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American Apparel Inc. (NYSEMKT:APP)

Q4 2008 Earnings Call

March 17, 2009; 8:30 pm ET

Executives

Dov Charney - Chief Executive Officer

Adrian Kowalewski - Chief Financial Officer

Glenn Weinman - General Counsel

Jean Fontana - Integrated Corporate Relations

Analysts

Todd Slater - Lazard Capital Markets

Edward Ruma - KeyBank

Mimi Bartow - Telsey Advisory Group

Howard Tubin - RBC Capital Markets

Matthew Waigner [Ph] - Vaness Trespae [Ph]

Operator

Good day everyone and welcome to American Apparel Incorporated, fourth quarter 2008 earnings conference. Please be aware that today’s conference is being recorded and now for opening remarks and introductions, I’d like to turn the call over to Ms. Jean Fontana, of Integrated Corporate Relations; please proceed Ms. Fontana.

Jean Fontana

Thank you. Good morning. Welcome to American Apparel’s fourth quarter and fiscal 2008 conference call. Joining us on the call today are Dov Charney, Chief Executive Officer; Adrian Kowalewski, Chief Financial Officer; and Glenn Weinman, General Counsel.

Before we begin, I would like to remind you that the statements contained in this conference call which are not historical facts may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results might differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company’s filing with the SEC.

Now, I would like to turn the call over to Dov Charney, the company’s Chief Executive Officer.

Dov Charney

Hi, again everyone. It’s good to be here to discuss our 2008 results and our plans for 2009. First, let me say that I’m proud of our accomplishments in our first year as a public company. We achieved quite a bit and have set ourselves up to leverage our brand and our retail concept to resonate with metropolitan young adults around the world.

We completed our merger with Endeavor Acquisition Corp., a little over a year ago in December 2007 and started 2008 as an independent public company for the first time. Like other retailers, we had to deal with some unexpected turbulence in the financial markets and in consumer spending, not only here in the U.S., but around the world.

In spite of these issues, we are able to continue to perform through the end of the year nevertheless. We are very proud to have achieved the EBITDA guidance that we gained at the beginning the year, despite the distractions we faced.

Along with achieving our earnings goals, we are also able to make good progress in other areas. First we wanted to expand our presences, both domestically and globally and we were able to open 81 stores and expanded into six new countries including China, Brazil and Austria. We now own and operate stores in 19 countries using young and passionate teams that also act to build our brand in their local market.

As we look at where we stand today, we like our stores. The new stores performed very well in 2008, including those that we opened in the fourth quarter, so performance has been good as far as the new stores are concern. We also like our brand continue to be widely embraced in many new countries and we will now look to maximize the potential of our new stores over the next couple of years. Also during the year 2008, we were able to built-out our finance and accounting team and improved our controls and systems.

During the year, we named Adrian Kowalewski, as our CFO. Adrian has been with the company since June 2006 and his knowledge of the workings of our unique company, his work ethics and his work in building our team and our internal financial capabilities over the past year made him the absolute best choice for that division. During the year, we also added a number of other qualified financial resources to our team.

We drove the same store sales comparison of 22% in 2008 and ended the year with sales per net square foot for stores opened at least year of $605. We are proud of this performance, but we also know there is room to continue to improve especially on sales per square foot basis.

Additionally, we posted an operating margin of 6.6% before one-time charges; again understand it’s a very tough environment. For the fourth quarter we post an operating margin of 6.3. This year we’ve also built our production capabilities by expanding our operations into a new facility where we began cutting, sewing and garment dyeing, a portion of the production in January.

Okay, so we have a new facility where we’ve integrated garment dyeing and selling and so forth. In May 2008, we also acquired a fabric dyeing and finishing plant in Garden Grove, California, where we subsequently added a knitting operation. We feel our existing facilities are positioned to support our expanded product line at a $1 billion sales volume.

Then early this year, in fact last week, we were pleased to be able to satisfy our funding needs, solidify our balance sheet and position the company for continued growth in the years ahead. We felt that we had a manageable level of debt to refinance last year, but the unprecedented trouble in the credit markets made that very difficult.

We are very happy to hold Lion Capital as our partner. They are as a sophisticated financial partner with experience in global consumer product companies and will be valuable advisors for us as we make important decisions on our expansion plans.

As we look to 2009, we know we will face some headwinds in the economy. However, at the same time, we feel our brand and the market segment we serve will allow us to weather the economic downturn well. We love that we are positioned as an important brand among young metropolitan-based and globally minded consumers, who continue depend on American Apparel’s, as part of their wardrobe.

Although, we reported a same store sales decline in February, we realized that we will have to live through some cannibalization from the stores we opened last year, in markets like New York City, London and Miami; coupled with tough comparisons in the first half of this year, which will make it challenging to post strong comp store sales increases.

