Normalcy Accompanies Growth and American Apparel Bounces Back

One of Northlake's biggest portfolio headaches is a lot better today. Pain relief came in the form of very solid quarter from American Apparel (APP). 2Q results were inline to a bit better than the few analyst estimates. Revenues of $133 million exceeded the estimate of $126 million. EPS of 10 cents matched estimates despite much higher expenses to beef up corporate support and dramatically increase manufacturing personnel in support of rapid overall and same store sales growth. Guidance was confidently affirmed. Given the history of controversy surrounding the CEO and accounting and reporting issues, the 2Q results should come as a great relief to investors and leave shorts scrambling.

Leaving aside the controversies, APP is executing quite well in its growth initiatives. Revenues rose 39% with retail only sales up 51%. Gross margins expanded by 300 basis points. Operating income grew 29% despite the aforementioned expense ramp. Net income rose 42% thanks to lower interest rates and some debt reduction. Same stores sales for 2Q were up 23% and are on track to exceed full year guidance of 15% even with a 40% comp coming up in 4Q.

Given this growth profile the shares are cheap at less than 20 times 2008 estimates and just 12 times 2009 estimates. Growth in 2009 will be driven by aggressive new store growth, high single digit to low double digit comps and leverage of operating expenses that are finally reaching the point at which a public company should operate. On the call, management indicated that over the next few years operating margins could expand by 600-800 basis points.

Were it not for the controversy surrounding CEO Dov Charney....

....APP would be the hot teen retailing stock of the moment. It is understandable why many investors will never invest with Charney. However, I challenge anyone interested in growth retailing to listen to the Q&A on the conference call and come away without thinking that Charney is a thoughtful, creative, and decisive retailer. He may be an asshole to some folks but the guy can do retail.

If 2H08 results support current 2009 estimates, a permanent CFO is hired, and Sarbox compliance is achieved, APP shares are headed to at least $10, possibly the teens. I think those things will happen and the upside is worth the risk of dealing with Charney's chaotic and controversial personality and management style. This quarter was going to be the one that made me either throw in the towel and take the losses or build confidence and convince me to hold on. I am not sure yet if I will average down but I am definitely planning holding onto client positions.

Good News From American Apparel But Stock Remains Under Pressure

I was quite pleased with the 4Q07 results, 2008 guidance, and conference call from American Apparel (APP), which reported after the close last night. The consensus I was using consisted of just one analyst so it wasn't really meaningful. Just three analysts asked questions on the call but they were enthusiastic, asked a lot of questions, and seemed very pleased by the answers they were getting. The only meaningful negative in the quarter was the announcement that the company has material weakness in accounting per Sarbanes Oxley. I think this is a routine matter for a newly public company via blank check IPO but some may not like it.

For 4Q07, APP reported revenues of $111.2 million, up 48%. This figure was a little higher than I was expecting driven by the retail business (the company operated 182 stores at year end), where same stores sales rose a stunning 40% in the quarter. Adjusted EBITDA came in at $13.3 million, up 56%. This was slightly short of the $60 million figure I hoped reflecting heavy investment by the company in its transition to public reporting standards and by its commitment to set the stage for America Apparel to be a major global brand with 100s of new stores over the next five years. The company reported a small net loss for the quarter after backing out a tax benefit. I was expecting a small net profit and the difference was due to the higher expenses I just mentioned and greater than expected net interest expense. Overall, I fund these numbers to be excellent for a growth retailer like APP and the analysts on the call all congratulated the company on the results.

APP provided detailed guidance for 2008, pointing to revenues of $470-485 million and EBITDA of $70-64 million, both up 24%, and EPS of 32-36 cents, vs. the adjusted 2007 result of 19 cents. At first I was a bit disappointed that EBITDA and EPS guidance was not higher but on the call it became pretty call that guidance is conservative. First, guidance is based on comps of 15% versus the 2007 figure of 29%. Tougher comps will lead to a slowing but January and February are up 40% and 45%, respectively! Also conservative is the projection for $15 million net interest expense given a total debt level of $117 million and current cash of over $80 million. Finally, at 74 million, the share count is about 4 million ahead of my spreadsheet. I strongly believe APP will easily beat guidance on the revenue, EBITDA, and EPS line in 2008....

....One other important takeaway from the call was the superb performance of CEO Dov Charney. Charney is a controversial figure because of an outstanding sexual harassment suit, two prior settled suits, and his flamboyant and "different" attitudes toward corporate culture and sex. That said, anyone listening to the call would have heard a superb merchant totally in command of every detail. Additionally, Charney clearly wants to please the street and to do so he said the company will now be announcing monthly comps. He talked in detail about specific stores, mall architecture, international expansion, foreign currency impact, inventory management, store productivity plans, gross margins, operating margins, apparel trends, and competition in the retail and wholesale business segments. APP will trade with a Charney discount for a bit but if the numbers continue anywhere close to recent results I don’t think it will last.

