American Apparel Heating up?

We are analyzing a special situation with American Apparel ($APP). As background, $APP secured rescue capital from Michael Serruya and Delavaco Capital on April 26 to help APP avoid filing for bankruptcy. The company was able to re-negotiate the terms of their debt to avoid default provisions triggered when 2010 financial statements contained a “going concern” clause. As part of the agreement with Delavaco Capital, APP CEO Dov Charney has anti-dillution provisions whereby he can purchase additional shares if the stock price meets certain targets ranging from $3.25 and $5.25 beginning in 2013 (see below). At that time we initiated a small long position in the stock, and we have been monitoring the situation ever since. On July 1 APP announced plans to replace 2 of their directors. At that time we added to our position.

On August 8 $APP reported earnings for the quarter ended June. EPS was $0.00, which represents an improvement over both the June 2010 quarter and over expectations. The earnings report confirmed the positive sales numbers released on July. Sales for the quarter were flat relative to last year’s June quarter, $132mm. US retail sales were down, offset by an increase in international sales. In the commentary management tells us that the trend is positive, with comparable store sales increase of 3% in June and 4% in July. Margins increased to 54.5% relative to 51.6% in the prior year quarter. International growth and margin improvement show us that the company’s turnaround strategy is starting to work.

We think APP offers a good risk/reward profile, with high risk but higher reward potential. Trend in both sales and margins are starting to turn positive. Here are the main points:

● Serruya and Delavaco Capital bought 15.8mm shares at $0.90 per share in April. In July they bought another 8.4mm shares. They have the option to buy another 19mm shares at $0.90 before October 26, 2011.

● As part of the terms of the investment, CEO Dov Charney of the company has an anti-dilution provision. If APP reaches stock price performance goals of $3.25 by 2013, $4.25 by 2014, and $5.25 by 2015, the CEO receives a total of 39.7mm additional shares.

● Total debt is well-collateralized:

Long-Term Debt as of June 2011: Total $141mm
Revolving Credit Facility at Bank of America, $75mm, $56.5mm is drawn, due July 2012
Term Loan at Lion, $84.2mm matures Dec 31, 2013

Assets as Collateral for Debt (as of June 2011): Total $294mm
Cash $6.9mm
Accounts Receivable $17.4mm
Inventory $193mm
Property and Equipment $77mm

● The company may now have enough time to return to profitability before cash runs out. The current rescue investment is for $22mm immediately plus an additional $18mm over the next 6 months at the discretion of the investor, for a total potential cash infusion of $40mm this year. Total cash usage for operating activities was $32mm in 2010, although it should be noted that in 2010 the company reduced inventory by $37mm (20%). For the six months ended June 2011, CFO was negative $8.5mm, better than the first half of 2010 in which CFO was negative $23.7mm.

Written by Jennifer Galperin. Follow me on Twitter and StockTwits.