This post should be complemented by all the research we have performed on the company since April 2011.
Back in 2011 when we first started writing about American Apparel ($APP), the stock was trading just below $1. The company had just received rescue financing of $15mm to avoid bankruptcy. The company could not re-negotiate its debt agreements, sales were stagnant, and the situation was highly distressed. We believed that the chance for the company to refinance was high because we thought sales were about to start expanding and there were enough inefficiencies in the operations for meaningful EBITDA improvements even without major sales growth. We also expected the company to reduce inventory decreasing the amount of working capital needed. At the time we hypothesized that over a 2 to 4 years period these improvements could allow them to pay down a good chunk of their debt, reducing interest expense substantially.
In addition, we saw the potential of EBITDA margin expanding to a 15 to 20% boundary condition (Source: Charney TV interviews) as it benefits from harvesting its lighter capital sales channels and with sales increasing to $800 million or higher, it allows the company to leverage its fixed cost asset (manufacturing) on a larger number of units.
In 2012 sales improved to $616mm and adjusted EBITDA reached $36.6mm for a 6% EBITDA Margin. In early 2013 the company refinanced its high cost debt. The stock took off and traded as high as $2.40.
The company implemented two important strategic initiatives in 2013:
- Elimination of the inventory room at the store level to increase sale space and reduce cost.
- Implementation of a new state of the art distribution center (DC) at LaMirada, Los Angeles to support its three business lines efficiently.
In addition, the company completed its roll-out of the RFID system and its implementation of the Oracle ATG Web Commerce Customer Service application for its e-commerce platform in 2013.
The implementation of these strategic initiatives has had a depressing effect on the 2013 baseline EBITDA forecast. At the end of Q2 2013, management's EBITDA forecast was reduced to $46 to $51mm from $47 to $54 million because of a $4.3mm cost impact from the transition to the new DC. We can't quantify the impact of the RFID implementation nor the backroom elimination. Therefore a normal adjusted EBITDA for 2013 baseline remains at $47 to $54 million on sales of $655mm for an EBITDA Margin of 7.8%.
In late 2013, the company was hit on two fronts. First, the distribution center going live proved to be harder than expected for the company. It just did not work as planned and as a result the company could not deliver merchandise to the stores on time. The result was lost sales and a negative delta impact of $13 million on EBITDA year-to-date 9/31/2013. The company cancelled its guidance for the rest of 2013 which stood at $46 million to $51 million as of Q2 2013.
In addition, the youth retail segment has been challenged recently which has dragged sales further down.
On December 13, the company filed a shelf for 50,000,000 common shares. To this date the company has not issued shares. On February 10, Sapna Maheswari published this interview of Charney that led us to lower our probability of a meaningful (>= $25 million) equity raise taking place.
On February 4, 2014 the stock plunged to $.85.
On February 20, some news outlets reported that some American Apparel's creditors hired legal counsel to represent them in a restructuring of the company. It was also reported that American Apparel hired Skadden, Arps, Slate, Meagher & Flom LLP to represent them in such negotiation.Charney denied that report, saying in an interview that Skadden has been the company's outside counsel for years and it's a "mischaracterization that they have been engaged as a restructuring firm." The firm is currently in a quiet period and it can't say more than this. Skadden has been American Apparel legal firm for a long time. The 2012 shareholder meeting was held at Skadden offices in New York city.
On this news the stock plummeted to $.55. At this level, the stock was currently trading at two time normalized EBITDA. The market is according a high probability that the company will seek bankruptcy soon. We believe that the maximum leverage ratio (Adjusted EBITDA as denominator) of the credit line covenant is problematic at the moment. The company will be reporting 4th quarter 2013 results within a few weeks. We are therefore in the dark as to what the numbers look like for basically a five month period. As of 9/30/13, the leverage ratio was between 5.75x and 6.0x, and it is likely it will shake out in that range for the quarter ended 12/31/13. Unless EBITDA grows significantly in the current quarter ending 3/31/14, the leverage trigger will be a problem at the end of this quarter but we believe the company will get a waiver.
Closing Date through March 31, 2013
7.35 to 1.00
April 1, 2013 through June 30, 2013
6.50 to 1.00
July 1, 2013 through September 30, 2013
6.25 to 1.00
October 1, 2013 through December 31, 2013
6.00 to 1.00
January 1, 2014 through March 31, 2014
5.75 to 1.00
April 1, 2014 through June 30, 2014
5.50 to 1.00
July 1, 2014 through December 31, 2014
5.25 to 1.00
January 1, 2015 through March 31, 2015
5.00 to 1.00
April 1, 2015 through June 30, 2015
4.75 to 1.00
July 1, 2015 and thereafter
4.50 to 1.00
The bond's covenant calls for no more than 4.5x leverage (debt - cash) / EBITDA. We believe the company failed to meet the covenant as of 12/31/13, the interest increased by 2% PIK. It goes without saying that there is much upside to reduce this burden once the business stabilizes.
