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American Apparel Inc. (NYSEMKT:APP)

Q3 2009 Earnings Call

November 10, 2009 9:00 am ET

Executives

Jean Fontana – Integrated Corporate Relations

Adrian Kowalewski - Chief Financial Officer, Executive Vice President, Director

Dov Charney - Chairman of the Board, President, Chief Executive Officer

Glenn A. Weinman - Senior Vice President, General Counsel, Secretary

Analysts

Edward Yruma – Keybanc Capital Markets

Todd Slater – Lazard Capital Markets

Operator

Greetings and welcome to the American Apparel third quarter 2009 earnings results conference. (Operator Instructions) It is now my pleasure to introduce Joe Teklits, IR for American Apparel. Thank you, Mr. Teklits. You may now begin.

Joe Teklits

Okay, thanks. Good morning, everybody. Before we begin, of course, I would like to remind you that during this call, we will be making forward-looking statements that are based upon the current beliefs and expectations of American Apparel's management team that are subject to risks and uncertainties which could cause actual results and timing of those results to differ materially from management expectations. The forward-looking statements are valid only on the date in which they are made and the company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

These risks are detailed in our filings with the Securities & Exchange Commission including our 2008 annual report on Form 10K. Our filings with the SEC are available at www.sec.gov, or our investor relations website. You are urged to consider these factors carefully in evaluating the forward-looking statements herein and are cautioned not to place undue reliance on such forward-looking statements which are qualified in their entirety by their cautionary statements.

With that, I will turn the call over to Adrian Kowalewski, Chief Financial Officer for American Apparel.

Adrian Kowalewski

Thanks, Joe. Good morning, everyone and thank you for joining us. Also on the call with me this morning are Dov Charney, President and Chief Executive Officer and Glenn Weinman, Senior Vice President and General Counsel.

We are relatively pleased with our performance in the third quarter and believe that the substantial investments and efforts we have put into the business over the past year are beginning to positively impact many areas of our business, including manufacturing, operations, supply chain, store operations, and financial reporting and internal controls. While our comparable store sales again ran into the negative double-digits in the third quarter, we believe that we are nearing the end of a period of severe cannibalization that was brought about by the opening of nearly 80 new stores in 2008, a more than 40% increase in our store base.

The sales results of this past October, which was the strongest comp result the company has had since January this year, has provided us with additional optimism about the possibility of renewed sales momentum that we hope will carry into 2010.

During the third quarter, we opened seven new retail stores and closed three stores. Four stores were opened in the U.S. in the quarter, one in Canada and two internationally, including our first store in Ireland in Dublin and a second store in Tokyo’s [Shabria] district. As of the end of October, we had opened 23 new store locations since the beginning of the year and closed five locations.

We currently have four signed leases for new retail stores in our store pipeline with three of those locations likely to open before the end of 2009. We are also evaluating a large number of potential locations for future openings.

On the wholesale side of the business, for the third quarter demand remained sluggish with year-over-year sales to distributors and screen printers falling into double-digits versus a year ago. We see this business as one that has been directly impacted by the economy and we will manage the downturn until demand recovers.

Finally, in the third quarter we had to deal with the difficult task of letting go of approximately 1500 manufacturing workers who were identified by a U.S. immigration and customers enforcement as having providing the company with suspect documents in order to gain employment. Many of these workers had worked for the company for as long as 10 years and had been some of our best employees.

Now turning to the specifics on the quarter, for the third quarter ended September 30, 2009, net sales decreased 2.9% to $150.3 million, down from $154.8 million in the third quarter of 2008. Net income for the quarter was $4.2 million, or $0.05 per diluted share, as compared to $2.3 million, $0.03 per diluted share last year. Backing out last year’s merger related share-based compensation expense in the third quarter, net income would have been $11.1 million or $0.16 per diluted share.

EBITDA for the third quarter of 2009 was $18.6 million versus $25.5 million last year, again backing out the share-based compensation expense. The EBITDA margin declined to 12.4% from 16.5% a year ago, a decline of 410 basis points. EBITDA through the first nine months of this year was $35.6 million versus $54.4 million last year. The EBITDA margin for the first nine months was 8.9% versus 13.6% a year ago, a decline of 470 basis points.