The shares have been crushed recently, mostly I think due the March 7th exercise of 16 million warrants. I believe the quarter cleared the air and the stock is headed higher. At 12 times EBITDA, the shares would be around $11.50 and trading at less than 30 times this year's probably EPS. I think that is a bargain for a very hot apparel brand that is executing superbly and comping at an incredible rate. I've been a buy for slightly over a year at prices ranging from the mid 8s to $13. I plan to buy more in the next few days if the stock stays near current levels.

Buying More Endeavor/American Apparel

With all the chatter about Lululemon Athletica (LULU) following the New York Times expose' on the seaweed or lack thereof in certain items the company sells, I thought it might be a good time to provide an overview of Northlake's only long position that is not involved in media and telecom.

Endeavor Acquisition Corporation (EDA) is a blank-check company that went public in late 2005 by raising $130 million. Blank check companies go public and then look to make acquisitions. One year ago EDA announced that it had found its acquisition target. American Apparel is the choice. And it's a good one. Recent SEC filings indicate the deal is on track to close in mid-December. At that time, EDA will change its name to American Apparel, Inc. I am not yet sure what the ticker symbol will be but with apologies to Alcoa, for the rest of this column I will refer to American Apparel as AA.

EDA/AA is not a widely followed stock. Nevertheless, I have read several research reports about the company. As discussed later, I think the lack of Wall Street sponsorship is a positive. The reason I mention this now is that I have recently gained a great deal of insight into EDA from a RealMoney.com subscriber. Special thanks to SG, a full-time investor who clearly knows his stuff.

I bought Northlake's initial position in EDA immediately following the announcement of the AA acquisition last December. I added the stock to new accounts during 2007 but it was only in the last few days that I increased client positions across the board. The analysis presented in this column is something I have believed in all year but I was hesitant to add to Northlake's position until I had a clear timeline for closure of the deal. That news was announced last week along with better than expected operating and financial results and guidance from AA.

My target on EDA/AA is a minimum of $15-20 based on my initial expectations for 2008, where I expect revenues to rise 30% and EBITDA to grow by 34%. This target assumes EDA/AA will trade at a similar multiple of sales, EBITDA, and/or EPS to other high growth specialty apparel retailers such as Urban Outfitters (URBN), Lululemon Athletica (LULU), Zumiez (ZUMZ), and Volcom (VLCM). I see URBN as the best comparable given a similar strategy of going to market as a progressive company that targets a broad demographic range....

....I recognize that each of these stocks has pulled back sharply from its all-time high. In general, this occurs whenever a high growth retailer that has become the stock du jour shows signs that its sales or earnings growth is beginning to decelerate. However, prior to the peaking of operating momentum, valuation on high growth retailers tends to expand dramatically. I believe that EDA/AA will become the next stock du jour in the specialty retail space. As its valuation expands to match the peak multiples given past specialty retailing stars, the stock should move up to at least the high teens and a price in the mid $20s could be justified based on peak multiples in the specialty apparel sector.

American Apparel operates 165 stores in 11 countries and also sells through its Web site at AmericanApparel.net. The company sells basics, targeting a young demographic with a progressive message. American Apparel does not use sweatshops in the Far East. All of the company's products are made in Los Angeles. Wages are relatively high at $8-15 per hour and benefits are provided to workers including health care and English classes. American Apparel competes with other specialty apparel companies targeting teens, young adults, Generation X and baby boomers.

The company has grown rapidly and is projected to have 2007 sales of over $350 million and EBITDA) of more than $55 million. According to the Wall Street Journal, sales in 2002 were just $30 million. Same store sales have boomed the last few quarters. 2Q saw a same store sales gain of 24%. 3Q same store sales rose 27%. Given a very young and rapidly growing store base, same store sales should hold at high levels although some moderation from the current run rate would be normal.

AA should also benefit from moderately expanding margins. The costs of rapid expansion in the store base will keep margins below optimal levels until the base of stores grows larger. However, AA will enjoy the benefits of a mix shift in favor of its retail stores. AA operates a profitable and growing wholesale business proving blanks to hundreds of t-shirt vendors.

For the nine months ending September 30, 2007, retail sales represented 53% of total AA sales. Retail sales growth this year is up 50% vs. a gain of 15% for the wholesale business. Retail store expansion is now the focus of AA's business plan so the mix should shift dramatically toward the more profitable retail business over the next few years.

