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American Apparel Inc.’s white knight may turn out to be an albatross.

This story first appeared in the May 20, 2010 issue of WWD. Subscribe Today.

Shares of the Los Angeles-based retailer fell more than 40 percent Wednesday after it said it does not expect to be in compliance with a covenant covering debt to adjusted earnings before interest, taxes, depreciation and amortization under a credit agreement with Lion Capital as of June 30. The firm based the projection on “existing trends” and results for the first quarter ended March 31.

Preliminary results for the quarter were released Wednesday and showed an expanded operating loss of $17.6 million compared with a $3.9 million deficit in the comparable 2009 period. However, various financial and operating issues have delayed the filing of American Apparel’s first-quarter results with the Securities and Exchange Commission, and the NYSE Amex Exchange informed the company Tuesday that it runs the additional risk of being delisted.

London-based Lion provided American Apparel with $80 million in financing in March 2009, allowing it to pay off a $51 million loan from SOF Investment, an arm of computer tycoon Michael S. Dell’s MSD Investments.

American Apparel said it is working with the lender to amend the agreement, but could provide “no assurances” it would obtain appropriate amendments prior to the anticipated covenant default. Additionally, noncompliance with the facility would constitute “an event of default” under the retailer’s revolving credit facility in the U.S., imperiling its ability to borrow and making both facilities “immediately due and payable.”

In a worst-case scenario, “there can be no assurance…that the company would be able to obtain the additional sources of liquidity required to continue operations,” according to American Apparel.

Lion Capital declined to comment. Shares of American Apparel closed at $1.63, off $1.11, or 40.5 percent, and established a new 52-week low of $1.58 in intraday trading.

Having been through a fiscal crisis just a little more than a year ago, Dov Charney, the controversial founder and chief executive officer of American Apparel, said on a Wednesday morning conference call with analysts and investors, “Our company in the past has been through these issues before and it has never presented us with any particular difficulties in running our business.”

Lazard Capital Markets analyst Todd Slater, who rates the stock a “hold,” also expressed a degree of confidence in the ability of the firm to achieve a resolution of the new fiscal emergency.

“We expect that American Apparel will be able to work out a solution with Lion and obtain the necessary amendment, although this could cause further equity dilution,” he said.

Slater said this period “could prove the trough” for American Apparel, and advised investors to “remain on the sidelines.”

Based on preliminary results for the three months ended March 31, the company anticipates a 6.6 percent increase in revenues to $121.8 million from $114.3 million, but that lower margins likely will pressure its bottom line.

Wall Street is looking for a first-quarter net loss of 11 cents a share on sales of $110.8 million, according to Yahoo Finance.

The company said it was unable to provide finalized results because it is still reviewing certain items such as store impairment charges, inventory reserves and provisions for income taxes. The firm expects to file its quarterly form 10-Q by the end of the month. It has until June 16 to respond to the Amex inquiry as to how it will return to conform with listing requirements by Aug. 16.

During the quarter, the company said wholesale sales increased 21.6 percent to $34.2 million, while retail sales rose 1.5 percent to $79.1 million. Online sales grew 3.6 percent to $8.4 million, and total debt increased 9.6 percent to $91.4 million at March 31, from $83.4 million a year earlier.

The company, which posted comparable-store sales declines in the U.S., Canada and abroad of 3 percent, 15 percent and 16 percent, respectively, suffered from inventory and speed-to-market issues in the quarter, Charney said.

The firm did not have enough inventory, due in part to lacking a sufficient manufacturing staff. In September, American Apparel said it laid off 1,500 immigrant workers because it was unable to prove to federal authorities they had the legal right to work in the U.S.

This negatively impacted gross margin, which declined to 50.4 percent of sales from 57.2 percent a year earlier.

The company said reduced manufacturing efficiency at production facilities is expected to continue through the end of the year, which could “impact the company’s financial results at least through early 2011.”

As a result, it deferred providing an outlook for 2010 due to “highly uncertain sales trends.”

Slater pointed out in his research note the retailer recently hired 500 factory employees but remains about 500 short of necessary levels to staff wholesale and retail positions.

While the company is addressing the worker issue with new hires, Charney added American Apparel also must become more efficient in delivering merchandise.

“We got blindsided. We made some mistakes. We are off our game, but we’re going to get back on our game,” he said.