American Apparel Opens the Kimono

American Apparel has long been one of our favorite companies, for a variety of reasons.  For one, CEO Dov Charney is an "interesting" fellow.

He openly displays his passion for his company… and sexy women.  When
he decides to wear clothes, he dresses like a ’70s-era porn star, and
defends his right to run a "sexually free" workplace.  This includes
walking around in his briefs, and exposing himself eight times to a
reporter.  As expected this has led to some legal issues, which he’s
vigorously defending.

But our main reason is that American Apparel has bucked the trend of clothing companies outsourcing to Asian sweatshops.

All of American Apparel’s items are made a the plant in Los Angeles
where he started the company.  He pays 3,500 people up to $18 an hour,
making them the world’s highest-compensated garmet workers.  Charney
stresses vertical integration.  Operations are consolidated at the LA
headquarters, allowing for close control of costs, quality, customer
service, and flexibility.  The company can design a shirt and have it
in stores in less than a week.

T-shirts and underwear.  Not exactly high margin products, but Dov has created a company that manufactures in a high-cost area of a high-cost state… in the United States.  And makes a very nice profit.  How much profit?  Well… that’s an interesting question.  But even after the last re-accounting it is still a very nice profit.

The front page of the Wall Street Journal this morning describes the excitement at American Apparel ever since the company went public to raise cash to fund further expansion… which of course means that the inner financial workings of the company had to be disclosed.  But first someone had to figure out what the inner workings actually were… and that’s some fascinating reading.

First, from the pre-public days…

In early 2005, chief financial officer Mark Schlein died unexpectedly
of heart failure, and Mr. Charney and others say a replacement wasn’t
found for a year. An interim CFO was later hired, though Mr. Charney
only remembers that "he had gray hair and quit after a week." Mr.
Charney delegated bookkeeping to a few younger staff members and
continued to open stores.

No real internal financial acumen for what was a $100 million company at the time.  Could you pull that off?  But let’s move on.

So, American Apparel began shopping for another source of cash. In
spring 2006, Plainfield Asset Management, a private firm that was
considering an investment, requested an outside audit, prompting the
company to begin its own internal audit. The internal auditors found
American Apparel had inflated its 2005 earnings by nearly 30%,
according to the company’s chronology.

Which reduced pre-EBITDA earnings to $18 million.  Still not too shabby for a company manufacturing in such a high cost area.

By the middle of 2006, Mr. Charney began looking for ways to boost his
finance staff. He offered an $800-a-week internship to Adrian
Kowalewski, a recent University of Chicago business-school graduate who
had briefly spoken with Mr. Charney about an academic paper the month
before. Mr. Kowalewski’s task: to devise a plan to save the company’s
deteriorating finances.

Rather than contact an executive recruiter, Mr.
Charney bought a classified ad in his hometown newspaper, The Gazette
of Montreal. Mr. Cieply, a former toy-industry executive, responded
to the ad and got the job. The CFO says he soon discovered what he
called "a lack of accounting knowledge" pervading the company. Mr.
Cieply says he was forced to recant the company’s earnings statement
for the first half of that year.

In November [2006], the chronology shows U.S. Bank forced the company to hire a turnaround consultant.
"It was a big waste of time," says Mr. Charney. The
books underwent another readjustment just after Thanksgiving 2006,
reducing year-to-date earnings before interest, taxes, depreciation and
amortization by $1.5 million to $24.5 million.

Still nicely positive.  But the story continues…

That fall, Mr. Charney turned to Mr. Kowalewski — now
his corporate finance director — for a solution. Having tried, and
failed, to court other lenders, Mr. Kowalewski says he knew a
traditional IPO was out of the question, given the rigorous accounting
scrutiny involved and Mr. Charney’s lack of a proven executive team.  Mr. Kowalewski came up with a solution: an
untraditional "blank check" initial public offering, in which a shell
firm, known as a "special purpose acquisition company," acquires a
private firm.

On Dec. 12, the company began trading on the American Stock Exchange. Mr. Charney was now worth more than $580 million.

Since going public last December, the company
has conceded it suffers a number of "material weaknesses." According to
a filing with the Securities and Exchange Commission, these include
"inadequate expertise in the application of U.S. generally accepted
accounting principles."

In an interview March 20, Mr. Charney said his current chief financial
officer, Ken Cieply, "has no credibility" in the retail apparel
industry and is a "complete loser."

But Mr. Cieply stays on.  Perhaps because it is such a fascinating place to work.

Mr. Charney grew increasingly public about his lifestyle, making
himself the brand’s mascot and provocateur. He entered into
relationships with employees and on occasions walked through the
factory in his underwear to model new designs, he says. Billboards
springing up across the country quickly gained attention for their racy
layouts. In one ad, a woman spreads her legs for the camera in company
stockings and underwear on a white bed — Mr. Charney’s bed.

Sporting vintage glasses and tight shirts, the
39-year-old Mr. Charney seems almost a living resurrection of the
free-spirited 1970s. He sees himself as crusading against today’s
puritanical conventionality and likens himself to Larry Flynt, the
Hustler magazine publisher who fought many First Amendment battles.

Mr. Charney stages provocative photo shoots in the
basement of his Los Angeles mansion — a hilltop perch filled with
stacks of his vintage porn magazines. On a recent evening there, a
young female employee served Mr. Charney tomatoes over rice while
another, dressed in underwear and a T-shirt, was quizzed by her boss on
competing brands.

Perhaps he’s on to something with this style of leadership?

Mr. Charney insists his leadership style provides a model of
authenticity for young people looking for alternatives to a "Baby
Boomer economy which is collapsing."

Perhaps not.  But we still like American Apparel for having the guts, and apparently the manufacturing knowledge, to do what most clothing companies can’t: manufacture profitably from the United States.

At a time when many large clothing makers were moving their
manufacturing overseas, Mr. Charney attracted attention to the brand by
electing to make all of the company’s clothes in a Los Angeles factory
and by championing social causes like immigration reform and universal
health care. Tailors at American Apparel’s factory receive subsidized
health-care benefits and generally make twice the minimum wage. The
factory’s proximity also allows Mr. Charney to create new designs, and
get them to stores, the week after he’s conceived them, a speed unheard
of in the industry.

If only Charney would hire a decent finance staff.  Or perhaps the lack of people whose traditional GAAP-driven mindset often flies in the face of business reality… or opportunity… is his hidden competitive advantage?