EDA's acquisition of AA is designed to give AA the capital and management depth required for AA to grow to 800 stores in several years. EDA will supply capital and management expertise and help beef up enterprise systems such as inventory management. EDA will also increase the professional management depth to support the rapid expansion of the store base. The latest SEC filings including the proxy for closing the deal outline specific steps to be taken. In particular, plans are outlined for beefing up management and providing attractive compensation packages to recruit high quality, experienced executives.

Assuming that AA can maintain its recent growth rate in same store sales, store openings, revenues, EBITDA, and net income, I see no reason why it will not trade at similar valuation levels to VLCM URBN, and ZUMZ. LULU's valuation is off the charts so I will ignore it but remind potential investors how high growth, momentum stocks like LULU can temporarily earn multiples well above what most people would deem rational.

Using 2008 estimates for AA of $460 million in revenues and $80 million in EBITDA, based on the current trailing EBITDA multiple for URBN or ZUMZ of 15, EDA/AA shares would be valued at $16 one year from now. On a price to sales basis, at 2.5 times, EDA/AA would reach just short of $17. At 3 times trailing sales, the same as URBN today, EDA/AA would trade over $20 one year from now. And if that is not enough, 4 times sales, or $26, is not out of the realm of possibility.

Key to EDA/AA achieving this upside is a dramatic expansion in the company's Wall Street profile once the deal closes. Presently just a handful of analysts are publishing on EDA. In contrast, URBN is covered by 29 analysts, ZUMZ is covered by 14 analysts, and VLCM is covered by 9 analysts. Given AA's rapid growth this year in same store sales, revenues, and profits along with the strategy to more than triple the current store base, it seems obvious to me that the stock will gain a lot of sponsorship from the sell-side. New coverage with buy ratings and increased targets from current analysts should be in the pipeline, especially as current favorites like LULU, ZUMZ, and VLCM have recently suffered sharp declines.

The buy-side has already begun to take notice. Shortly after the EDA announced it would be acquiring AA, several major hedge funds began to accumulate large positions. 13G filings continued throughout the first half of 2007. Among those filing were well-regarded entities such as SAC Capital, Morgan Stanley Investment Management, and Fidelity. Given that EDA/AA is outside my media and telecom expertise, I was extremely comforted knowing that I had good company in EDA. With recent financial and operating performance at AA even better than expected, it appears that some smart folks know what they are doing.

The bottom line is that Wall Street is always searching for the next big thing and AA should be it in specialty retailing.

Beyond the risks associated with deal closure and EDA's status as a blank check company, there are several risks specific to AA. First, AA is a young company with a limited operating history. Management depth is not great and the company could be considered a one-man show. Second, American Apparel uses sex to promote its brand. This has caused problems for specialty retailers in the past (think Abercrombie) and has already brought some notoriety to American Apparel. The sex issue is a further risk at American Apparel because its founder, Dov Charney, has been sued for sexual harassment and is outspoken about the use of sex as part of his company's strategy. His controversial attitudes and actions have already attracted negative media coverage. Third, specialty apparel, particularly targeting younger demographics, is a very competitive industry. It is difficult to maintain a competitive edge and keep your brand fresh and in favor with a fickle consumer base. Finally, current concerns about weakening consumer spending and signs that apparel sales this holiday season are mediocre create a macro risk.

American Apparel/Endeavor Delivers Good News All Around

In the midst of the carnage yesterday, Northlake had one winner: Endeavor Acquisition Corporation (EDA). EDA is in the final stages of completing its acquisition of privately held American Apparel, a very hot teen retailer. The shares rose over 5% on heavy volume in response to a very positive press release.

EDA announced that that it will file the definitive proxy to complete the acquisition by the end of November. A shareholder vote is scheduled for December 12th. These items while routine are significant because EDA's status as a blank check company means that it has to complete the deal by mid-December or return its assets to shareholders. Those assets are worth just $7 or $8.

More significantly for the long-term prospects of the company, EDA announced that AA's 3Q same store sales rose 27%. This is on top of a 24% gain in 2Q. Furthermore, EDA stated that AA has already produced over $40 million in EBITDA through nine months and would significantly exceed previous full year EBITDA guidance of $40 million.

As a result of AA's outstanding financial performance this year, the terms of the acquisition were amended to give AA's founder and CEO, Dov Charney, more shares. Additional shares were also allocated for AA employees while Charney's partner will now be bought for cash by EDA instead of Charney himself.