With that said, our new stores are performing great and will add to our profits in 2009. As we look over to the next two, three years, we know that we will be able to drive the productivity and profitability of our current store base higher, and also continue to strategically expand in existing and in new markets.

In 2009, we will look to cut our capital expenditures to roughly $20 million to $25 million, from $72 million in 2008, which will allow us to generate significant free cash. We’ve planned to open it up to 30 stores in 2009 and we are getting much better leasing terms than in the past. This year stores will cost much less to build due to the fact that landlords are providing us with a more complete store to work with right from the get go.

We will take advantage of opening fewer stores and focus on optimizing and implementing systems, controls and production and distribution, as well as at the store level and continue to implement additional phases of our ERP program. We will optimize our ability to produce more sophisticated products like button-downs and jackets as a means of treating our customers whose taste level is constantly maturing as their client gets incrementally older.

We will also continue to build our upper and middle management team, which will be facilitated by the increase in the talent flow due to the economic recession that we are experiencing. As always acknowledge to leverage our design and technology, to advance our business and bring value to our customers, our employees, our shareholders and the carriers within which we operate.

I thank you very much and I’m now going to put things over to Adrian, who’ll take you through the financial. Once again, thank you very much and I appreciate everybody’s support. Go ahead Adrian.

Adrian Kowalewski

Thanks Dov. For the fourth quarter of 2008, net sales totaled $145.6 million, an increase of 31% over the fourth quarter of 2007. Total comparable store sales increased 11% for the fourth quarter on a constant currency basis, versus a 40% comparable store sales increase in the fourth quarter of 2007.

Gross profit in the fourth quarter increased 34.3% to $80.7 million. Gross margin increased from 54% in the fourth quarter of ‘07 to 55.4% in the fourth quarter of 2008; mainly due to a higher mix of retail and online consumer sales, resulting from our continued store expansion in the U.S. and in international markets, as these sales generate a higher gross margin into sales in our wholesale channel.

Due to the more rapid growth of our retail business, the U.S. wholesale segment represented just 26.1% of sales in the fourth quarter, versus 34.2% of sales in the quarter a year ago.

Operating expenses increased 20.2% to $71.5 million or 49.1% of sales versus 53.4% for the fourth quarter of 2007. Operating expenses increased overall, due to higher payroll, rent and occupancy expense, related to the increase in the number of retail stores in operation over the past 12 month, leases found on stores in our pipeline as well. Pre-opening expenses for retail stores were $3.6 million in the fourth quarter of 2008 versus $1.6 million in the same period last year.

Operating expenses were also higher, due to an increase in corporate expense, related to an increase in accounting and professional fees, as a result of American Apparel operating as a public company in 2008, as well as additional payroll and increased IT and other office related expenses. Operating income for the fourth quarter was $9.2 million versus 600,000 in the prior year fourth quarter. Operating margin was 6.3% versus 0.6% a year ago.

Interest expense for the third quarter totaled $3.2 million, as compared to $4.4 million for the fourth quarter of 2007. The decrease in the interest expense is primarily due to a lower LIBOR rate on which the company’s asset-based revolver borrowings are determined. Our effective tax rate for the period was 35.1%.

Net income for the fourth quarter was $3.9 million or $0.05 per diluted share. Net income for the fourth quarter of 2007 was $3 million or $0.06 per diluted share. Pro forma for American Apparel’s conversions with the C Corp, net income for the fourth quarter of 2007 would have been negative $1.7 million or a loss of $0.03 per share. Weighted average fully diluted shares outstanding were $71.6 million for the quarter, versus $52.4 million shares for the fourth quarter of 2007.

I will now briefly go into the operating results of each of our four business segments. I’d like to highlight something we mentioned in our earnings release; which is that in the fourth quarter, we implemented changes to our inter-company transfer pricing policy to reduce our effective tax rate on international operation.

The changes recorded in the fourth quarter reflected a full year impact on the change in transfer pricing. These changes have the impact of increasing the reported margin for our U.S. wholesale segment or decreasing the reported margins of the Canada and international business segment.

In the results I will go over, I will present the information on a pre-transfer pricing basis, to aid in comparability versus previously disclosed results. The sales for our U.S. Retail segment increased 41.5% for the quarter to $49.8 million. We ended the period with 148 stores in the U.S., up from 105 stores in the same period last year.

Comparable store sales in our U.S. retail division were up 1% during the fourth quarter, in light of the large number of store opening in the U.S. region in the third quarter and fourth quarter. Gross profit rose 43.2% to $37.9 million. Gross margin was 76.1% as compared to 75.2% for the fourth quarter of 2007, representing an increase in 90 basis points.

