American Apparel: When Dov cries

Dov Charney made American Apparel in his own eccentric image, but now the company faces a fight for financial survival.

These days, it’s hard for American Apparel to shock. But on May 19, the Los Angeles-based clothier surprised everyone. The company disclosed it does not expect to be in compliance with one of its debt covenants by June 30, which could set off a chain reaction of loan payments. That would cripple the company, potentially tipping it into bankruptcy.

Anyone familiar with American Apparel should have seen trouble coming. Founder and CEO Dov Charney even alluded to his company’s checkered financial history in a conference call that day. “Our company, in the past, has had plenty of these types of issues before, and it’s not really presented us with any particular difficulties in running our business,” he said.

That American Apparel is still around is something of a miracle. The company swallows the higher costs of manufacturing all of its garments in the U.S. while serving a fickle niche, constantly at risk of falling out of fashion. The bulk of American Apparel’s products – T-shirts, sweatshirts and underwear – can be found elsewhere for less. The more outrageous clothing, lame leggings and mesh bodysuits, is not likely to draw huge international sales.

And then there is Charney himself. Born in Montreal, he is the mastermind behind American Apparel, from the hip clothing to the salacious advertising. But he’s also a liability. He is open about relationships with employees, and has been involved in a handful of sexual harassment lawsuits from former employees alleging strange behaviour, such as strutting around in his underwear. “There were months I was in my underwear all the time,” he said in a deposition a few years ago. “It became very common.” One suit is in arbitration. At least one has been settled, and another withdrawn.

Both the media and those in the industry have speculated that Charney’s antics would result in American Apparel’s implosion. But Charney has so far proven them wrong. He’s found investors to back him and customers who are indifferent toward, or even admiring of, his eccentricities – American Apparel racked up US$558.8 million in sales last year, up from 2008. Instead, the company’s current crisis is largely the result of a common entrepreneurial mistake: too much debt and unchecked growth. American Apparel, struggling with $91.4 million in debt, is a relatively small operation to support more than 280 stores in 20 countries.

The company is negotiating with its lender, London-based private equity firm Lion Capital, to get some breathing room. It may also need to hunt for more cash if the non-compliance triggers a US$46-million repayment of its credit facilities. As of December, it had only $9 million in cash. The company warned in its May 19 statement, “There can be no assurance that if either or both of these events were to take place, that the company would be able to obtain the additional sources of liquidity required to continue operations.”

The prospects look bleak, but Charney has always defied expectations. “Knowing Dov and knowing the organization, they will solve whatever problems they have,” says Rob Smith of C3 Capital, a former major investor. Even so, what happens to Charney is unclear. Responsibility for the mess – and past close calls – rests with him. “One question is whether Charney will finally be out on the street,” says Howard Davidowitz, chairman of retail consultants Davidowitz & Associates in New York. A more important question is whether American Apparel can exist without him.

Dov Charney, 41, built American Apparel producing T-shirts. They were fitted, unlike the boxy variety peddled throughout the 1990s, and they were higher-quality. Charney is an expert marketer, however, and in his hands, those T-shirts were blank slates on which to carve his aesthetic – young, urban and promiscuous.

American Apparel clothing has become a hipster uniform, and Charney, with his oversized glasses and ironic facial hair, a hipster messiah. “We could see that his customers were fanatical about him and his products,” Smith says. “It was cult-like.” Girls still e-mail pictures to Charney in hopes of being featured in ad campaigns, which he occasionally photographs.

The infatuation with the energetic, self-described “Jewish hustler” is puzzling, but nothing is straightforward about Charney. He started by purchasing T-shirts in the U.S. as a teenager and selling them in Montreal, where the higher-quality garments were unavailable, later moving to Los Angeles in 1997 to manufacture wholesale.

American Apparel is unique for producing everything in the U.S. instead of outsourcing, and proved it was possible to turn a profit without going overseas. Charney pays his factory workforce generously, typically twice the minimum wage, and provides them with health insurance. He trumpets his “sweatshop free” clothing and has thrown himself into causes such as immigration reform.

American Apparel didn’t become a phenomenon until it opened stores in 2003, expanding its clothing line and developing a stronger brand. Charney’s advertising was beyond risque, featuring scantily clad women (often employees) spread-eagle or bent over. The ads evoked the creepy basement porn vibe of Calvin Klein’s infamous campaign from the 1990s, but updated with the gritty look favoured by contemporary photographers such as Terry Richardson.

Beyond that, Charney also built a nimble manufacturing machine. Choosing to operate as a vertically integrated company was not purely moralistic; it was a shrewd business decision. Since Charney’s production facility is located so close to his market, a new garment can go from a rough sketch to production in days. Other retailers have to make longer-term bets on what will sell, and could get stuck with large volumes of unwanted clothing if they’re wrong. “Charney can reinvent himself so quickly he’s always ahead of everyone,” says Nancy Sheridan, an assistant professor of fashion merchandising at the Fashion Institute of Technology in New York.

Finances, however, were never the company’s forte. When its chief financial officer died in 2005, a replacement wasn’t hired until a year later. American Apparel still opened 65 locations that year, its second-largest annual expansion. Charney called his next CFO, Ken Cieply, who subsequently departed, a “complete loser” in a Wall Street Journal article. Cieply was replaced, but American Apparel still has work to do. It conducted a review of its financial reporting controls along with Deloitte & Touche last year. Despite past improvements, the review found “internal control over financial reporting control was not effective.”

