|Shares Out. (in M):||110||P/E||0.0x||0.0x|
|Market Cap (in $M):||107||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||245||EBIT||0||0|
APP is a retail apparel company offering fashion basics (i.e. mostly replenishment items) that is undergoing a turnaround and has immaterial mall exposure. A string of unusual adverse events depressed margins but recent numbers indicate reversion to profitability is underway and the top-line is experiencing impressive resilience compared to other teen apparel companies.
Over the next few years I think American Apparel could trade for multiples of the current stock price of less than $1/share. My ranges for intrinsic value are roughly $2/share to $3.50/share depending on whether you look at 2014 numbers or 2015 numbers. My targets incorporate a ~$100mm NOL, which nearly eclipses the market cap, and are adj. for dilution from warrants that are currently antidilutive. These targets rely on 7-8x EBITDA multiples based on normalized EBITDA margins of 10-12% and do not require meaningful growth in the store count or SSS, both of which I’d expect to trend up (SSS growth beginning in 2Q14 and meaningful store growth beginning in 2015).
There is significant leverage, which explains the large gap between my target prices, but my method for getting there is simple and despite the unusually large upside, I think these estimates of intrinsic value are surprisingly reasonable and this is why...
In 2014 and 2015 APP is going to lap unusual costs that polluted the 2013 P&L and they should realize savings and incremental earnings from initiatives they’ve already completed. I estimate these figures combined amount to $18 to $27mm in incremental EBITDA compared to 2013 annual guidance of $46 to $51mm given in 2Q13, and together this implies normalized earnings power of 10-12% EBITDA margins.
Importantly, and I believe this is why the opportunity exists, while some of these benefits can be identified through a careful analysis of press-releases and company filings, significant chunks of potential incremental earnings are not quantified by the company in press releases, filings, or transcripts (they don’t hold earnings calls) so they are not readily apparent to an analyst looking at the name. I don’t contend I’m smarter than the average bear, I just think this opportunity is very easy to miss upon casual, even borderline thorough inspection. Add in the fact American Apparel is essentially a leper stock, abandoned by most of the analyst community due to size, past strategic blunders, and a history of bizarre behavior by CEO, Dov Charney, and there are likely relatively few eyeballs on the name.
APP sells fashion basics and doesn’t do logo wear like AEO, ANF, and ARO. They manufacture nearly all of their own merchandise in Los Angeles, CA, and are currently running at ~60-70% of capacity. The customer mix is 60/40 female/male and the target age is 13-35 year olds. They have roughly 250 stores (over 40% are abroad), immaterial mall exposure, and also operate an e-commerce business and a wholesale arm. Wholesale revenue is primarily driven by North America but they are expanding internationally. 2012 total revenue was $617mm with a retail, wholesale, and e-comm revenue split of $389 (63% of sales), $173 (28%), and $55mm (9%), respectively ($634mm in 2013 but 10K isn’t out yet). Nearly 40% of revenue is from outside the U.S. By category, retail, wholesale, and e-comm categories saw revenue expand by 11%, 12%, and 28%, yoy, respectively, for total revenue growth of 13% in 2012 (up 3% yoy in 2013). Now to the earnings power…
The Polluted P&L & Hidden Earnings Potential
APP moved their distribution operation to a new facility in 2013 and stumbled mightily in the process. The issues were one-time in nature and are behind them now but even prior to the cost overruns encountered during the transition, the 1H13 P&L included a host of initiatives that disguised the underlying earnings power of the business. In addition, the company was undergoing changes that should result in meaningful savings and incremental earnings in future years, and these were not, and are not, being accounted for by the analyst community, at least the analysts I have spoken to (only two sell-side firms cover, Roth and Brean). Specifically, these items include an RFID roll-out and incremental selling space from shrinking the size of back-stock rooms.
In 2013 APP completed the roll-out of RFID in all of their stores. RFID carries many benefits, two of which are a reduced need for excess inventory and the savings associated with reducing the amount of merchandise each store maintains. Other benefits include improved shrink management and impressive incremental sales from optimized inventory management. To learn more about this you can Google search RFID journal or read investor presentations by CKP and white papers available on the web.
Another benefit, one related to RFID, is APP was able to reduce the size of the inventory rooms at each store location. This effort was completed in 2013 and it added incremental selling square footage of roughly 25k square feet. The consequence of this was twofold: (i) instead of paying 2-4 employees to run the back-stock room at a store location, they now only need 1-2 employees, and (ii) incremental selling square footage will boost revenue/store and make stores more productive.
Add these to items the company has quantified and there is substantial hidden earnings potential and again, it’s important to note not all of these items are easy to quantify, but after a lot of research and many conversations with CFO, John Luttrell, I think earnings are setup to meaningfully increase.
