American Apparel +21% Gave Us the Green Light

American Apparel just reported fantastic sales numbers for the quarter ended March 31.  Total sales were up 14% Q/Q and comparable store sales for March were up +21% and 15% for the quarter.  They reiterated EBITDA guidance for 2012, with a commitment to reducing high-cost debt within 12 months.  This affirms our view that the probability a favorable outcome here is high.  

The company provided EBITDA guidance in March for $32mm to $40mm based on a very small sales growth (less than 1%).  Given the first quarter growth of 15%, we think this number is extremely conservative.  

If the company successfully cuts SG&A costs to $300mm, which is a 4.5% reduction from 2011's costs, the numbers speak for themselves.  Here is a scenario analysis for our estimate of EBITDA based on different levels of sales growth:

Sales Growth (% Y/Y) -> Our Estimated 2012 EBITDA

5% -> $35mm

10%-> $50mm

15%-> $60mm

As you can see, with sales growth strong there is significant cash available for debt reduction.  Inventory reductions to generate cash are icing on the debt reducing cake in this scenario. We believe the company will reduce inventory by $40mm in 2012.

On April 2012, the Board awarded 7,500,000 shares to Dov Charney, CEO of the company, vesting over the next three years as long as the company meets or exceeds the following annual EBITDA targets (one third of the award vesting annually):

2012: If EBITDA is greater than $32,253,000 he gets 2.5mm shares

2013: If EBITDA is greater than $53,251,000 he gets 2.5mm shares

2014: If EBITDA is greater than $68,212,000 he gets 2.5mm shares

Charney also owns 22.5mm warrants struck at increasing levels starting with the first struck at $3.50 maturing in March of 2014. There is a big incentive for the CEO to do everything in his power to achieve the EBITDA targets and to move the stock to above $3.50.

Charney discusses APP's business model in this video. He believes there is about $100mm to $140mm of EBITDA capacity in the current business without adding new stores.  

But.....

There are a few hurdles to overcome here.  First, if sales growth is slower than forecast, debt reduction will be slowed significantly.  With the current high-interest debt burden, it will be difficult for APP to achieve profitability.  Second, in order to secure financing over the last 3 years, the company has issued 21.6mm warrants to a creditor, Lion Capital, with a strike price of $1.00 expiring 2/18/2022.  These warrants are subject to a $0.25 strike price reduction if the company fails to meet aggressive EBITDA targets, the first of which is $37.5mm for the 12 months ending March 31, 2012.  EBITDA for 2011 was $20mm.  Based on that it is likely Lion will have 21.6mm warrants struck at $0.75.  This represents 20% of the 105.5mm shares outstanding as of 12/31/2011.  

Overall, we reiterate our view that the situation here is binary.  Either the company is able to generate a sustainable profit, in which case it is worth several dollars per share, or it declares bankruptcy and is worthless.  After monitoring the company for more than one year, we have determined for ourselves that APP is a good risk/reward tradeoff at the current price, and we think the Q1 sales numbers give us more conviction that the outcome will be favorable. We increased our long position significantly last week after the March sales were reported.

Written by:

Jennifer Galperin. Follow me on Twitter and StockTwits.

Michael Bigger. Follow me on Twitter and StockTwits.