Operating income grew 9.5% to $9.2 million or 18.4% of sales, as compared to $8.4 million or 23.7% of sales in the same period last year. Pre-opening store expenses for U.S. Retail were $2.6 million in the quarter, versus approximately 500,000 in the quarter a year ago.

Sales for our Canada segment increased to 53.9%, to $18.7 million. At the end of the period we had 37 stores in Canada up from 30 a year ago. Comparable store sales in our Canada segment were up 36%. Backing out the impact of the transfer pricing changes, gross profit rose 54.5% to $11.5 million and gross margin was 61.5% as compared to 61.2% for the fourth quarter of 2007. Operating income for the Canada segment increased to $5.3 million to $3.8 million or 20.1% of net sales.

Sales for our international segment increased to 51.5% to $39.1 million. We finished the quarter with 75 stores in 17 countries, up from 47 stores a year ago. Comparable store sales in our international segment were up 19%. Backing out the impact of the transfer pricing changes, gross profit rose 17.4% to $21.4 million and gross margin was 54.8% as compared to 70.7% for the fourth quarter of 2007.

In addition to the transfer pricing change discussed, in the fourth quarter the company began charging its Canadian and international subsidiaries through the manufacturing variance incurred between actual cost and standard cost and these adjustments are reflected in the numbers for the fourth quarter. Pre-store operating expenses in the international segment were approximately 800,000 in the current quarter versus approximately 1 million last year.

Finally for our wholesale, net sales for our U.S. Wholesale division were flat in the fourth quarter at $38 million, the same as in the fourth quarter a year ago. Third-party wholesale sales decreased 2.9%, while online consumer sales increased 13.2%, despite significantly reduced online ad spending to lower customer acquisition costs to focus on more profitable customers. Online consumer sales in U.S. were $7.6 million for the quarter versus $6.7 million in the same quarter a year ago.

Backing out the impact of the transfer pricing changes, gross profit increased to $2 million or 24.8% to $9.8 million. Gross margin was 25.9% in the fourth quarter of 2008, versus 20.8% in the same period of 2007. Operating income for the quarter was $4.9 million or 12.9% of net sales as compared to $1.7 million or 4.5% of the sales in the same period last year.

Turning to liquidity, we finished the year with $111.7 million of debt on our balance sheet and $11.4 million in cash. As of December 31, we had approximately $12.1 million of excess availability on our asset-based revolving credit facility. The $51 million second lien term loan, which is on the books at 12/31, was retired as part of the investment by Lion Capital announced last Friday.

Capital expenditures for the fourth quarter were approximately $20 million as we completed the build out of the remaining retail stores in our pipeline. Our inventory position decreased approximately $5.4 million from the end of the third quarter as a result of reduced production in light of tighter liquidity with the company’s lenders and greater optimization of supply chain and production planning due to the investments in our new ERP system, which went live in April last year.

Finally turning to guidance, I wanted to note that despite a number of dramatic dislocations of the global economy in 2008, we were able to come within the original guidance range we gave last year of $70 million to $75 million of EBITDA before merger related stock-based compensation expense and $0.32 to $0.36 of EPS.

This was while opening a significantly higher number of stores in our original guidance of 40 to 45 stores and the incremental store pre-opening expenses that is involved. Store pre-opening expenses in 2008 on an aggregate basis across all segment was $10.3 million versus $5.3 million in 2007.

For 2009, as mentioned in the earnings release, we currently expect consolidated net sales in the range of $575 million to $600 million and income from operations in the range of $55 million to $65 million. We expect depreciation and amortization for the year of approximately $25 million. CapEx is expected to come in under our revised covenants with Lion Capital at $20 million to $25 million, putting us in a position to drive significant free cash flow in 2009.

As we mentioned on our third quarter conference call, with a greater than anticipated number of store openings falling into 2008, we expect the number of store openings in 2009 to be lower, but that we would still achieve our goal of 20% to 25% unit growth per year annualized over the period.

For the year thus far we have opened five new retail stores and currently have nine remaining in the pipeline and we are in the process of building out. We expect to open approximately 25 to 30 stores for the year depending on market condition.

While the overall economic climate is difficult and it’s difficult in particular for retail, the sales performance of the stores we opened in 2008 have been exceeding our expectation with average sales per-store for new unit contracts to coming at about $1.8 million per year, while existing stores are running at a rate of approximately $1.7 million per year.

With that, I will turn it over to Dov and open it up to Q-and-A.

Jean Fontana

Operator, can you start Q-and-A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first today will come from Todd Slater with Lazard Capital Markets.

Todd Slater – Lazard Capital Markets

Good morning.

Dov Charney

Good morning Todd.

