American Apparel: A Growth Opportunity On Sale for $2
- Posted by Michael Bigger
- on July 22nd, 2013
Last Friday Seeking Alpha put out an article by Josh Arnold about American Apparel ($APP) saying it is “A Worthless Stock on Sale for $2.” American Apparel is a distressed situation but worthless? We think some of the points Josh makes are oversimplified and miss some of the key competitive advantages $APP has with its customers and its supply chain.
Josh argues that the company’s array of stores is too vast, with stores in over 20 countries. The majority of APP’s sales come from the US and Canada (about 70% if you include wholesale). By expanding overseas the company is simply responding to demand from customers located in major centers, particularly in Asia where the unique look and feel of the brand is valued very highly. In fact, customers ARE willing to pay a premium for the products both domestically and overseas.
Josh also makes the point that there is cost to manufacturing in the US and in particular in Los Angeles. We agree that labor costs are higher in Los Angeles relative to, for example, Bangladesh. In Josh’s simple example of a single pair of jeans, yes, in a perfect world if you can pay your workers $2/day your gross margins will be higher. However, you still have to work with an overseas manufacturer, ship the finished goods to the US, and pay import taxes. These intermediate steps can be very costly.
American Apparel’s unique business model has several advantages relative to other retailers. First, by vertically integrating, $APP owns the manufacturing and can control run sizes and lead times much more effectively relative to it’s competitors. Retailers who outsource manufacturing overseas can end up with large inventory in unpopular products that have to be sold at incredibly low margins (or even written off). APP does not have to manufacture in such large quantities because it owns and controls the manufacturing. Management can quickly change the manufacturing towards the most popular products. With the new distribution center, time from manufacturing to sale will decrease even more, allowing $APP to capitalize on it’s unique business model. $APP can create a new style on Monday and have it on its retail shelves on Friday.
Finally, to the point about capitalization. Josh argues that the company is overly leveraged, and he is right. The company just refinanced about $200mm of debt at 13% interest. The fact that they were able to refinance the debt at all speaks to the confidence the lenders have in APP as a going concern. To be sure, a lower interest rate is preferred and the company will seek to reduce interest rates when it becomes feasible. And Josh uses the first quarter to illustrate how high expenses were relative to revenues. The first quarter tends to be the slowest quarter for retail, and if you look at the full year 2012 the company achieved positive operating profits. But how do they turn operating profits into net income? They need to continue to grow revenues in order to leverage their fixed cost manufacturing capacity. $APP’s capacity is about $900 million right now and they are operating at a $700 million run rate. At full capacity, we expect EBITDA margin to reach 15% and if everything goes well it could reach up to 20%. The trick here is to grow revenues to $900 million in order to generate the cash need in order to repay the debt.
2012 revenues grew 13% over 2011 revenues, and 2013 growth numbers were 5% for the March quarter and 9% for the June quarter. So growth is happening. Can APP grow revenues enough to cover the interest expense? We agree that it is not a slam dunk. If it was a sure bet the stock would not trade at $2. But in due time we think APP will recover because of the strength of the brand and the loyalty of the customers. We think $APP will be cash flow positive this year. In addition, we expect the company to start opening 20 to 25 stores a year starting in 2014. That will help sales growth push towards 15% per annum. Revenues should reach $900 million in 2016.
Also, the new distribution center will help the company reduce inventory by $40 million from 2012 year end level. Most of this gain will be realized in 2013.
Who do you think will be right on American Apparel?
Disclaimer: We are long $APP. $APP is highly distressed and is very risky and it is not suitable for the majority of investors. There is a high likelihood of losing your entire investment in this situation.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.blog comments powered by Disqus
Michael Bigger is an investor and a trader who has been involved with trading technologies for more than twenty years. In 1992, Michael joined Citibank as head trader of U.S. single-stock derivatives, where he managed a $5 billion portfolio of equity derivatives. In 1998, he joined D.E. Shaw & Co., L.P. to trade the U.S. equity derivatives portfolio. (More)