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.
Let's break down the balance sheet to see whether the company is indeed on the cusp of a bankruptcy filing.
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.
Short and 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."
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%.)
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 bankers 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.