Todd Slater – Lazard Capital Markets

First of all, let me just congratulate you for hitting numbers that you’ve guided to over a year ago when the world was a very, very different place. I also think you maybe the only retailer guiding to an increase in revenue in ‘09, as well as expansion in operating margins and an increase in earnings, so that you’re in a pretty elite group there.

I just wanted to ask you about your assumptions, a little bit especially on the comp line. What comp are you assuming in ‘09 and just sort of maybe give us some range for the first half versus the second half. I am assuming flat to down in the first half given the cannibalization, something a little better than the second half. I wonder if you can just give us some color around your expectations.

Dov Charney

Yes, Todd I mean just to give you a little bit more color, I want to preface my comments by saying that given what’s going on in the economy, we are very hesitant to put out any guidance whatsoever, so what I’m going to give is highly speculative, but what we are assuming in our model is we would have flat to mid single-digit negative comps for 2009 given the amount of store openings that we’ve had in the second half of ‘08. I think we are expecting wholesale to be flat to negative in a range of zero to negative 10%. That’s what we are looking on the sales line.

Todd Salter – Lazard Capital

Could you just sort of also bracket that first half, second half? Do you see an improvement over the course the year given the easier comparison and also talk, when does the cannibalization start to end, what quarter?

Dov Charney

The Cannibalization really comes in to play in the U.S. markets, because are Canadian and international stores, the stores that we opened in ‘08 were very spread out, so we didn’t really see as much of an impact.

In the U.S. retail where you had a large number of store openings, you had 39 in the last two quarters and that’s why you see a slowdown I think in our comp performance in the U.S., but once those stores start to annualize, I think that’s going to provide a list to our comps and so I think it’s going to elevate in the second half.

So, taken as an average over the year I think, it’s conservative to think we’re going to come in at mid-single digit negative to zero. I think there might be some upside to that. All that depends on the economy and how the consumer continues to see their position evolve over ‘09.

Todd Slater – Lazard Capital Markets

What is your estimate; I mean how much you think cannibalization is hitting the overall comp, is it in the 5% range or perhaps or may be more? Maybe you can give us some examples of comp performance in cannibalized market or stores versus comp performance in non-cannibalized markets?

Dov Charney

Todd what we did, if you take a look at February, we posted 9% comp that kind of took into account the leap year. Had you backed that out, the number would have been about negative 5%.

If you look at that negative 5%, if you split it out, we did a analysis where we looked out markets where we’ve opened up more than 30% new unites and markets where we haven’t had that kind of growth, and the delta between the comp was on the order of 15%. So, if a non-cannibalized market was comping at zero, then you’d have negative 15 for example at the cannibalized markets.

When you look at it over a period of time and you look at it by market, when the stores are being layered in, where the comps drop off is when there’s a significant number of new stores. So in New York and in LA we had a large number of store openings. The comp really deteriorates when you open up a significant number of new stores that you have.

Todd Slater – Lazard Capital Markets

Sure. Well in ‘06 you also had a significant amount of cannibalization if I remember correctly, and comps decelerated like from 45% to 5% and then they reaccelerated the next year from mid singles to up 25% and I’m just wondering, is that sort of the type of expectation you might have in terms of the acceleration as that cannibalization ends?

Dov Charney

Well, I think in 2006 we were smaller players, so we were trying to penetrate I think a bigger market opportunity and we also had a more positive consumer environment in 2006. So, this is a different world that we’re in, but I think given the success that we’ve seen our expectation is that we would have comps improving towards the second half of 2009, for the reasons you mentioned.

Todd Slater – Lazard Capital Markets

Okay and then you said that the new stores are still coming on at the $1.8 million annualized level. Can you just give us a sense of how the four wall contribution is performing in your first year source; is it paying in there?

Dov Charney

Since I’ve known we haven’t had a lot of it; like I said we only opened five stores for the year. So, there is not much of an update over that, but when we are at the conference, we were saying that the formal economics were looking at a contribution margin of 25% to 30% and I think that’s still what we’re targeting.

Todd Slater - Lazard Capital Markets

Okay, and then a quick question moving to cash flow. You have a number of positive changes in sort of the working capital and CapEx that might benefit your cash in ‘09. Just sort of what type of free cash flow do you expect to generate if you sort of hit the midpoint of your implied $80 million to $90 million in EBITDA in 2009?

Dov Charney

Well, given the financing from Lion Capital, which is a PIC loan where we don’t have to pay cash interest at our option, it gives us a lot more flexibility over our working capital. So on call it EBITDA of $80 million to $90 million, which we are guiding to, if cash flow from operations would have been say $40 million for 2009, aside from the fact that you now have this PIC feature in the loan and you’ll only be doing about $20 million to $25 million of CapEx, I think that still gives you a lot of flexibility to have a fair amount of debt pay down or store openings depending on what’s appropriate in the future.