In the 2Q13 earnings release the company issued the following guidance for 2013. I reference this guidance because it excludes the one-time costs realized in the 2H of 2013 associated with the mishaps encountered during the transition to a new DC.
This EBITDA guidance of $46 to $51mm was not representative of the actual earnings power because the following unusual items were running through the P&L.
Total: $6.3mm to $7.3mm drag on EBITDA
Note: items where the source is “research, item not specifically quantified by company” are items I’ve estimated and items that I believe are not readily apparent to the analyst community. These items are my own bracketed estimates based on conversations with management, industry experts, and other general research. These are the items I think the street is missing because they are not readily apparent and must be identified by doing some digging (for example, talking to companies like CKP about RFID and reading the industry work on average ROIs associated with RFID roll-outs).
In addition to these items, APP expected savings and incremental earnings from these and other initiatives. These included the following…
Total: potential $11.25 to $18.5mm of additional EBITDA
Adding the unusual expenses APP will lap in 2014 and the potential savings leads to incremental EBITDA of $17.6mm to $25.8mm. Importantly, $10mm to $17mm of this is not easy to identify and I think the street is missing it.
Adding the total incremental earnings power of roughly $18mm to $26mm to the initial annual guidance given on the 2Q13 call implies normalized EBITDA of $64mm to $77mm and earnings power margins of 9.8% to 11.6%. This is substantially higher than current low to mid-single digit margins. Applying these margins to forward revenue estimates and putting a reasonable 7-8x EBITDA multiple on earnings leads me to my target prices of 2-3x the current stock price. Here is the math:
Valuation Note: reasonably priced growing retailers are scarce to find right now. A retailer like Buckle, forecasted to grow a mere 2-3% in coming years is trading for 7x 2014 EBITDA and almost half their business is purely denim. APP is on track to grow top-line at mid-to-high single digit rates in the coming years. Ross Stores, Urban Outfitters, and L Brands, are some of the only other reasonably priced retailers expected to grow at a similar rate and they all trade for 9-10x EBITDA. Even applying a discount to APP for their high level of leverage leads to target prices well above the current trading price. Considering APP’s resilient SSS and growth potential, I don’t believe it’s reasonable to assign the company a mid-single digit multiple of 4-6x EBITDA, a multiple in-line with struggling brands like AEO and ANF.
A reasonable argument can be made my valuation above is too aggressive because it’s based on earnings power, and if the wider analyst community doesn’t appreciate the potential then logic would indicate the stock will not trade off of this potential. I understand this argument, but I would argue that just because the potential isn’t being recognized by others, it does not mean it doesn’t exist, so I don’t believe it’s unreasonable to assess the valuation according to an earnings power based analysis. Furthermore, my EBITDA estimates above are based on revenue figures that I think could prove to be conservative.
2014 and 2015 Revenue
A snapshot of APPs revenue history by category follows (see table below). The company will indicate they are comfortable with forward expectations of 5% top-line growth at Wholesale and Retail, and 12-15% for the E-commerce business. To estimate EBITDA I handicapped e-comm to 10% yoy growth to be conservative but using the other guideposts we wind up with 5.5% total top-line growth in 2014 and 2015, or $35mm in incremental revenue in 2014 and $37mm in incremental revenue in 2015.
I think APP’s history suggests these are easy to beat bogies and I think the recent stock performance has motivated management to refrain from offering any commentary they can’t beat. Here is the history of revenue by segment going back to 2008 (2013 figures are my estimates)…
In the 4Q12 earnings press release management laid out a three to five year strategic plan to achieve an EBITDA margin of 15% and it included the following items.
Goal #1: Open 60-70 new stores in the next five years, expand accessories from 2% of sales to 15% of sales, substantially eliminate back-stock to increase selling-square footage and reduce employee count. Let’s go through these items individually…
Goal #1 Takeaway: 5% growth indicates an additional $20mm in retail store revenue. My math suggests they could blow through this level and perhaps double it in a good year.
Goal #2: Grow E-commerce to at least 17% of sales (in a September presentation they quoted a goal of $100mm of sales vs. $55mm achieved in 2012).
Goal #2 Takeaway: My EBITDA figures are based on the revenue levels in the previous table, which assume 10% growth, or roughly $6mm/year in 2014 and 2015. They could end up reporting $9 and $11mm instead.
Goal #3: Grow the Wholesale business a minimum of 25% by offering a wholesale online store, expanding the assortment of product, and increasing the reach of the sales force.
Goal #3 Takeaway: My figures assume 5% wholesale revenue growth per year but they could achieve 8% which would take nominal revenue growth from $9mm in 2014 and $10mm in 2015 to $14mm in 2014 and $15mm in 2015.
Main Takeaway on Revenue Potential: Add this all up and we could see revenue as high as $765mm by 2015. Apply this revenue against what I estimate normalized EBITDA margins to be, i.e. 10-12%, and we have potential EBITDA of $77-$92mm in 2015. This is roughly double the 2013 annual guidance given in the 2Q13 earnings release and is far above analyst estimates (but not completely unreasonable).
