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April 13, 2007
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.
On the negative side, the 2007 EBITDA figure will be about $10 million short although still up 33%. They explain the shortfall well as it relates to lack of financing to expand the store base. Good news there is that it implies that new stores contribute quickly to EBITDA. Another potentially negative takeaway is that the press release pretty clearly states that after the deal closes there will be an equity offering of around 10 million shares ($120 million). On the one hand, it is dilutive. On the other hand, it will get the company lots of sponsorship and a much higher profile on Wall Street. That is especially good news if the comps are still double digit. Also, a better balance sheet does have benefits as the growth profile will be more clear.
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.
Posted by Steve Birenberg at April 13, 2007 09:31 AM in eda
