American Apparel: Still Very Overpriced

| About: American Apparel, (APPCQ)


APP still has structural issues that prevent profitability.

Recent management infighting has caused significant issues with the stock.

Debt load and negative FCF will send APP into bankruptcy or a fire sale.

Avoid a long position in APP.

The ongoing saga of American Apparel (APP) has been an entertaining one to watch from the sidelines both as an investor and an interested observer. As we all know APP has subjected itself to some interesting events in the past year or so, not the least of which is the very public infighting that has been going on between former CEO Dov Charney and the board, which threw him out recently. In light of these recent events I'd like to take a look at my APP views from last year as articulated in "A Worthless Stock On Sale For $2" and see how my views played out and where we go from here.

To start, I think the title of my previous article says it all; at the time APP was hovering around $2 and after my analysis I concluded the stock was worthless. We'll go through the factors of why but to be clear, I still think this stock is worthless and that it has only completed half of its decline I forecast last year in moving from $2 to under $1 as I write this. APP is in serious trouble and its series of Hail Mary moves aren't going to fix any of its problems; we'll see why now.

The first thing I called out in my previous article as evidence APP's business model makes no sense is that the company's stores are spread very thinly across the globe. For a manufacturer/retailer of APP's size it is completely counterintuitive to spread yourself so thinly across such a huge geographical area as no scale can be gained. APP has managed to prove that in spades as operating margins are terrible in part due to supply chain costs of simply getting product from the factory to the stores. This has not changed since last July when I first profiled APP and it isn't going to change. This will hinder APP as long as it is a going concern and will continue to cost shareholders money. This is one way the business model remains structurally unprofitable.

Second, APP is a vertically integrated company, meaning it makes everything it sells and it does so in the US exclusively. This is great for a marketing message but from a business standpoint, the jeans would be the same if they were made in China or somewhere else, they'd just be a lot cheaper. This is the second area where APP is structurally unprofitable and this hasn't changed either. APP is committed to making its apparel in America and that's fine but with labor and occupancy costs so high in America compared to the developing world, operating margins will be depressed forever and that is exactly what we've seen. This is the second way APP is shooting itself in the foot with the poor design of its business model.

Third, in my previous article I profile in detail the amount of debt that APP has in relation to the insignificant amount of cash on its balance sheet. This situation also has not improved since last July as APP has more than $250 million of debt, and at very high interest rates, for a company that lost $106 million last year, pays ~$40 million per year in interest expense alone and has less than $20 million in cash on the balance sheet. This is the central tenet to my "worthless stock" thesis as the math simply doesn't work out for APP.

For a company that has SG&A expenses that are greater than gross profit every year, taking on any debt means it will likely never be paid off. Consider what I just said; APP's gross margin dollars can't even cover the costs of making and selling product irrespective of debt servicing, taxes or anything else that the business consumes. This is a joke; no business can continue to operate this way forever but that is exactly what APP is trying to do. Gross profit doesn't even cover basic operating expenses and yet we are led to believe from bulls (see here and here) that the company is in a turnaround and that profits are on the way. The amount of margin increases that would be needed for APP to just break even are astronomical and impossible to attain. As I pointed out last July and again in this article, APP is structurally unprofitable and always will be unless drastic changes are made. However, given the fact that the board of directors is a circus sideshow to this disaster of a company, I'd say that's unlikely.

Let's say that APP magically finds a way to sell 100% more product than it does now; it is still on the hook for $40+ million annually in interest expense alone. At $630 million in annual revenue and 50% margins it has to sell product for a month and a half just to cover interest costs exclusive of SG&A. Think about that; even if APP had zero SG&A expenditures it would have to commit six weeks' worth of gross profits every year simply to cover interest expense. This is the fantasy world that APP bulls live in and it's why they've lost substantial amounts of money over the past year being long this train wreck.

Finally, not only is APP chronically unprofitable but it produces negative free cash flow as well. We'd expect this for a terrible retailer like APP but there are some businesses, particularly depreciation-heavy companies that produce GAAP losses but still produce free cash flow; those companies can exist forever despite accounting losses because they are producing cash. APP, however, doesn't do anything right so its FCF is also negative. This poses a significant problem for debt servicing and this is why I maintain my call that APP will eventually be worth nothing unless it is sold to some unsuspecting sap that doesn't know any better.

APP has an unbelievable amount of debt and the reason is because the business burns through cash every single year and as such, APP needs outside money to keep the lights on. This condition will persist forever as the board is clueless and doesn't realize the business model is broken. As such, APP will have to find funding in two ways; either it will continue to take on 13%+ coupon debt that it cannot afford to even service, let alone pay down, or it will dilute shareholders by raising equity. Neither of these are good options but let's consider them as they are the only ways APP can remain in business.

APP can't service the debt it has now and it certainly can never pay any of it down so more debt will simply exacerbate this issue. I suspect this is the way APP will go when it runs out of money again, which it will, so expect that the company will crawl to a lender on its hands and knees and beg for funding at 20% interest or something. Either way, APP is unprofitable and doesn't produce any cash so the idea of actually paying down debt at some point is a fairy tale.

Other than that APP could raise equity again but who is buying this thing? Yes the stock looks "cheap" at 92 cents but what are you getting for 92 cents? A company that loses enormous sums of money every year, has a debt load that is suffocating it and will never be repaid and produces negative free cash flow, perpetuating the negative internal funding cycle that leads to more problems down the road. In other words, you're buying a worthless stock for that 92 cents.

I maintain my call from last year when APP was trading for $2 and I deemed it worthless. I still think the stock is worthless and any bull remaining out there is just delusional at this point. There is so much evidence that APP is unable to fund itself that you are kidding yourself if you believe the turnaround story that never materialized. APP will either be sold in a fire sale or it will go out of business. Either way, there is no value even at 92 cents so please stay away from this worthless stock. The story hasn't changed in the past year very much and if anything, it has gotten worse for APP. The company lost its founder and the share price has been cut in half. There is nothing to like here.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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