I believe that AA's operating and financial momentum will prove sustainable through at least 2008. If so, there is substantial upside to the shares as the EBITDA multiple is just under 13 on my 2008 estimate. For the hot teen retailer of the moment this is a cheap valuation. Previous hot retailers have traded at 15-20 times EBITDA. 15 times my 2008 estimate gets EDA to $16, 25% higher. Personally, I think this target will prove conservative. To back up my optimism I was bidding for more stock all day yesterday but I didn't buy any as I kept my bid too low given the crappy stock market action.

Strong Quarter Boosts American Apparel

Outside of ETFs, Northlake clients own only one stock that is not involved in media or telecom. The company, Endeavor Acquisition Corporation (EDA), is a special purpose vehicle that has agreed to purchase teen retailer American Apparel (AA). The deal was announced last December and is scheduled to close in the second half of 2007. EDA is required to close the deal by mid-December or it must give back the initial investment to its shareholders. With EDA trading at $11 and the IPO having been completed around $8, obviously both management and shareholders will benefit if the deal closes.

Yesterday, EDA shares rose 6% following the a press release updating investors on American Apparel's second quarter results and progress toward closing the deal. I have not yet read the 10-Q that accompanied the press release, but on the surface the news looks very good.

AA reported a 35% increase in 2Q revenue to $96 million. The gain was led by the retail stores where sales rose 51% to $53 million. The critical same store sales number was an impressive 24%. Wholesale revenue (AA sells blank t-shirts) rose by 19% to $43 million. The sales gains translated to improved profitability. EBITDA rose 70% to $18 million. EBITDA margins expanded from 15% to 19%.

These results were better than expected. In April, EDA announced that it was proceeding with the AA acquisition even though it was waiving a condition that AA budget $50 million in EBITDA in 2007. The new "guidance" was $40 million. Following the April press release, I commented that I thought the simultaneous announcement that 1Q same store sales rose 17% would offset the lower guidance. That turned out to be a bad prediction as EDA shares pulled back in April and never recovered even as the market moved to new highs.

The latest news should put concerns raised by the April guidance to rest....

....1H07 EBITDA is already $28 million. Sales, EBITDA, same stores sales, and margins all accelerated in 2Q. With favorable back to school and holiday seasonality in 2H07, it seems like the $40 million EBITDA guidance could be significantly too low. Reaching the original goal of $50 million might even be possible.

Additional growth of 30-40% should be achieved in 2008 as the retail store expansion accelerates and recently opened stores mature. EDA also announced that AA completed its bank refinancing in July prior to the credit market meltdown. This should give company enough capital to continue the aggressive store expansion strategy. As the young store base matures, same store sales should remain strong for a couple of more years. Fast growing teen retailers can receive healthy stock valuations. At 12 times 2008 EBITDA of $70 million, EDA shares would be worth $14. A more aggressive valuation of 15 times would target an $18 stock price.

I plan on hanging around in EDA in anticipation of a smooth deal closing and a likely post-close equity offering which will serve to broaden investor interest in one the hottest retailers around. The stock has some warts as AA's founder and CEO Dov Charney has a bad reputation stemming from several unsuccessful sexual harassment lawsuits. In addition, the founders of EDA have some bad deals in their past. My strategy to deal with these risks is to keep positions sizes small. Since I see substantial upside, even small positions can provide meaningful profits and relative performance.

News On Northlake Stocks

Several stocks in the Northlake portfolio have had newsworthy items over the past week. Here is a recap of the latest news, all of which I think is positive.

Disney (DIS) completed the sale of almost all of its radio operations to Citadel Broadcasting (CDL). DIS shareholders received .0768 shares of CDL for each share of DIS they owned. DIS received $1.35 billion in cash from CDL. I plan to hold CDL and will look to add to the small positions if the shares come under pressure as DIS shareholders sell their small holdings. The profile of a DIS and CDL shareholder would seem to have little in common which could lead to lots of selling. Given that the DIS deal about doubles CDL shares outstanding, I think supply-demand imbalances could put some downward pressure on CDL. That was not the case yesterday when CDL rallied on the first day of post-closing trading. CDL has a current yield of over 5% which should limit downside....

Central European Media Enterprises (CETV) announced that it was acquiring 5% of its Romanian operation form its long-time partner and current senior executive Adrian Sarbu. CETV now owns 95% of Romania with Sarbu holdings 5% that has a newly restructured put option. CETV paid $50 million for the 5% stake, placing a value of $1 billion on Romania. I expect Romania to produce about $85 million in EBITDA this year, putting the multiple at 12 times. This actually seems a little cheap to me given that Romania has been growing at 30-40% per year and is projected to sustain a growth rate in excess of 20% for several more years. I suspect that CETV held the upper hand in the negotiations given Sarbu's small minority stake. I am always happy when CETV is able to buy more of its own operations and it is even better when the price is right. I remain a buyer of CETV which has lagged over the last month.