Todd Slater - Lazard Capital Markets

Okay, two more quick questions. You had to cut back on production due to the liquidity issues in the fourth quarter. What kind of impact do you think that had on fourth-quarter results?

Dov Charney

There’s always an impact with respect to unabsorbed overhead, with the larger production base that we currently have, that’s going to be a larger number. To quantify it, I think you are talking about $1 million or $2 million spread out over the quarter, but it’s something that is difficult to quantify, because as we’re going into the winter quarters, we are also changing the composition of our production which also has an impact on overhead absorption.

The reduction in production that we saw in Q4, that’s something that is ongoing through Q1, so that’s another reason we’re hesitant to give guidance on; how the quarter is going to play out for 2009, but I think moving forward, we are in the process right now because we are going into the spring season to ramp up production, so that impact is going to go away.

Todd Slater - Lazard Capital Markets

Okay, one last question for you Dov, before I move on. You hit about a 9% operating margin this year if you back out you some of the one timers, so if you sort of look at things on an operating basis. Dov, do you still feel that your goals of mid double digits or higher operating margins is achievable, especially as the retail piece continues to grow as a percentage of the mix that obviously carries a much higher margin. What do you think sort of the range of opportunities are in the operating margin.

Dov Charney

I think what we talked about in the past, getting into the mid-teens is possible. We really only find out how things are going in spring and summer and I’d like to see how things play out. We’re in a very uncertain economy, but I’m always optimistic, and it’s just hard to say until the sun is shining and it’s warm in Central Park.

I think over time, definitely, we feel we can become a premiere player as far as operating margins is concerned. We’re going to go up this year in my opinion, but I think how far we take it may not be determined this year; it might be something that spreads into years to come.

I have to think about it. We have to see how things go. I think it’s too early in the year to kind of guess at it, but we’ll know more soon, I’ll say that, we’ll know more soon. American Apparel, again, really the action starts when the sun is shining and we’re past the spring solicit. We’re getting close to the launch point in the year.

Todd Slater - Lazard Capital Markets

Okay, all the best.

Dov Charney

Thanks Todd.

Operator

(Operator Instructions) We will now go to Edward Ruma [Ph] with KeyBank.

Edward Ruma – KeyBank

Thanks so much for taking my question. I noticed that you continue to have the deficiencies, when do you expect to remediate them, listed in the K?

Dov Charney

Well, we remediated two deficiencies over the course of 2008. If you look through the disclosure, it does say that substantial measures have been taken to remediate the remaining material weaknesses; however, there’s not been enough time to test whether the measures that have been put in place are effective, so that’s something that’s going to take a period of time to work through.

I can’t put a time line on when that is actually going to happen, and when our auditor is going to get comfortable with removing them, but we have been working on stocks for the last 15 months, and there’s been a lot of progress in terms of closing down weaknesses. So that’s something that’s ongoing.

I think the fact that two of them have gone away is a positive, and the fact that our auditors have recognized that there have been substantial measures to remediate the remaining ones is also positive, but this is something that takes a period of time.

Edward Ruma - KeyBank

I notice that you had some restrictions around advertising commitments. Does that actually restrict the amount you can spend on advertising or is that some specific type of commitment?

Dov Charney

This is advertisement that we’ve committed o in advance?

Edward Ruma - KeyBank

I see. So, that actually doesn’t reduce your advertising spend overall?

Dov Charney

Correct.

Edward Ruma - KeyBank

And I noticed only three of your Directors or your non management Directors had signed the K, is that normal or…?

Dov Charney

I think if Glenn could take that question. My understanding was that all the Directors had approved the filing in the 10-K.

Glenn Weinmanl

The 10-K was unanimously approved by all the Directors. We had signature pages out and they were all going to sign them. I don’t know where they are and what got filed. I think you’ll see everything electronically filed. It may just be a delay in the filing, but everybody was on and everybody approved at the Board meeting, approving the K, unanimous.

Edward Ruma – KeyBank

One final question if I may. Do you have any update on your headquarters situation and your expected lease payment, thank you.

Dov Charney

We are trying with our lease obligations and we are in negotiations with our landlord, but at this point we have nothing further to report.

Edward Ruma - KeyBank

Thank you.

Operator

We’ll take our next question from Mimi Bartow with Telsey Advisory Group.

Mimi Bartow - Telsey Advisory Group

Hey guys, thanks and a great quarter. First, I was just wondering if you could talk about; I notice you opened seven new close-out stores; I’m just wondering if you could just talk a little bit about that strategy and obviously I saw it had a positive effect on gross margin just given the inventory reserve. If you could just talk about that as a strategy and obviously what the effect we could see on gross margins going forward there?

