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August 22, 2007

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.

Posted by Steve Birenberg at August 22, 2007 09:38 AM in eda