Putting aside the credit issue for a moment…
American Apparel major strategic initiatives, which were highly disruptive in 2013, have been completed. While the operational risks still exist, we think a lot of the challenges of these integrations are now behind the company, yet the benefits of these initiatives and the reduced operational risk are not reflected in the current stock price. So if you look beyond the fog and include the benefits of these initiatives into your assessment of the business, the thesis becomes much more compelling now than it was in April 2011.
Here is why in detail:
- Despite the fulfillment issues, 2013 total sales increased 3% to $634 million and the company also stated that the negative impact of the distribution center issues should not affect 2014 results.
- Although integration of the new center did not go as smoothly as management forecasted, the new facility is now in place and should allow the company to reduce inventory while leveraging more effectively the advantage of local manufacturing and vertical integration. We believe it should save the company about $5 million in cost a year.
- The cost savings from the backroom elimination in the stores are estimated to be $10 million in 2014. (based on our assumption: Elimination of two employees per store, $20m per employee on a 250 store count basis)
- The savings from the new RFID system is expected to be $1 to $2 million.
- These efforts will result in about $13 to $17 million (conservative estimate) in annual EBITDA improvement starting in sometime in 2014 over the 2013 forecast baseline.
Our baseline 2014 EBITDA Forecast stands at $57 million to $71 million for an EBITDA margin of 8.9%. Annual Interest Expense should come in at around $36 Million in cash. We believe Capex will come in at $17 million. This forecast assumes little sales growth over initial 2013 sales forecast and no benefit from increased sales resulting from the additional selling space at the store level.
How will American Apparel look in 2014 and beyond?
During this interview Dov Charney admits that the company is in a retrenching mode after experiencing the issues in 2013. Charney plans on polishing and fine tuning its operations in 2014. He does not expect as much growth for the next 1 to 2 years. We appreciate the fact that Charney admitted that he is his worst own enemy. We welcome the candor and we are convinced Charney remains a manic about engineering a differentiated apparel business model that will carry this brand forward for years to come. Most of the pieces are coming together.
Here we are in 2014 with American Apparel stock trading at $0.70 - basically a level 30% lower than our cost basis which we have accumulated since April 2011. But so much has been accomplished by the company in these last 2 years. If the company can manage its debt issue, we believe management would be in a great position to focus on fine tuning the model, connecting with its customers, experimenting and paying down debt.
Assuming a fully diluted share count of 160 million, the company could generate 38 cents of EBITDA per share in 2014. The stock is currently trading at 2 times this level. We believe this stock could trade at up to 10 times (boundary condition) this level in two to 3 years as investors gain conviction that the worst is over for the company. A while back I wrote a blog post about distressed apparel companies. In that post, I observed that when a recovery is realized, top brand apparel companies can trade up to 10x to 15x EBITDA.
We believe American Apparel is a top of the mind brand in its youth target market. This video provides a clue as to why we believe so.
During Sapna Maheshwari interview of Charney, he said:
Our 247 stores could be 20% more productive with the right tweaks, the online business could double, wholesale could grow by 20% to 30%. We could even develop a $100 million third-party retail business, selling items like American Apparel nail polish at drugstores or having hooded sweatshirt blowout sales at Costco.
Using this delta over the 2013 sales baseline, American Apparel could generate between $800 million to $900 million in sales in 2017.
At $800mm in sales and EBITDA margins reaching 15% to 20%, we could see the stock price reach $7.
We think that if the company raises a token amount under the shelf to help it through the seasonally slower first half of 2014, the fog will lift rapidly and investors will start focusing on the bright future ahead.
We also believe that given all the cash management can squeeze out of operation, the company will get a waiver on its credit line if it needs to.
Many thanks to my friends who have provided feedback on this post.
Additional disclosure: Bigger Capital, LLC, Bigger Capital Fund, LP, Bachelier, LLC and the Bigger family own more than 1 million shares in American Apparel. We intend to increase our position opportunistically.American Apparel is a highly distressed situation and it is not suitable for the majority of investors. The likely outcome of an investment is a loss of principal. In other words, the probability of losing all your investment in this situation is very high. We have been purchasing American Apparel since May of 2011 and we have nothing to show for it. Take our opinions with a grain of salt and do your homework.