Endeavor Acquisition (EDA) released 2006 and 1Q07 financials for American Apparel and also filed the proxy. These filings indicate the acquisition of American Apparel remains on track for a 3Q07 closing. I have not had a chance to read all the filings but the headlines suggest that everything is on track. Management indicated that same store sales remain strong in 2Q and 1Q EBITDA suggests that the company is on track to meet 2007 guidance. The shares have moved to new highs since the filings. I still think EDA can reach $14-18 assuming American Apparel is able to maintain operating momentum in the first few quarters following the closing of the deal.

Rogers Communications (RG) announced the purchase of five traditional over-the-air TV stations in Canada. All major cities except Montreal were included. It is not a huge deal at $350 million Canadian but based on Canadian press reports it looks like a favorable deal for RG. RG shares remain right at their 52 week high and the prospects for further upside remain as wireless and cable drive mid-teens growth in operating profits and significant free cash flow begins to flow. A price target of at least $45 is realistic.

Follow-Up On Endeavor/American Apparel

Back on April 5th, following a press release from Endeavor Acquisition Corp (EDA), updating investors on its acquisition of American Apparel (AA), I noted the news was mixed but thought that the good news (17% same store sales growth) would outweigh the bad news (a reduction in 2007 estimated EBITDA growth and the likelihood of an equity offering later this year). It turns out I was wrong and EDA shares have fallen about 8% since the press release. Nevertheless, EDA shares are still up almost 25% from the day after the acquisition was announced and 16% so far this year.

As a reminder, EDA announced that it was going ahead with the acquisition of EDA which was subject to certain conditions when it was announced in December.. The press release also stated that 2007 EBITDA, projected in the initial filing to be $50 million would actually come in near $40 million. EBITDA will still grow 33% in 2007. The shortfall from initial projections of 65% growth is attributed to AA's inability to access adequate bank financing to open as many stores as previously planned. The press release noted that AA's growth profile remained on track and would be back to previous expectations after the deal closed and the company had easier access to financing. Several comments in the press release clearly alluded to the fact that a portion of the new financing would be equity. Softening the blow was an announcement that same store sales for the March quarter were up 17%.

After reading the press release, I immediately went to retail consultant Elizabeth Haynes of Haynes and Company Consulting to get a second opinion. Here is what I wrote to Elizabeth initially:

Overall I think it will be favorable for the stock but the news is a little mixed. On the plus side, and the overwhelming takeaway, 1Q comps are +17%. That will boost the multiple considerably if it holds through the year. Also on the plus side is the 2006 results.

So despite lowering the base of earnings in 2007 off which the growth will occur things still seem to look fine. I think this news might delay my reach upside target of $18 by 6-2 months but if the same store momentum holds and the news stores are opening that is still a realistic target in 2008.

Elizabeth generally agreed with my analysis but she did offer several valuable insights....

First, she noted that AA is achieving a lot of 2007 growth in its wholesale division and that this growth is being driven by the expansion of new product lines that were previously only available in AA stores. Elizabeth thinks that AA probably pumped the wholesale business partially to make up for the shortfall in new store openings. AA should benefit as new store openings pick up because the wholesale business has lower margins and the costs of upping the output of the wholesale business will be amortized over a much larger revenue base.

One other item Elizabeth noted is that she is hearing that AA is getting a lukewarm reception across the Street due to concerns about AA's controversial CEO Dov Charney and the background of one of the founders of EDA. Elizabeth also noted that some investors she knows who are "all about making returns" are even steering clear for now.

That is certainly a concern but not unexpected given EDA is a blank check company and Charney's high profile views on sex a couple of dismissed or settled sexual harassment suits. On the other hand, several hedge funds, including SAC Capital, have already filed significant ownership stakes in EDA representing shares acquired following the announcement of the AA acquisition. Additionally, since I am a believer in the fundamentals of AA's growth profile, I see the reluctance of many investors to take positions as a source of future buying power once the deal closes and new store openings pick up.

After updating my spreadsheet and giving EDA/AA a lot more thought I've decided to stick with my long and consider adding to the small positions held in client accounts. I've adjusted my target based on 2007 expectations to $13. I am sticking with my stretch target of $18 but now expect that to occur in 2008 rather than 2007. The bottom line is that AA's high growth will sustain premium valuations historically accorded other teen focused retailers during their new store/same store growth phases. The growth profile is now delayed by 6-12 months but at the same time it is extend by 6-12 months. I don’t think anyone on the Street is going to care in six months that EDA had $40 million in EBITDA in 2007 instead of $50 million. Investors will chase the momentum and just base the growth profile off the $40 million. That provides plenty of upside which means that current weakness should be used as a buying opportunity.

