the construction of 46 new stores in the United States and Canada and the remodeling of 66 stores in the United States and Canada. Remaining capital expenditures will relate to the continuing construction at our Ottawa, Kansas distribution center, construction of our new corporate headquarters in Pittsburgh, Pennsylvania and the construction of our new data center.

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.

Critical Accounting Policies

Our critical accounting policies are described in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and in the notes to our Consolidated Financial Statements for the year ended January 28, 2006 contained in our Fiscal 2005 Annual Report on Form 10-K. The application of our critical accounting policies may require management to make judgments and estimates about the amounts reflected in the Consolidated Financial Statements.  Management uses historical experience and all available information to make these estimates and judgments, and different amounts could be reported using different assumptions and estimates.

As a result of the adoption of SFAS No. 123(R) at the beginning of Fiscal 2006, we have added "Share-Based Payments" as a critical accounting policy.

Share-Based Payments

We account for share-based payments in accordance with the provisions of 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 ("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 allowed by SEC Staff Accounting Bulletin 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. 

Impact of Inflation/Deflation

We do not believe that inflation has had a significant effect on our net sales or our profitability. Substantial increases in cost, however, could have a significant impact on our business and the industry in the future. Additionally, while deflation could positively impact our merchandise costs, it could have an adverse effect on our average unit retail price, resulting in lower sales and profitability.

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