Dov Charney

Well, actually I don’t know if the close-out stores are responsible for the reduction in the inventory reserves. I think the reduction in the inventory reserve is because the creative team in American Apparel, which I think it’s important to highlight some of these individuals on the call, they are remanufacturing, taking damaged product, garment dyeing, tie-dyeing or just distressed products or obsolete products are getting remanufactured at our new dye house facility or they are being printed; so that’s really where the reduction comes from.

As far as the close-out stores, we are using the close-out stores as a vehicle to sell predominantly damaged products. It’s going okay, but there’s room for a lot of improvement as far as the allocation methodologies that we’re planning to pursue at the closeout level.

The stores are good. I think we can open a few more of them. We are trying to achieve some scale. We’ve developed some systems internally to manage slightly damaged products. I think it’s an area of growth, but it’s a little bit of a black art to manage these units. I think it will take another six to nine months before we really get them mastered. We have made progress.

We’ve had some phenomenal progress at Woodbury Commons and places like that. We were at the bottom of the list as far as performers at those centers and now we’re climbing up to the top, but I just want to say that the obsolescence reduction in how we are managing that, is really also being managed through our first quality stores. That’s all what I have to say about that I guess. There’s room for improvement. I think we could open another four to five close-out stores.

Mimi Bartow - Telsey Advisory Group

Great and just how do you think about kind of inventory turns in this business? I know Adrian mentioned that you’ll be entering sort of the ramp-up period as you guys look to the second and third quarter. Obviously turns picked up a little bit in the fourth quarter. Do you have a goal or something that you see as something you guys are looking to achieve?

Dov Charney

I think I can allow Adrian to answer that question as well, but one thing I think I should emphasize is that inventory turns should be seen by segment. For example, yarn should turn so many times a year; fabric should turn so many times per year; finished clothing should turn so many times per year at the distribution center level; and inventory should turn at stores so many times a year. If you look at the turns globally, we have some goals; what would you say that goal would be?

Adrian Kowalewski

At retail stores I think, we believe we can move the turns to two to three times, which is lower than a typical retailer, but given that we generated higher a gross margin in our stores, I think that allows us to achieve the levels of profitability that deliver the kind of return on investment that we’re looking for.

Dov Charney

Right, I think overall we talked about an overall inventory turn number that we are working toward, but the things you have to understand; at the store levels for instance when you talked about inventory turns, we need to have bathing suits at the store year round, because one thing people see at American Apparel, as far as our customer is, you can get a bathing suit 12 months a year.

We need to have jackets even in the summer. If there’s a cold spell, people want to get a jacket. Miami, we have to have sweatshirts year round, because from time-to-time you need a sweatshirt in Miami. If you’re traveling or if there’s a cold spell during the Christmas vacation or whatever and we’re selling predominantly commodity products, but we want to be there. I don’t know if you ever had the experience of walking down Broadway in August and you’re looking at all these institutional retailers with the fall collection and its 100 degrees outside.

We want to be at the moment for our customer, who’s a younger customer that’s looking for instant gratification. If they want a jacket, pair of socks, a bathing suit, lingerie and they want it then and there, right away, and we want to try and offer it to them when and how they want it. So that reduces turns, but it increases convenience to the customer and fluidity as far as their expectations and their shopping experience.

I think overall we could goal towards two turns globally throughout the whole organization right, I talked about that.

Adrian Kowalewski

One of the major areas of inventory where we have better ability to get efficient on is now the factory inventory and by having a more efficient supply chain and more visibility on demand, we are able to generate more sales with the amount of inventory that we have in stock.

Now, we’ve been bringing down inventory over the fourth quarter and also going into the first quarter of this year. So I think overall there’s going to be some improvement in inventory turns.

Dov Charney

Inventory in the United States was approximately; I’m talking all inventories, raw materials, stores, all forms of inventory in the United States of America, at a high point was $134 million. I want to mention what it is today, but we’ve got it down over $15 million quite quickly, possibly $20 million at a certain point.

Adrian Kowalewski

I mean this is probably due to the fact of a better visibility or better systems to manage all this stuff.

Dov Charney

The ERP system, and we’re about to bring in another phase of it; the ERP systems are incredible and we got daily inventories at this point. The whole creative team has access to inventory turns by color, by fabric style. The amount of information we’re getting is incredible.

We have a department of people now that are involved in designing, creating reports, and I believe we can continue to improve inventory trends, but also by knowing what we have and knowing what’s selling and what’s trending. We are also able to improve sales that way.

I think we could take inventory levels down on a raw material level by an additional 10 million, $15 million this year. It’s something I’m working toward and at the same time I want to have healthy inventories at the store level. So when someone walks in and says, “Hey, I want six white V-necks right now” we can pull them out of the back stock and hand them to the customer.