Looking at the third quarter broken down into our retail and wholesale businesses, total retail sales for the third quarter increased 3.7% to $101 million, with the growth driven entirely by $17.5 million of incremental revenue from 48 net new store openings over the past year. Sales at existing stores fell by $13.9 million, or a decrease in comparable store sales of 16% on a constant currency basis. As mentioned earlier, we believe the decline in comparable store sales is primarily attributable to the cannibalization of existing sales by new stores opened in existing markets but has also been exacerbated and prolonged by the difficult consumer environment over the past year.

We ended the quarter with 276 retail stores, a net increase of four stores for the third quarter and net increase of 16 stores for the first nine months of the year.

Total wholesale sales, which originate predominantly in the U.S., fell 14.5% to $40.2 million, as we continue to see weakness in demand from our distributor, screen printer, manufacturing, and private label customers.

Online consumer sales remained at levels somewhat lower than in previous years, falling 12.6% to $9.1 million, due not only to general consumer weakness but also in part due to the aforementioned cannibalization from a much larger U.S. retail footprint than we had in place a year ago, and a significant reduction in our online ad spend, which began during the third quarter of 2008.

Sales for each of our business segments were as follows -- sales for the U.S. retail segment increased $8.3 million to $50.5 million, primarily driven by the additional 20 stores in operation compared to a year ago. Comparable store sales for the U.S. retail segment were down 23% as this region was going up against a very difficult positive 24% comp in 2008, as cannibalization in most metropolitan markets continued to play itself out and due to the overall challenging consumer environment. At the end of the period, we had 157 stores in the U.S.

Sales in the Canadian segment fell 5.7% to $18.7 million in the quarter, with comparable store sales declining 11% on a constant currency basis. We operated 39 stores in Canada at the end of the quarter.

Sales in the international segment fell 2.6% to $40.9 million, with comparable store sales down 8% over the same period last year. At the end of the period, we operated 80 stores in 18 countries.

Sales in the wholesale segment fell 13.3% to $40.1 million. Demand from distributors we’ve seen shift towards more basic lower cost items, such as our basic t-shirts. As such, even though unit sales have been more resilient, we have seen total sales dollars decline.

Turning to gross profit, for the third quarter gross margin increased to 58.1% of net sales, as compared to 49.1% of net sales in the third quarter of 2008. The difference is primarily accounted for by the $13.2 million of share-based compensation expense arising from the award of approximately 1.9 million shares to manufacturing employees of the company in the third quarter of 2008. On a normalized basis, gross profit for the third quarter of 2008 would have been approximately 57.7%. We showed an improvement of approximately 40 basis points quarter over quarter. Most of this improvement stems from a favorable shift in sales channel mix towards higher margin retail sales and away from the wholesale sales channel, for reasons mentioned earlier.

Operating expenses increased by 9.9% to $76.1 million for the quarter, driven primarily by an increase in G&A expenses from increased costs associated with the operation of a larger number of retail stores. $1.5 million of the increase was due to higher legal and professional fees and $1.2 million was due to fixed asset impairment charges related to under-performing retail stores. These increases were offset by an overall reduction in miscellaneous G&A expenses of approximately $1 million.

Selling expenses increased 3.4% to approximately $47.7 million, or 31.2% of net sales, up from 29.8% of net sales a year earlier. The increase in selling expenses was due to an increase in rent and occupancy expenses of $4.7 million, due to an increased number of retail stores in operation. This increase was partially offset by a reduction in advertising, trade show, and catalog expenses of approximately $3.4 million. The remainder of the increase was a result of small increases in payroll and benefit expenses offset by a decline in store pre-opening expenses.

Warehouse and distribution expenses fell 11.3% to $3.8 million from $4.3 million as a result of lower payroll compared to last year, because of a decrease in sales in our U.S. wholesale segment.

Operating income for the quarter was $11.2 million for an operating margin of 7.5%. Last year we reported operating income of $20 million for an operating margin of 12.9%.

Turning to our liquidity and capital resources, we ended the quarter with approximately $6.1 million in cash and approximately $23 million of availability on our $75 million revolving credit facility. At September 30th, we had drawn approximately $32.5 million on our revolving credit facilities, down from approximately $51 million at the end of Q2.

