By  on April 1, 2010

After years of fast expansion, American Apparel Inc. is experiencing some serious adolescent growing pains.

Over the past year, financing issues and stumbles in overseas markets have forced the trendy California specialty retailer to halt retail expansion and curb investments in its existing stores and marketing, negatively impacting top-line growth and same-store sales. At the same time, production problems in its much-hyped domestic manufacturing facilities in Los Angeles have driven up costs and lowered its gross margins and profitability.

The company has retrenched and is focused on improving the productivity of existing stores and production lines, improving operational systems and using cash flow to pay down debt. American Apparel has also sought to beef up the management ranks with new talent in crucial areas like production and information systems.

“We are a young company and we haven’t worked out all the kinks. Right now we are in a period of rationalization, in a period of working with less and deploying our assets more productively,” said Dov Charney, founder and chief executive officer of American Apparel, in an interview with WWD. “That means reducing inventory, paying down debt and getting more sales out of the stores we have. We’re upgrading software, improving distribution methodology and updating our point of sale systems. If there weren’t any problems — then I’d be worried.”

There is no lack of issues for Charney to be concerned with. Chief among them is American Apparel’s overseas business, where same-store sales are down dramatically due to the weak economic situations in many international markets, including much of Europe and Japan.

“The company is bouncing around positive comps territory in the U.S., but Europe and the rest of its international business is in vastly negative territory,” said Mimi Bartow, a director at Telsey Advisory Group. “It’s all about boosting productivity in those stores and Dov needs to refocus on that.”

Worldwide, American Apparel’s same-store sales declined 10 percent last year after climbing 22 percent in 2008 and 29 percent in 2007. For the first three months of this year, American Apparel has forecast another 10 percent decline.

The company operates 282 stores, with about half in the U.S. and half in international markets. After opening 40 stores in the second half of 2008 and 21 stores in 2009, the company only has three units lined up to open this year.

U.S. comps over the past year have been negatively impacted by the cannibalization of sales by overlapping stores, the company admitted during its fourth-quarter earnings call last week.

“If you open too many stores that are close together, it takes about a year and a half to mitigate cannibalization. You’re driving sales growth before you drive positive comps,” said Bartow. “Their real estate strategy was not as disciplined as it should have been, but their newest stores are doing well and I think that speaks to a new discipline in making sure the locations are right, that they make economic sense and that the demographics can support the new stores.”

On the upside, Charney said stores in New York City, Miami, the mid-Atlantic region, the Southeast and Texas are all comping positive this year, an indicator of the improving economy, as well as better merchandising and planning strategies on the part of American Apparel.

Despite those upticks, some investors and analysts remain concerned about the company’s earnings prospects. The stock closed at $3.03 a share on Wednesday, down 5 cents. The stock is off its 52-week high of $6.97.

“The company is clearly moving toward financial independence by improving working capital and reducing debt, but the core fundamentals — comps, gross margins and selling, general and administrative trends — continue to deteriorate,” noted analyst Todd Slater of Lazard Capital Markets in a March 26 research note.

Slater has a “hold” rating on the stock and expects first-half earnings for the company to be “disappointing.” He has slashed his 2010 earnings per share projections to 8 cents from 30 cents.

Gross margin has been hit hard by the forced termination of 1,500 experienced manufacturing employees by the U.S. Immigrations and Customs Enforcement agency in the second half of 2009. The loss of those workers lowered productivity in the factory, driving up costs and lowering margins. The company has also been making more sophisticated product, noted Charney, which is harder to produce. American Apparel has new women’s blazers, men’s trousers and men’s golf shirts as key fashion items that will ship this spring, as well as a push with more skirts and hair bows, he added.

Bartow estimated that about 70 percent of American Apparel’s business is in basics and 30 percent in fashion product. “I think the product looks good, and it speaks to the Eighties trend that is still happening now, but like all retailers they need to constantly reinvent themselves — especially with the fashion component,” she noted.

The company’s current production issues aside, Charney believes American Apparel can eventually grow to 600 to 800 stores worldwide, which he believes would leverage the company’s domestic manufacturing abilities to greatest effect. “We have the space, and it would reduce our overhead costs exponentially. We could add a third shift during the week as well as a weekend shift. We have a surplus of industrial space now,” he explained.

Charney said stores down the road could include smaller kiosk units, airport stores and stores dedicated to certain categories such as men’s wear, swimwear or footwear. He expects the company to return to growth mode next year and envisions opening 25 to 30 stores in 2011.

“We think we have a good two- to four-year plan. China could add an enormous amount of stores, as could South America. In the U.S., there are opportunities in [secondary markets like] Albany and Syracuse,” said Charney.

Since a major refinancing of its debt in March 2009 with London-based Lion Capital, American Apparel has been under strict guidelines regarding capital expenditures and the amount of new debt or credit it can take on. “We’ve been running around in a 5-by-8 room. We were all hunched over,” said Charney of the credit restrictions, which he believes have hampered the company’s operations over the past few quarters.

Last year the company generated free cash flow from operations of $45.2 million and spent less than half of that, $20.9 million, on capital expenditures. The company has focused on paying off debt and since June it has reduced total debt by $36 million. American Apparel ended 2009 with total debt of $83.4 million, including $65.6 million owed to Lion Capital.

In recent weeks, however, Lion Capital has agreed to loosen some of the debt covenants so American Apparel can make new investments in store improvements. American Apparel’s total allowable debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio was increased to 2 (from 1.75) in the first quarter of 2010, and to 1.9 (from 1.65) in the second quarter. The changes will allow the company to access a larger amount of its $75 million credit facility with Bank of America. (For example, hypothetically, if trailing 12 months EBITDA is $75 million, American Apparel would be allowed access to $18.8 million more in credit with a 2 ratio than a 1.75 ratio.)

“It provides us with an enormous amount of room to work with — not that we are going to use it all. We are going to make strategic investments,” said Charney.

Those investments could include improved cash wrap systems, antitheft systems (shrinkage has been a major problem for the company), additional radio frequency identification inventory management systems, forecast and demand software, remodeled store layouts, improved lighting and even simple things like new mannequins.

“Why do stores buy mannequins — for fun? No, because they help sales,” said Charney of the rationale for boosting store spending to help drive productivity.

The company is also making investments in management talent. Recent hires include an information technology manager with expertise in Retail Pro, a point of sale and store operations system, and a production engineer with almost 30 years of experience in bathing suits to help oversee a bigger push into that category.

For the three months ended Dec. 31, net income at American Apparel was $3 million, or 4 cents a diluted share, down 21.5 percent from $3.9 million, or 5 cents, in the year-ago quarter. Total sales grew 8.6 percent to $158.1 million from $145.6 million last year.

For the full year, net income contracted 92.1 percent to $1.1 million, or 1 cent a diluted share, from $14.1 million, or 20 cents, in 2008. Total sales were up 2.5 percent, to $558.8 million from $545.1 million.

“I think the brand is healthy,” said Telsey Advisory Group’s Bartow. “Operationally, I think there is room for improvement and the real estate strategy needs to be worked on, but I think those are the things management is focused on.”

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