So I think there’s an opportunity for a top-line improvement as a result of the ERP, as well as inventory turn improvement which will lead to I think more profitability as well. I’m excited about the ERP system and I’m looking forward to the implementation of additional phases. It’s taken a long time, but its working well as it comes in.

Mimi Bartow - Telsey Advisory Group

All right great. Thanks guys and good luck.

Dov Charney

Thank you.

Operator

We’ll now move next to Howard Tubin with RBC Capital Markets.

Howard Tubin - RBC Capital Markets

Hey guys. Your gross margin performance in the retail side was quite strong in the fourth quarter, but maybe looking forward, are you contemplating any changes to your promotional strategy or pricing strategy or cadence in the business given the overall environment?

Dov Charney

No discounting, that’s not what we do. We are not going to do it. We’re holding our gross margins and that’s not part of our strategy to lower margins or discounting product. We sell what we make. If it’s the wrong color, dye it, but don’t discount it. That is not what we do. We’ve never discounted products at the retail level, barely and that’s not what our strategy is about, but I appreciate the question. Do you have another question?

Howard Tubin - RBC Capital Markets

No, that’s it. Thanks.

Dov Charney

No problem. Anybody else have any questions?

Operator

We’ll now take a question from Matthew Waigner [Ph] with Vaness Trespae [Ph].

Matthew Waigner - Vaness Trespae

Hey gentlemen, Good morning. Transfer pricing, not withstanding the margins still looked a little bit lighter than I was expecting in international and Canada. I’m wondering if we can get a wholesale and retail breakdown in those segments.

Adrian Kowalewski

You have it both by quarter in the earnings release; so net sales by class of customer. If you look at the fourth quarters 2008 in Canada you had $2.9 million of wholesale sales, $15.3 million of retail and about $400,000 of online consumer. In International in the fourth quarter you had $2.9 million wholesale, $32.8 million retail and $3.3 million of online consumer sales.

As I also mentioned, in the fourth quarter, the US wholesale division started charging the international and Canadian subsidiaries for the variances on manufacturing costs between standard and actual cost. So that’s a part of the difference. I guess the delta that you’re trying to figure out is that difference between standard and actual, but that’s not something that we’re disclosing.

Matthew Waigner - Vaness Trespae

Okay. Can we get a US wholesale margin without the transfer?

Adrian Kowalewski

So if you go to the earnings release and go to table C, we calculated pro forma gross profit, which is to eliminate out the transfer pricing and in my remarks on the segment financial information as I was going through them in speaking of the margins, all that information was net of transfer pricing. So if you look at fourth-quarter wholesale, gross margin was 25.9% for the fourth quarter.

Matthew Waigner - Vaness Trespae

Great, and then Adrian, can we speak a little bit on the trend for both international and Canadian retail margins? I mean it might not be disclosing any more, but if you go back and look at say ’06, it was like 77% gross margin in Canada. I mean, is that trending sort of in line with that or has there been any movement over of the course of the last 12 months?

Adrian Kowalewski

I think the way we price products in international markets, we do keep an eye on what the exchange rates are, which would have an impact on the gross margin, but we don’t chase the exchange rates. So, last year there was some modification to the prices, because we felt they had gotten a little out of that, but over any period of time, there is no reason for those margins to really diverge in one direction or another.

The only real variances you would have in looking at the segment information is that you might have different amounts that are going through the wholesale and retail channel. So, I think in previous years we didn’t really give the breakouts between what channel of customer those segments were selling to, but if you were to back that out, I think you’d find that the margins have been pretty consistent, other than for the affects of the exchange rates.

So I think if you look at the US retail business, we are targeting a 75% gross margin. I think that’s kind of what we have in mind at the international divisions as well, because we’ll mark it up for that and for duty and for transportation.

Matthew Waigner - Vaness Trespae

Okay great; and then just on the expense side, it looked like the advertising expense came in quite a bit in Q4. Can we look at that as a run rate going forward as well? Also with the professional fees, I noticed there was a little bit of a bump in Q4, can we expect that to come back down more in line with what it was in Qs 1 through 3?

Dov Charney

Well, going forward you have a number of good things going on. I mean having additional staff in-house is going to reduce expenses. So, for example by bringing Glenn onboard, that I think is going to help bring in our legal expenses. We brought in additional people into accounting, but that should reduce our overall accounting fees. Sarbanes-Oxley is not going to be as big of a burden on 2009 as it was on 2008. We did a lot of work and we’ve had a lot of success there, so going forward that’s going to be a reduced drag.