American Apparel’s history has been, in effect, one long struggle to fund Charney’s grandiose vision. In its early days, American Apparel’s senior lender, U.S. Bank, sought out investors to back Charney’s retail expansion. The bank approached C3 Capital in Missouri, which invests in small businesses. “We were obviously really impressed with the strategy and the team,” Smith recalls, which put US$12 million into American Apparel. Smith tried to find more investors, but Charney turned many of them off. “He’s a genius,” Smith says, “but there’s a lot of baggage.” Still, he eventually found two other firms to back the company. Charney proved to be a relentless operator. “Dov’s vision for the business has always outrun the balance sheet,” Smith says. “We spent a lot of our time trying to hold back the execution of his vision.”

By 2006, American Apparel was pursuing a public financing, and announced a merger with Endeavor Acquisition Corp., a special-purpose acquisition company. A SPAC is a public company created solely to purchase another one. Endeavor was founded in 2005 by Jonathan Ledecky, who popularized SPACs in the 1990s. He had mixed results, burning many investors and sullying his reputation. According to a 2006 Washington Post article, Ledecky had taken up Bible study and “tried to make peace with some of the people he may have used or misled.” But for American Apparel, the acquisition meant it could raise money without the rigorous scrutiny of an initial public offering. The deal closed in December 2007, and American Apparel became a publicly traded entity with a US$125-million cash injection.

In 2008 and 2009, during the depths of the recession, Charney opened roughly 100 stores and struggled with debt. He twice made personal loans to the company totalling US$6.5 million. In March 2009, American Apparel needed to renew or extend a $51-million loan from one of its backers, SOF Investments. This was the second such amendment in months. Failure to reach an agreement would have triggered immediate payment of a multimillion-dollar credit facility. Bankruptcy was a possibility.

Just over a week before the deadline with SOF, American Apparel found a white knight: Lion Capital, a private-equity group in London, that invested US$80 million. Lion’s investment came with what KeyBanc Capital Markets analyst Edward Yruma, in a recent note, called “unusually tight” debt covenants. It’s not hard to see why Lion Capital wanted to keep Charney on a tight leash – he was musing in the media a couple of months prior about growing to 800 stores.

But American Apparel is in danger of breaching those covenants anyway. It is back to where it was last year: renegotiate, find a saviour, or face bankruptcy.

Two major issues have so badly damaged American Apparel’s finances that it risks violating debt covenants. Last September, the company let more than 1,500 factory workers go after a federal investigation found hundreds of undocumented employees at its facilities. “I am crying as I write you this letter,” Charney told employees in a public note, vowing to continue fighting for immigration reform.

Even though the cuts represented one-third of its factory employees, American Apparel insisted the layoffs would not affect its finances. But in May, the company said its manufacturing efficiency was suffering as result of the massive employee cuts, contributing to a US$17.6-million operating loss in the first quarter. The problems will remain until early next year, it said.

Meanwhile, the company’s same-store sales are plummeting. American Apparel posted a 10% decline in the first quarter – the fifth quarterly decline in a row. The metric is an important measure of longevity because it includes only sales from stores that have been open for more than a year. The declines at American Apparel suggest the growth in top-line sales is primarily coming from its wholesale business and new store openings. The company attributed the dismal performance to the recession and from having too many locations in certain cities, saying some may have to be shuttered – not that consumers are tiring of the brand.

That risk is particularly great for American Apparel since its demographic is so style conscious. “This consumer moves really, really quickly,” says Sheridan at the Fashion Institute of Technology. “That’s very scary for the company. Every time they do something brilliant, they just raise the bar for themselves.”

Serving the customer is tricky when the company is trying to stay afloat. Both equity analysts who follow the company believe a resolution with Lion Capital is likely. The firm has an interest in seeing American Apparel succeed since, in addition to debt, it owns equity in the form of warrants. If exercised, Lion Capital would possess 18% of the company. Charney, meanwhile, has an interest in ensuring that doesn’t happen. His 53.3% stake would be diluted, and he could lose majority control.

That may happen anyway, unless Charney can either convince Lion Capital or yet another investor that, even after his turbulent history, he is capable of running the company. “The question is, does he have any credibility left?” says Davidowitz of Davidowitz & Associates, who is doubtful. But what would American Appeal be without Charney? It is strange to fathom, given how tightly the two are entwined. The company’s securities filings stress Charney’s loss would be “particularly harmful” to American Apparel. “If he wasn’t running the business and directing all the different functions, I can’t imagine it would be as good a business,” Smith says.

Others are less charitable. “I can give you 10 people who can take the company and run it very well,” says Ilse Metchek, president of the California Fashion Association. An admirer of Charney, she still points to many successful labels whose founders are not in full control, like Tommy Hilfiger and Calvin Klein. Like them, Charney has built a powerful brand known in many parts of the world, which is why American Apparel is an attractive acquisition target in its weakened state.

Only Charney knows what he’s willing to concede to keep American Apparel alive. But Charney, whose mouth has gotten him into trouble countless times, is not talking. He declined to be interviewed, other than offering a statement over e-mail. “I am very proud of our company’s performance,” he wrote. “I am very confident that our company will continue to flourish and be relevant for many years to come.”