Total debt in the quarter decreased by $14.7 million to $104.6 million as compared to $119.3 million at the end of the second quarter. Our loan with [Kline] Capital stood at $64.7 million net of discount at the end of the quarter. As of 9/30, the company was in compliance with all of its loan covenants.

Currently for the fourth quarter, we are anticipating a limited amount of CapEx of approximately $5 million. In the third quarter, the company approached its lenders about raising its CapEx covenant for the remainder of the year to permit the company to take on additional store openings and make additional investments in equipment and information technology but we were unfortunately unable to reach a workable solution with our lenders.

As for our 2009 earnings guidance, we remain comfortable with the range that we provided on our last earnings call in August with net sales for 2009 in the range of $540 million to $555 million, income from operations of approximately $25 million to $30 million, and net income of approximately negative $1 million to positive $4 million.

We intend to provide guidance for 2010 on our fourth quarter earnings call in March. One change that we anticipate making next year is that we will be reporting our comparable store sales on a quarterly basis at the same time that we report earnings instead of on a monthly basis.

Finally, despite the difficult environment, we believe that we have been able to make important progress in a number of different areas in our business. When we started out the year, we indicated that we were oriented towards running the business to generate cash flow and we believe that the results of the third quarter demonstrate our success in doing that. As we’ve been making a number of investments into the business over the past year, we believe that American Apparel will be well positioned for growth and enhance profitability moving forward.

At this time, I would like to conclude my remarks and open the line to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is coming from the line of Edward Yruma with Keybanc.

Edward Yruma – Keybanc Capital Markets

Sorry if I missed this earlier but could you discuss the tax rate and how we should think about the tax rate going forward? I noticed it was a bit higher year over year and sequentially.

Adrian Kowalewski

Our effective tax rate is very volatile with where our pretax income is because we have such a large decline year over year, because we are deleveraging in our operating business so because we have so many permanent items as part of our tax provision, swings quarter to quarter in earnings will significantly move the tax rate around. So for the -- if you are looking at the third quarter, the effective tax rate was in the range of about 44%. That’s up from the prior quarters. The tax rate primarily differs from the statutory rate primarily due to changes in foreign, federal, and state tax estimates, you know, [permanent] differences between [inaudible] tax and we also remeasured some of our state deferred income tax assets.

Edward Yruma – Keybanc Capital Markets

Great, and then how should we also think about your ability to deleverage in the fourth quarter? And I know that your covenants, you are looking a little bit tight for the fourth quarter. What is your interest or ability to negotiate some type of consent for the fourth quarter or some type of less restrictive covenant?

Adrian Kowalewski

I think it would be beneficial for all parties to have more headroom on the covenants, so that’s definitely something that is of interest to the company but I think from the standpoint of shareholders, we’d have to weigh what the cost of that kind of relief would be versus what the benefit of the relief would be.

Edward Yruma – Keybanc Capital Markets

And what should we think about for the targeted level of debt at the end of the fourth quarter? I mean, what is your ability to delever in that quarter?

Adrian Kowalewski

Well, in fourth quarter you have a few of our -- some of our strongest retail months in October and in December, so even though wholesale starts to peter off a bit, I think with the way we have been running our capital expenditures and with our inventory, there is definitely room to drive more cash flow and to pay down debt in the fourth quarter.

Edward Yruma – Keybanc Capital Markets

Great, and my final question, can you help us quantify the impact of the 1500 departures in your manufacturing facility? How is the performance of your existing facility now with new workers and have you been able to replace the ones that you have lost? Thank you.

Adrian Kowalewski

I think what we said back in July when we had this issue was we didn’t think it was going to have a material impact to our financial results, and one of he reasons was because we had been operating with a higher number of workers than we would have needed under normal circumstances. So we do think some of the headcount has improved our overhead situation because we have more workers working [inaudible] work weeks and working more hours per week but as I mentioned in my remarks, some of the workers -- a lot of the workers that we lost were some of our most efficient people. I think if you look at on a year-over-year basis where we were last year where we were hiring up a lot of people, there was a lot of training costs that the company bore, so I think on a year-over-year basis the efficiency in labor is just probably pretty comparable.