The real question becomes what is the right multiple, and while arguing for multiple expansion can be a dangerous investing strategy, I think there is ample evidence to suggest APP has a strong brand and should continue to grow. As APP continues to grow, I think the stock will indeed re-rate to a more reasonable level; if not, I expect they will pay down debt, expand the cash balance, and the multiple will just continue to compress until the spring is too coiled for investors to ignore it.
Justifying 7-8x EBITDA
APP has posted impressive comps relative to peers, the stores are increasingly more productive, and there success is despite a history of near perpetual negative headlines regarding the company and its founder and CEO, Dov Charney (more details at the end).
To get a sense of brand strength I put together a comparison of brick-and-mortar SSS data by combing through the filings of a number of retailers and backing out the contribution of e-commerce sales for each period. I think the results demonstrate the perhaps well-known shift taking place in the apparel industry, a shift away from the legacy brand leaders. I had to comb through each company’s filings because many of these companies recently started including e-commerce in their comps, (and E-comm figures have been up at double-digit rates in some cases) thereby boosting the metric and disguising the underlying weakness at brick-and-mortar stores.
The trends are easier to digest when 2006 is used as a base year, and in that case, you can see from the table below AEO, ARO, and ANF have experienced the greatest decay in store productivity; the worst being Abercrombie, where stores are half as productive as they were in 2006 (although this takes 2012 and applies 2013 SSS in sequential form, so not exact but you can get the picture). Notable is American Apparel stores are 50% more productive than they were in 2006.
What is apparent is the sustained deterioration at the legacy logo-wear companies and the relative strength of the rest of the group. These numbers would be worse if I was able to back-out e-comm figures from every data point, but not every company provides the disclosure each period. My takeaway is this: APP is doing pretty well. And more importantly, I think their success should continue. They have more selling square footage from opening up the back-stock rooms, they are introducing more high-margin accessories, e-commerce is growing like a weed, they could benefit from a men’s denim launch in 2014 or 2015, and they should also benefit from RFID and the new distribution center.
It’s difficult to find reasonably priced retailers posting similar results to APP. The companies that match these results include Urban, L Brands, and Ross Stores (other successful retailers are trading for astronomical prices) and as I mentioned earlier, they trade for 9-10x EBITDA. So apply a discount to APP for the leverage ($100mm market cap and $225 in adj. net debt), and perhaps a 7-8x multiple is fair.
Why Does the Opportunity Exist?
Potential multi-baggers with reasonable risk/rewards are exceedingly rare in my experience so this is a very fair question but I think there is a logical answer. APP has a disturbing history from an investment perspective. Reading from here on is optional to understanding my thesis but it provides context and I think understanding their history is helpful to understanding why the stock has been abandoned by many investors.
The short version is this: the company was woefully mismanaged, grew much too fast, didn’t have the infrastructure in place to efficiently scale or even maintain prudent records, and then the company collapsed under its own weight. They successfully avoided bankruptcy, the CEO, Dov Charney even made personal loans to keep them afloat, and PE group Lion Capital was instrumental in bringing on current CFO, John Luttrell, who in my experience seems supremely capable to execute their strategy and achieve their goals (long-term target of $1B in revenue and 15% EBITDA margins). If you are interested in the details, though, here they are…
The company produced peak adjusted EBITDA of $70mm (13% margin) in 2008 and then EBITDA collapsed, hitting $56mm in 2009 (10%) and negative $10mm in 2010. EBITDA began to recover in 2011 to $15mm (3% margin) and reached $37mm in 2012 (6% margin).
The collapse in EBITDA was due to several factors: (i) a labor disruption that forced them to fire 25% of their workforce at their sole manufacturing facility (turned out none of these folks were U.S. citizens), (ii) the economic downturn, (iii) a spike in raw material costs, and (iv) liquidity issues that forced them to raise expensive capital. Compounding all these problems was the fact that they had grown the chain of retail stores much too rapidly and they didn’t have the infrastructure or systems in place to sufficiently support their network and prudently track their business operations.
It really was a perfect storm of damaging events and the company survived but came out of it essentially as a reorg equity with a boatload of expensive debt and an unmanageable number of locations. It appears they have gotten religion, though. A Private Equity group, Lion Capital (owns 17% of common) was instrumental in putting a CFO with some pedigree in place, management has right-sized the retail footprint, optimized their inventory management (RFID initiative completed), optimized their distribution (moved to an automated facility), is in the process of optimizing the web experience (rolled out Oracle software across their large number of e-commerce sites which differ based on the region of the world), and is focusing on growing the wholesale business.
