For many retailers, the slow
economy
has made it hard to meet sales and
profit
targets. Formerly stellar retailers such as
Talbot's (NYSE:
TLB
)
,
Pacific Sunwear (Nasdaq:
PSUN
)
, and
Coldwater Creek (Nasdaq:
CWTR
)
have all seen their stock move below $3 as investors grow tired of
waiting for sales to rebound. Crucially, these companies have
decent balance sheets, so they will at least likely hang in there
until the economy picks up.
The same can't be said for
American Apparel (AMEX:
AAP
)
, a retailer known for its eccentric executive Dov Charney, who has
been the target of several sexual harassment lawsuits initiated by
former employees. Charney has repeatedly been criticized for paying
more attention to his image than his company. And with a seemingly
casual disregard for the health of his business, he's brought it to
the precipice of bankruptcy. In fact, there's a series of metrics
that will appear on the company's
balance sheet
in the next two quarters that may spell the end for this stock as
the company potentially declares bankruptcy.
.png)
Let's break down the balance sheet to see whether the company is
indeed on the cusp of a bankruptcy filing.
Inventory
Short sellers targeting retailers often go right to the
inventory
line on the balance sheet, as a growing pile of unsold merchandise
implies sales weakness. Though inventories fell modestly in the
most recent quarter, they are far higher than a few years ago. This
is acceptable if sales are rising at a commensurate rate as
retailers look to match stocking levels. But American Apparel's
sales rose only 2.5% in 2009, fell 4.6% in 2010 to $533 million,
and have been roughly flat in the first nine months of 2011
compared with the same period in 2010. Runaway inventory is just
one of the mark's of poor management oversight, and as I'll note in
a moment, the cause of significant shareholder
dilution
even if bankruptcy is avoided.
.png)
Short and
long-term debt
At the end of the third quarter of 2011, American Apparel had $57
million in the current portion of its long-term debt and $92
million in long-term debt. It's the $57 million figure you need to
focus on because these are obligations that need to be met within
the next 12 months. That's a considerable sum for a company with
just $8 million in cash. The company has already been flagged by
auditors with a dreaded "
going concern
" qualifier: "The current operating plan indicates that losses from
operations will be incurred for all of fiscal 2011. Consequently,
the company may not have sufficient liquidity necessary to sustain
operations for the next 12 months and this raises substantial doubt
that the company will be able to continue as a going concern."
Roughly $51 million of the $57 million is owed to
Bank of America (NYSE:
BAC
)
, which extended a credit line to American Apparel that will expire
next July. Back in April, BofA waived a requirement that any "going
concern" statement would automatically force American Apparel to
instantly pay off the credit line, but as the company notes, "There
can be no assurance in the future that the company will be able to
receive a waiver, if necessary, with respect to its fiscal 2011
audited
financial statements
."
Operating cash flowIn the first nine months of 2011, American
Apparel generated $10 million in negative operating
cash flow
. Many retailers count on the all-important holiday season to make
up for cash flow shortfalls earlier in the year, but it's worth
noting American Apparel generated a $5 million operating cash flow
loss in last year's December quarter. The company's lines of
apparel aren't usually bought as holiday gifts to the same extent
that many other retailers experience.
If American Apparel generated the same cash flow loss in the
current quarter, it would have less than $5 million in the bank by
the year's end. A repeat performance in the first quarter of 2012
would officially drain any remaining cash. Were it not for the fact
that American Apparel has already sold $22 million worth of stock
thus far in 2011, the company would already be in bankruptcy court.
(One sale of stock generated the issuance of 34 million warrants at
$0.90 a share. So if this stock ever moved back up above $0.90 for
a sustained period, then this would instantly dilute current
shareholders by more than 30%.)
Triggering covenants?
Here's where things get tricky. American Apparel maintains a much
smaller $4.65 million line of credit with the Bank of Montreal to
fund the company's Canadian operations. Although that bank also
waived the "going concern"
covenant
earlier this year, it still insists that the retailer maintain a
degree of financial health:
"The Bank of Montreal Credit Agreement contains a fixed charge
coverage ratio
, tested at the end of each month, which measures the ratio of
EBITDA
less cash, income taxes paid, dividends paid and unfinanced capital
expenditures divided by interest expense plus scheduled
principal
payments of long term debt, debt under capital leases, dividends,
and stockholder loans and advances, for the Company's Canadian
subsidiaries. The ratio must be not less than 1.25 to 1.00."
American Apparel adds that as of Sept. 30, it remains in compliance
with that covenant. Yet as operating cash flow is negative, it's
not clear how that measurement can be positive. Even after
accounting
for $1.4 million in taxes paid, EBITDA is about $8 million in the
red thus far in 2011. And this seemingly minor banking relationship
has major implications. If the Bank of Montreal calls in the credit
line, then Bank of America -- which really holds the purse
strings - has the right to also demand immediate
repayment
of the credit line, as it would likely want to control the
company's huge pile of inventory as a secured
asset
.
In an another ominous turn, acting president Tom Casey abruptly
resigned at the end of last week. Casey was brought in 13 months
ago to help impose more rigorous financial discipline on the
company. The inventory bulge noted earlier is a clear refelection
that his advice went unheeded.
Risks to Consider:
Further capital infusions can always keep the wolves at bay,
and an eventual rebound for the company could boost sales to the
point where these financial metrics turn positive. A high short
position could lead to a "
short squeeze
" that pushes the stock up significantly if that happens.
Action to Take -->
This is a
business model
that is booby-trapped with explosives. One false step and the
bankerscall in the chits. Short sellers, which hold a position
equivalent to 26 days worth of trading
volume
, likely expect that this stock will eventually move to zero. This
sounds like an increasing possibility, making the stock look like a
good short candidate, provided you monitor company news for any
possible positive developments that might derail the stock's march
to zero.
-- David Sterman
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.