Endeavor's American Apparel Purchase To Proceed

Endeavor Acquisition Corporation (EDA) announced that the deal to purchase American Apparel (AA) will proceed. AA met the requirement that 2006 earnings before interest, taxes, depreciation and amortization (EBITDA) be at least $30 million. An additional requirement that 2007 budgeted EBITDA reach $50 million was waived. The press release says that AA did not have adequate access to financing to open as many stores as projected, leaving 2007 EBITDA to be budgeted at around $40 million. The press release also noted that AA same-store sales for 1Q07 were up 17%. EDA management expressed great confidence in AA and noted that when the deal closes and financing, including equity, becomes available, AA's growth will remain on track.

I'll have more on this soon but I think the takeaway on the Street will be positive as the same-store sales number will trump the reduction in 2007 EBITDA growth. Additionally, even without all of the new store openings, 2007 EBITDA is still projected to rise 33%.

I am still long EDA across the Northlake client base and believe that when I reset my spreadsheet the reach target of $18 will still be valid, but it might be delayed to 2008 instead of late 2007.

Endeavor Acquisition Due Diligence

Last week I had an opportunity to talk with Elizabeth Haynes of Haynes & Company Consulting about the acquisition of American Apparel (AA) by Endeavor Acquisition Corporation (EDA). Haynes & Company Consulting is a management consulting organization specializing in retail. Elizabeth's insights are especially valuable because she has spent time working on Wall Street and her company has completed projects for hedge funds.

Elizabeth was very positive on American Apparel and has not been surprised by the quick rise in EDA shares. She feels that EDA bought American Apparel on the cheap for two reasons. First, a traditional IPO was probably going to be difficult due to the controversy surrounding the company's founder and CEO Dov Charney. Second, by offering shares and a controlling interest in EDA, Charney would get back any discount on the deal with price appreciation.

For the next year or two, Elizabeth feels that AA's growth plan is likely to succeed....

Geographic expansion into smaller cities outside the super-major urban centers has succeeded for other trendy, teen-oriented retailers and the company's focus on basics should ease geographic expansion. Furthermore, with just 143 stores, the expected rapid expansion of the store base will set up favorable same store sales performance as the young store base matures. Finally, Elizabeth believes the company's wholesale t-shirt business reinforces the strength and positioning of the company's brand with the target audience by putting high quality t-shirts into distributors reaching the teen, indie, and urban customer base.

Longer term, Elizabeth identified a few challenges AA may face. First, sustaining store traffic may prove difficult with a relatively narrow focus on basics. Second, conversion rates of traffic to buyers may prove challenging as basics tend to last a long while in most wardrobes. Third, the competitive advantage the company has maintained with its Los Angeles only manufacturing may falter as the company's rapid expansion plans may require overseas sourcing. AA has benefited greatly from its ability to keep inventory fresh, limit markdowns, and respond quickly to fashion trends by having its manufacturing so close to its retail stores. If the company doubles or triples its store base, maintaining an LA only model may prove impossible.

EDA shares have moved up sharply since the announcement of the American Apparel acquisition, rising close to 30% from initial post deal trading levels. I still think a target in the mid to upper teens is very plausible if the company hits the growth goals for 2007 and 2008 outlined in the merger filing. I think the easy money available due to the cheap deal price and odd deal structure has been made but plenty of upside remains and I am sticking with my long position. Special thanks to Elizabeth Haynes for helping me out.

Endeavor Gains First Buy Recommendation

Endeavor Acquisition Corporation (EDA) gained its first analyst coverage which not surprisingly was a buy rating. Lazard picked up EDA with Buy rating and a $13 target price. I haven’t seen the report but apparently it talks about EDA as a play on the growth of American Apparel. One of my reasons for entering the shares was that American Apparel would attract Street sponsorship. Brokers have to jump through a lot of hoops before recommending stocks and I am a little surprised that Lazard acted so quickly. But I think this is just the beginning for analyst coverage and analysts don’t pick up stocks unless they have buy ratings. EDA popped 8% yesterday to close at $9.94. Until I have reason to doubt the numbers in EDA's filing about the deal, I think the shares can be legitimately valued anywhere from $10 to $18. And in case you missed it, we have company in EDA as SAC Capital Advisors has taken an 8.7% stake. A giant hedge fund like SAC taking a substantial long position should help attract analysts as well --- after all, SAC will want to trade around and eventually sell their position.

We Have Good Company In Endeavor

I have to admit that I am flying a little blind on Northlake's long position in Endeavor Acquisition Corporation (EDA), the blank-check company that has agreed to purchase American Apparel. Usually, I like to have an analyst report or two to review before making a new purchase but EDA had no coverage before it announced its acquisition of American Apparel.