I think the company is a different animal today and it is certainly a much more mature operation (according to IR, only a few years ago they were tracking their operations by using Excel). But due to the historical issues and their unusual CEO, it’s essentially an orphaned stock. Only two analysts cover it (Roth and Brean, both have Buys on it) and I imagine those who were once familiar with it would be biased against revisiting it.
Detailed Background and Summary of History
SEC Issues & Management Turnover
Note: John, IR and the sell-side have indicated an opinion that some of these hires were weak. They were essentially people forced on the company as a result of the balance sheet issues. These hires didn’t “get” American Apparel or the customer and the relationships didn’t work well. John saw a ton of low hanging fruit, though, and was extremely impressed by Dov when he was determining whether to come on board. John explained Dov scheduled some store walkthroughs for them and John was dreading it because in his experience, walkthroughs were generally “just a chance for the CEO to stroke his own ego”. But John said the walkthroughs were different with Dov. He knew everything about the products and stores and seemed obsessed with making the business successful. John reported he was impressed by what a brilliant retail mind Dov seemed to have. I would encourage investors to speak to John and ask him about the changes he has implemented. The company has come a long way and it seems to me Dov will stop at nothing to see APP reach their long-term targets of $1B in sales and 15% EBITDA margins.
I think the checkered past, $100mm market cap, high leverage, and unusual CEO has reduced the number of eyeballs on this and that is why the stock is trading where it is. I’d add they filed a $50mm shelf recently but our conversations with the company indicate this is more of a safety blanket than a current need, and plus, our valuation assumes the sharecount expands by nearly 40%.
The last thing I want to include is some brief comments on Dov. I think he is misunderstood and is an asset to shareholders. Google “Dov Charney, interview” and you will find ample examples of his bizarre behavior but while he might be an unusual person, his employees seem to love him (other than some sexual harassment lawsuits which I’ve found to be pretty dubious cases and essentially exercises in extortion), and in my opinion, he is clearly maniacal about his business.
I’d also cite two comments he made in recent interviews. First, in an interview with NPR’s Kai Ryssdal on January 30th, about 50 seconds into the interview Dov explains he will be at the factory all night. I think that reflects an impressive work ethic and is just one example of his maniacal focus on making APP a success.
Second, in a more recent interview he discusses his stock price and quotes Buffett on the market being a voting machine in the short-term, so I think he gets it, i.e. that he is aware his company is mispriced and undervalued. I think he wants to close the gap and I think he will do it. See links below…
Quoting Buffett: https://soundcloud.com/buzzfeednews/the-stock-market-is-a-voting
Outlook & Final Thoughts
I realize this is painfully long but in case anyone is interested, these are my thoughts for the near-term outlook.
Q1 will likely be weak due to the Northeast being pounded with snow and ongoing declines in mall traffic and shopping activity, (ex: see recent SBUX call), but despite Q1 weakness, I expect APP to produce positive SSS through 2014. I’d expect deferred demand to produce good numbers in 2Q where they are up against a 5% comp at the retail stores and entering the back-half, they will have fairly easy comps (0% in 3Q13, Q4 hasn’t been announced yet). With likely commentary on the progress of the savings initiatives, incremental earnings, etc., I think this is when the stock could first start to move higher.
Entering the fall of 2014 I think investors will start to pay more attention as 2015 numbers start to come into focus. The company has also discussed they are considering getting out there and telling the story, perhaps even doing earnings calls again, which would obviously raise awareness. Overall, I think 2014 is a year for APP to get their house in order to prepare for store growth in 2015. If they appear to find their footing, I think we could see additional sell-side analyst coverage as well.
The risk to this idea is a balance sheet that doesn’t provide a lot of leeway for missteps. I think the dramatic upside potential compensates for this risk but a significant equity raise at these prices would be an unfortunate development that is possible ($50mm shelf out.), although from conversations with management, I don’t believe it is probable. They have a demonstrated believer in Britain based PE group Lion Capital, and Dov, who owns nearly half the company, and has provided personal loans to operate the business in the past.
DISCLAIMER: This write-up is not an offer to provide investment advice or a solicitation of such an offer. No one should rely on the information contained in this write-up to make any investment decision. The write-up contains and is based upon information the author believes to be correct but may be inaccurate. The author assumes no liability if such information is incorrect. The author has no duty to correct or update the information contained herein. The author may buy, sell or sell short the security at any time without notice. This document contains forward-looking statements based on the author’s expectations and projections. Those statements are sometimes indicated by words such as “expects”, “believes”, “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.
|Entry||02/20/2014 01:36 PM|
|Entry||02/20/2014 01:37 PM|
Sorry - errant keystroke and early send - what do you make of rumors bondholders organizing and co hired Skadden?
|Subject||thoughts post secondary?|
|Entry||03/26/2014 06:33 PM|
toby - any thoughts post the secondary? obviously it's not fun to get diluted but want to see if there was anything new to add to the story. thanks for the write up.