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November 15, 2007

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.

Posted by Steve Birenberg at November 15, 2007 03:04 PM in eda