Edward Yruma – Keybanc Capital Markets

Great. Thank you very much.

Operator

(Operator Instructions) Our next question is from Todd Slater with Lazard Capital Markets.

Todd Slater – Lazard Capital Markets

I have a series of questions regarding the inventory plans and the effect of producing inventory on the manufacturing variances on the gross margin, so I am going to throw a bunch of questions out and feel free to address them in any order.

It seems like one of the goals is improving cash flow and reducing debt and to that end, you made some progress. A related issue is optimizing inventory, it sounds like an increased turns now. So the inventory was down only about 1%. In your list of near-term goals, how would you rank the importance of the inventory optimization and streamlining? What inning are you in? What should we expect in this area as far as reducing inventory going forward? And then on manufacturing, what capacity is the facility at and what volume levels you guys need to sort of overcome these negative factory variances and when do you envision reaching that inflection point? Thanks.

Adrian Kowalewski

Just to correct you, inventory quarter over quarter was down about $6.6 million, so that’s a reduction of about 4.5%, so I think the reduction has been a little bit bigger than you were alluding to. Sorry, Todd, what was --

Todd Slater – Lazard Capital Markets

I was looking at year over year but okay, so down 4% -- so talk about where that should -- how that should progress over the next -- over the near term on a quarterly basis and then how important is this inventory optimization or the streamlining that you are trying to do, what inning are you in, how is that going to impact the manufacturing variances that we have seen, and what capacity is the factory at and when do we reach an inflection point where you are generating enough throughput so you actually get variances going in the other direction?

Adrian Kowalewski

Well, I think we are still early in the process of our inventory optimization because it’s only now that we are really starting to get the benefit out of the MRP, the material resource planning component of the ERP package, so that I think is going to make our production side a lot more efficient than it’s been in the past, so I think on that front we are pretty early.

But in terms of efforts to reduce -- I think there is some reduction in inventory that is going on because of destocking some SKUs at some of our retail stores, really having more of a targeted assortment so we are pushing more of the stuff that is selling and maybe destocking some of the product that isn’t selling and finding other channels to get it out through.

Dov, you may have --

Dov Charney

I agree with what Adrian said but also now that we have -- now that we kind of have a stability in the workforce at the factory level, we are starting -- you know, in July we knew we were going to have to lose some people. I think now that we are getting the factory kind of focused on what we need to make and who is going to be making it, organizing which teams are making what, we are trying to find some -- so the proper inventory levels for each SKU. We are starting to bring a lot of analysis to seasonality, volatility of each style, and trying to get to that sweet spot. So I think there is still a lot of progress that can be made. As Adrian indicated, we just -- we are new on the -- we are pretty new as far as having the improved ERP software and there is still more to be done there.

What inning do you want to give it, Adrian? The second inning or the third inning?

Adrian Kowalewski

Yeah, I mean -- with a lot of things, I think we are kind of like in the top of the second inning.

Dov Charney

Top of the second inning -- yeah, there’s a lot to be done with inventory at the factory level.

Adrian Kowalewski

And also, Todd, I think there’s a number of things that are somewhat out of our control because of the decrease in wholesale volumes that are going through so as we are adding capacity, production capacity in 2008, anticipating large increases because we are opening a large number of stores and we are seeing our comp up 20% and also we have wholesale up double-digits -- I mean, we added a [garment bag] facility, we added a new die house and added knitting and sewing capacity there. So part of the reason we have some utilization issues just because there is not enough volume going through and I think that is really going to be dependent on either having more stores put product through or seeing a rebound in the wholesale.

Dov Charney

Well, the [inaudible] is store productivity. You know, you have three things that are probably going to improve just naturally as a result of the economy -- one, we think wholesale -- well, we think we’ve turned the corner on wholesale. We think it’s going to continue to improve. Two, as you increase the sales per square foot or the productivity of each store, that’s going to ease the pain at the factory level and increase the utilization. And three, as we open new stores, of course we are very cautious right now about opening new stores. But over time, that caution may subside. So the more you flow through the factories, the better. There are some inefficiencies now because we have a lot of new workers. I don’t know if Adrian touched on it as well as I would have liked, so I’ll mention that -- that the average worker is probably at 80% of where they need to be, or 70%, and we think it could take 12 to 15 weeks to get the -- there’s some issues there.

