American Apparel's Financial and Legal Woes Continue

As evidenced by their most recent quarterly filing, American Apparel's continues to grapple with financial issues.  Despite its strong brand recognition (among a host of accolades, they were named "label of the year" by The Guardian in 2008), it's reputation as a trendsetter, and it's provocative advertising, they are struggling to survive. The company lost $9.5 million in the 3rd quarter of 2010 (alone)  compared with a profit of $4.2 million for the same period in 2009.  To make matters worse, their auditors, Deloitte and Touche, resigned in August, 2010 claiming that there were "potential material errors in the consolidated financial statements for 2009".  This has become the subject of an official FBI criminal investigation. 

A review of their 3rd Quarter 10Q SEC filing reveals the following:

Sales/Gross Margin:

Although sales decreased by 10.5% compared to the same 3 month period in 2009, what is perhaps more notable is that gross margin as a percentage decreased by an additional 10%.  This means that while their sales went down, their direct costs of selling went up.  The company attributes the change in gross margin to "lower labour efficiency" and a shift towards "more complex retail styles" i.e. it is more expensive to make pants and bedding than T-Shirts and underwear.

Interestingly, as of September 30th, there have been virtually no store closures.  If fact, 2 stores were added in Canada during 2010.

Cash Flow Issues/Default of Credit Agreements:

Given their negative cash flow and loss from operations it is possible that AA will not be able to sustain operations for the next twelve months.  If they do not comply with the covenants of their credit agreements, all amounts due will become payable immediately.  This could result in immediate bankruptcy for AA.  Management is of course actively working on ways to increase sales, reduce costs and improve liquidity.  The company currently has approximately $126 million of debt.

US Immigration Problems:

Pursuant to an inspection by the US Immigration department, the employment eligibility of 200 employees could not be verified.  Additionally another 1,600 employees appeared not to be authorized to work in the US.  AA terminated the employees who could not provide evidence of their eligibility to work.  Of the employees that were sacked, 59 initiated claims of which 23 have been settled.  Approximately $1.6 million has been accrued to deal with the remaining 36 claims.

Employee and Other Litigation:

Several claims have been initiated by former employees for wrongful dismissal, sexual harassment and failure to pay wages.  One lawsuit relating to wrongful termination and gender discrimination for Ms. Mary Nelson was settled for $1.3 million.  However it has not been paid as AA claims that the terms of the settlement agreement were not upheld.  There are several other charges relating to sexual harassment and a "hostile working environment".  According to their SEC filing  "On August 9, 2010, the EEOC issued a written determination finding that reasonable cause exists to believe the Company discriminated against Ms. Hsu and women, as a class, on the basis of their female gender, by subjecting them to sexual harassment."  To make matters worse AA's insurance carrier has declined to provide coverage.

Additional both the FBI and the SEC have launched an investigation relating to the change in the company's auditors.

It is difficult to pinpoint the exact reason for their difficulties. Perhaps Mr. Charney lacks financial discipline.  Or perhaps they are a victim of the recession (people are trying to cut down on American made leotards).  It is also possible that, given their prior accounting firm’s assertion that there were potential material errors in the financial statements, the problem is one of accounting shenanigans. Regardless of the reason,  the bottom line is that sales are down, costs are up and they are unable to meet their cash flow requirements.  These are challenges that all companies face.  Some just manage them better than others.

About the author: Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals.  Please sign up to receive articles pertaining to small business, accounting, tax and other occasional non business topics of interest.  You can also follow her on Facebook or Twitter.