American Apparel Continues Nosedive: Increased Ad Expenses on Declining Sales

American Apparel (APP)'s Q2 2010 earnings report arrived today like an artifact unearthed from an archaeological dig: Too old to be currently useful but fascinating nonetheless.

The company is teetering on the brink of bankruptcy and is attempting a turnaround with new management, so it is on a delayed schedule for reporting numbers to the SEC. Even though it only covers April through June, the 10-Q is still the most recent information available about the condition of fashion's most-watched advertiser. Here are the highlights:

Sales down 3 percent to $133 million.
Selling expenses, advertising expenses and administration expenses all went up.
That led to a loss of $15 million from a profit the year before of $4.5 million.
The loss would have been greater if not for a one-off tax benefit of $2.2 million.
The company warned for the second time that if it cannot pull out of its debt-nosedive it may not be a going concern.

Let's dispense with the obvious first: You cannot rack up increased expenses when your sales are declining. This is a company that must -- must! -- become smaller in order to survive. That will mean reducing its marketing costs. In fashion, that's not such a bad thing. Small can also mean "hard to get" or "exclusive," if played right. Unfortunately, AA's finances show few signs of the cuts required. The company said:

The increases in rent, advertising and promotion were incurred to support the increased number of stores in operation compared to in the prior year.

That's how CEO Dov Charney operates in a crisis -- the same way he operates when he's not in a crisis.

An even worse story is unfolding on the cashflow statement, which measures the company's actual use of cash as opposed to the formal accounting on the income statement. There was a loss of $24 million from operating activities (i.e. the company's bread-and-butter business) but an inflow of $31 million from financing activities (i.e. debt). In other words, this company's underlying business is currently out of control and it is only surviving on what it is borrowing.

New management can really help here: Slowing down accounts payables and quickening accounts receivables are legitimate tactics for companies with cashflow problems. They are not a long-term solution, however.

There is some indication that reality is finally arriving at AA. The company wrote down $6 million in "impairment charges" and closed five stores in the first six months of the year. We'll need to see more of that to bring AA back to profitability.

Also, even though all of AA's business segment are down, U.S. sales are actually up, including the under-exploited wholesale and internet sales segments, which I've argued before are AA's hidden gems because they are more isolated from the whims of the fashion world and have a greater potential to sustain price increases.

That suggests to me that AA continues to have an underlying business that can be rescued. It's simply a question of whether Charney's creditors can convince him of this.

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