So even though I am comfortable with my analysis of EDA, when InsiderScore.com reported that SAC Capital has taken an 8.7% position in EDA, I was quite pleased. SAC is one of the largest and most successful hedge funds in the world. Here is a paragraph that I excerpted from a longer story that appeared when I pulled up a quote on EDA at Yahoo! Finance:

"A "blank-check" company no more, last month, Endeavor agreed to purchase American Apparel Inc. for $244 million. Under the terms of the deal, EDA will pay American Apparel founder and CEO Dov Charney approximately 32.3 million shares of restricted stock, assume $100 million in debt, create a one-time merger bonus pool of $2.5 million, and reserve up to 2.7 million shares of additional common stock to be made available to American Apparel employees. Charney's stock will be locked up for at least three years, and he is expected to buy out an existing American Apparel investor for $60 million. He will also stay on with the company as CEO, and the deal is expected to close sometime this summer (and one would suspect that Endeavor will change its name at that time). On Dec. 29, SAC disclosed holdings of 1,751,550 shares of Endeavor, or an 8.7% stake. The firm's holdings include options for 200,000 shares, and it previously disclosed no holdings in Endeavor. SAC's filing lists Dec. 19 as the triggering date for its filing, the day it surpassed the 5% ownership mark and the same day Endeavor announced the American Apparel acquisition."

I also was buying EDA for clients on Dec. 19 and then again on Dec. 20. Good to know the millions of shares that traded those day were at least partially being purchased by someone with a good track record.

Details in Endeavor's SEC Filing Support Bull Case

Endeavor Acquisition Corporation (EDA) submitted an SEC filing yesterday with lots of details about its acquisition of American Apparel. Most importantly, the company provided historical and projected revenue and EBITDA figures. The data is better than I expected, particularly for 2007 and 2008, giving me greater faith in my buy recommendation and leading to more conviction in my $10-12 target. In fact, assuming the company hits the numbers in the filings, I think a stretch target of $14-18 is realistic.

Here is a copy of the investor presentation contained within the SEC filing. The presentation is designed to introduce Wall Street to American Apparel from a financial and operational perspective.

The news articles discussing the acquisition indicated that 2006 revenue and EBTDA would be $275 million and $30 million, respectively. I had initially assumed that EBITDA would grow to $40 million in 2007 and $50 million in 2008. However, one of the closing conditions contained in the filing is that American Apparel will submit its 2007 and 2008 projections following the completion of the 2006 audit and that the projections will show EBITDA of at least $50 million in 2007 and $70 million in 2008.

My stretch target assumes an EBITDA multiple of 12-15 times 2008 results. Given the growth rate, I think this multiple range is very realistic especially with American Eagle Outfitters (AEOS) and Urban Outfitters (URBN) presently trading at 14 times 2007 estimated EBITDA....

The filing contained lots of other information including historical revenue and EBITDA and a breakdown of sales between wholesale and retail. American Apparel has a significant wholesale business providing primarily blank t-shirts to more than 10,000 screen printers and ad specialty companies and 11 U.S. distributors. This business has grown rapidly but stalled in 2006. I presume the stall is due to the company's focus on expanding its retail operations. From just 3 stores in 2003, the company expanded to 38 stores in 2004, 108 in 2005, and 143 in 2006.

EBITDA margins have been fairly stable at 10-11% for the past few years. I also assume that the wholesale business has a lower margin and that the rapid expansion in the store base has penalized margins. The "guidance" provided in the SEC filing implies significant margin expansion in 2007, to 14%. This seems aggressive and is probably the key financial risk related to the shares. I would guess that the margin expansion is the result of a mix shift in favor of retail, a growing base of maturing stores, and less impact from new store openings as they shrink as a percentage of the base.

The filing also contains quarterly historical same stores sales. After very rapid gains in 2005, averaging 45%, same store sales have slowed in 2006. 1Q06 was 16%, but 2Q saw a sharp drop to just 1%. 3Q and 4Q saw a pickup to 4% and 6%, respectively. This slowing could concern some investors, especially as recent gains are below some peer retailers. It is not clear from the filing what the projections assume for same store sales. I would guess that mid to upper single digit growth is targeted with most of the sales gains, projected at 30% for 2007, coming from new store openings.

Not surprising but comforting, the filing also indicates that Endeavor will beef up American Apparel's management team by adding a Chief Operating Officer, Chief Financial Officer, and Chief Information Officer. Additionally, investments will be made inventory management, employee training, and other enterprise resources.