But as we optimize all that, and you know, whereas Adrian said, we were in a position to scale back, we could be missing some kind of one [inaudible] operator or a team -- one operation we are looking for a [flat locks], a short [flat locks] operator. That could destabilize some of the -- but naturally as the economy improves, as we improve our ability to generate sales through each store, as wholesale improves, as we open a couple more stores that utilization is going to get better and better. I mean, we are probably positioned right now where we can handle the facilities we have and probably handle another 120 stores quite easily without much effort. So there’s a few -- you know, the future looks good as far [inaudible] raise the factory utilization is concerned and we think a lot of that will flow to the bottom line. Because I want to reiterate the long-term goal is to get the store, the operational margins at American Apparel into the mid to high teens, as I indicated many quarters ago. Those are the kinds of aspirational goals that we have here.

Todd Slater – Lazard Capital Markets

On a more simplistic level, are you planning to reduce inventory further on a year-over-year basis? Or do you even look at it that way? And can that be achieved if you are starting to see comps increase, you are opening a couple of stores, wholesale gets better -- I mean, is there a plan to improve inventory turnover? Is that one of your goals?

Dov Charney

Well, I think even if sales were to go up, we could potentially improve the efficiencies as far as how we manage inventory. A lot of it is about building the proper speculative models. A lot of it is about historical analysis, a lot of it is -- you know, it’s like trying to predict the stock market. Something -- we have guys that we call analysts, they are inventory analysts, something -- you know, I think a lot of improvements could be made, even if there is growth. Do you want to run with a popular SKU, do you need 1.3 months of inventory or do you need 0.8 months of inventory or is the right place to be at 1.5 or 1.6 months of inventory -- it depends on the time of year, it depends on the popularity of the SKUs, it depends -- you might want to do some color analysis, might want to bring a weather component into it. But as we improve our ability to kind of get our arms around the predictive models and the historical modeling and so forth, we think we can improve the overall, the efficiency as far as how we manage inventory, even if sales increase. And that is something that I am personally focused on as well as a few dozen other people here, so -- I hope I’ve answered your question.

Todd Slater – Lazard Capital Markets

Okay, and just lastly on the wholesale side, obviously it’s getting a little better. Where do you see an inflection there or how long do you think before you get to growth on the wholesale side again?

Dov Charney

I think we are well past the high noon as far as the problem is concerned. As far as I see it, we’ve turned the corner there and right now we are moving into the point where as last year, things started getting bad. I think the wholesale is very -- wholesale is connected to the economy in many ways because it is driven by the [inaudible] industry, it’s driven by the screen print industry, so we’ve definitely turned the corner. We see things improving now quite rapidly, even as -- I have the benefit of looking at the most recent numbers. I see things moving in the right direction.

So I think we are past -- we’ve turned the corner there but at some point, maybe mid next year we will be in a very good position, as we think our competitors will also be in a good position as well on the printable t-shirt -- in the printables business.

Todd Slater – Lazard Capital Markets

Great. Okay, well, all the best.

Operator

Thank you. There are no further questions at this time. I would now like to turn the floor back over to Mr. Dov Charney for closing comments.

Dov Charney

Well, I just want to thank everybody for coming on the call. I thank Adrian again for doing a fantastic job, along with the rest of the accounting and finance teams, as far as preparing for the call. We are very focused on store productivity and managing the stores we have and learning how to make them better and reach out to our customer in better and better ways and we appreciate everybody’s support. We appreciate also a lot of the efforts that are being made at the factory level. Marty has done a terrific job in the transition that we went through over the last number of months -- it was virtually seamless based on what -- you know, losing that -- the amount of workers that we lost and the amount of workers we had coming in here, so [inaudible] I think Marty and the production and factory team did a fantastic job and I am just proud of a lot of people that are connected to the company and we are looking at enlarging the management team as well and we are out there wanting to broaden our base in that respect and there’s more to come and I appreciate everybody’s support and [looking to make] people proud. So I wish everybody the best and we’ll see you in 90 days. Thank you very much.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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