With respect to advertising, for the fourth quarter, ad spends in SG&A was $3.8 million versus $4.4 million a year ago. We brought down our online ad spend significantly and cutbacks from our advertising commitments and print and publications. I think that’s kind of what everyone’s been doing. I think we’re selectively looking to get a little bit more involved in the online space, because we think there’s a lot of a good opportunity.

I think as we get more sophisticated in our marketing tactics, I think that’s something that might increase, but we wouldn’t do it unless we saw that there was a great return in terms of acquiring new customers and driving online sales. So that’s something we’re going to look very carefully at, we’re not going to spend money recklessly.

Matthew Waigner - Vaness Trespae

So, bluntly would you say on quarter-to-quarter, closer to 3.8 versus the 5.5 in Q3 of 2008?

Dov Charney

I think a 4 number is a good number is probably a good number to work off.

Matthew Waigner - Vaness Trespae

Okay and finally on the opening costs; I mean obviously you guys had a lot of stores you needed to work through on Q4. On a quarter-to-quarter basis, are we looking at a return to more in line with Q1, Q2 of ‘08?

Adrian Kowalewski

I think that pace of openings is more inline with what we’re contemplating for 2009 right now, but it’s subject to change depending on whether we sign additional leases or if we see cost over runs at some of the stores that we are opening. Right now I think everything is kind of getting opened on time, so I don’t expect any negative surprises in that regard.

Matthew Waigner - Vaness Trespae

Okay great and then Dov, you alluded a little bit to how you were getting good breaks and the leases that you’re seeing out there, I wonder if you could provide a little more color on that?

Adrian Kowalewski

Well, we had just a lot of stores out there. There’s a lot of vacancies in terms of the real estate inventory situation and many of these stores are completely built out. I didn’t rent any of these, but the Cure Plastina stores were closed. They were totally built out with air conditioning and beautiful floors and changing rooms.

There were the Sharper Images, but there’s also a variety of Ann Taylors, Mango, there’s a lot of stores that are completely built out in cities and in major centers that one could rebuild for $30,000, $40,000 in the space of a week and just move in.

Whereas before you were getting really raw space and the landlords were expecting you to rebuild their building at this point you could say “if you want me to rent it, I want a vanilla shell. I want this, I want lighting, I want air conditioning.” You could make demands on the landlords that you weren’t able to make before and notwithstanding you are obviously going to get better pricing per square foot, kick-out clauses and all kinds, I mean some landlords are ready to write you a pretty substantial check to come on in and some landlords see it as some kind of anchor to bring traffic.

So the landscape of opportunities has changed in terms of stores, but also we have to be more cautious on what we pick and choose. So I guess our demand is down and the supply is up, but there is going to be a recalibration somewhere. We want to cherry pick some great stores and pick out some diamonds to help advance our productivity over the next five to ten years.

So we are looking and we’re thinking and we’re talking with a lot of people and see a lot of opportunity. With that said, I think our expectation right now is still CapEx of $20 million to $25 million.

Dov Charney

Yes, we feel like I mentioned in this call 30 stores, that’s inside the CapEx of $20 million. I mean right now you could be handed a store. Some landlords will completely do the builds. Robertson here in Los Angeles, Robertson and third, one of our most beautiful stores, you can check it out. Unbelievable store; the landlord built the whole store for us to our specs and did a fantastic job. The entry costs were very low.

So I wouldn’t be surprised. I mean, he’s offering us another store which we probably won’t take, but there are landlords willing to do cartwheels to get new and they understand that we don’t want to do CapEx, so they are working around that obstacle. So that’s what I’d say about the landlord situation and the CapEx issue that Adrian alluded to.

Matthew Waigner - Vaness Trespae

Great, thanks guys.

Dov Charney

Thanks Matt.

Operator

That does conclude our question-and-answer section for today. I will now turn the conference back over to Dov Charney.

Dov Charney

Well, I just want to say that I think we have had a great year. I think we hit our numbers at unbelievable challenges that I could have never thought would happen as others. I guess Wall Street also could have never speculated what would have happened as far as the way things went, but I’m happy about where we’re going, and I’m happy where we’ve been, and I’m proud of the financial team, the accounting team, but also proud of the creative team.

I really think that we’ve created a special brand that people have respect for all over the world. I mean I met a girl from Denmark at Magic in Las Vegas and she was saying many people in Denmark just love American Apparel and they talk about it and they buy it online and they travel to purchase it and I think it’s special that what we’ve done and I think that this company’s going to grow over many years to come. I appreciate everybody’s support and I wish everybody a wonderful spring. Good luck to everybody. Thank you very much.

Operator

And that does conclude today’s teleconference. We’d like to thank everyone for their participation and wish everyone a great day.

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Source: American Apparel Inc. Q4 2008 Earnings Call Transcript
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