These investments should comfort potential investors who are concerned by the flamboyant and controversial CEO of American Apparel, Dov Charney. A simple Google search on Charney will reveal many profiles (positive and negative) including several that recap the fact that he has been sued four times for sexual harassment and admits to personal behavior and attitudes that would turn off many investors and consumers. In fact, the primary risk I see in EDA/American Apparel is that as the company ramps its store rollout and rapidly increases it sales, the mainstream media will revisit the controversy surrounding Charney. Besides the negative sentiment this would create for the stock, it might also impact sales as the company's reputation as an very progressive organization is tarnished. The addition of a beefed up management team and the experience provided by Endeavor's successful founding investors mitigates but does not eliminate this risk.

I believe that American Apparel's rapid historical and projected growth and hip brand will attract investors and sell-side analysts. With valuation reasonable compared to similar high growth concepts, I think significant upside exists even after the move over the last two days.

Endeavor Aquisition Buys American Apparel and Northlake Buys Endeavour

Following the news that American Apparel is being purchased by Endeavor Acquisition Corp. (EDA), I decided to take a small position in EDA for client accounts. EDA is a blank-check company that went public about one year ago by raising $130 million. Blank check companies go public and then look to make acquisitions. For EDA, American Apparel is the choice. And it's a good one.

My target on EDA is $10-12 based on my initial expectations for revenues to rise 30% in 2007 and EBITDA to grow by 35%. This target assumes EDA/American Apparel would trade at a similar multiple to other high growth specialty apparel retailers serving teens such as American Eagle (AEOS) and Urban Outfitters (URBN).

Background on American Apparel

American Apparel operates 140 stores in 11 countries and also sells through its Web site at AmericanApparel.net. The company sells basics, targeting a young demographic with a progressive message. American Apparel does not use sweatshops in the Far East. All of the company's products are made in Los Angeles. Wages are relatively high at $8-15 per hour and benefits are provided to workers including health care and English classes. American Apparel competes with Abercrombie & Fitch (ANF) and American Eagle Outfitters (AEOS) as well as other specialty apparel companies targeting teens, young adults, Generation X and baby boomers.....

The company has grown rapidly and is projected to have 2006 sales of $275 million and earnings before interest, tax, depreciation and amortization (EBITDA) of $30 million. According to the Wall Street Journal, sales in 2002 were just $30 million.

EDA intends to accelerate American Apparel's growth rate with a target of 800 stores in several years. EDA will supply capital and management expertise and help beef up enterprise systems such as inventory management. EDA will also increase the professional management depth to support the rapid expansion of the store base.

The Details Behind the Deal

EDA is paying about $385 million for American Apparel composed of 32 million shares valued at $250 million, the assumption of $110 million in debt, a cash bonus pool of $2.5 million and 2.7 million shares reserved for company employees.

Prior to this deal, EDA has 20 million shares outstanding, $125 million in the bank and no debt. Following the deal, there will be about 55 million shares outstanding, $110 million in debt and $120 million in cash. With EDA shares trading at $8.25, up about 10% following the deal, the total enterprise value is around $450 million, putting the multiple of current EBITDA at 15. Assuming an aggressive 30% growth rate in 2007 would lower the multiple closer to 11. Taking away the cash on the balance sheet that will be spent on store expansion leaves the 2007 multiple around 13. Price to sales is under 2x excluding cash.

How EDA + American Apparel Stacks Up vs. Competitors

As a comparison, based on data at Yahoo! (YHOO) Finance provided by Capital IQ, ANF trades at 7.5x trailing 12-month EBITDA and 1.9x sales, while AEOS trades at 15.5x trailing 12-month EBITDA and 2.7x sales. Urban Outfitters (URBN), which might be the best comparable from a concept and target market standpoint, trades at 17x EBITDA and 3x sales.

Jumping on This One Ahead of the Analysts

Given the growth rate, I think EDA has reasonable valuation. I also think it is a valuation that will attract Wall Street analyst coverage, especially since American Apparel is a hot brand in the always exciting specialty apparel industry. Over the next few months, I'd expect new analyst coverage with buy recommendations to be bullish for EDA shares.

Risks

There are some risks. First, American Apparel uses sex to promote its brand. This has caused problems for ANF in the past and has already brought some notoriety to American Apparel. The sex issue is a further risk at American Apparel because its founder, Dov Charney, has been sued for sexual harassment and is outspoken about the use of sex as part of his company's strategy. His controversial attitudes and actions have already attracted negative media coverage. Second, specialty apparel, particularly targeting younger demographics, is a very competitive industry. It is difficult to maintain a competitive edge and keep your brand fresh and in favor with a fickle consumer base. Finally, current concerns about weakening consumer spending and signs that apparel sales this holiday season are mediocre create a macro risk.