In July of 2005, "Endeavor Acquisition Corporation (A Development Stage Enterprise) was formed in Delaware. Just before Christmas 2005, the company raised around $130 million in a "blank check" IPO, as a "Special Purpose Acquisition Company," effectively a promise to go buy something worth owning, eventually.

The thing about SPACs is that they don't generally start with an investment in mind, and they have particular restrictions on how long they can spend looking. In some cases, management must pay the fees paid out by the SPAC if it liquidates. This can get pricey. Think $1 million and above. In this case, Endeavor had 18 months from the "consummation" of the IPO to sign a letter of intent. After that, it was required to liquidate.

Said the firms filings:

Our efforts in identifying a prospective target business will not be limited to a particular industry, although we intend to focus on service businesses in one of the following segments: • business services; • marketing services; • consumer services; • health care services; and • distribution services.

They had about 6 months left when they filed an 8-K announcing their intention to acquire American Apparel, "a leading provider of cotton leisure wear geared toward contemporary metropolitan adults and sold through company-owned retail locations and online," which I suppose might have been termed a "distribution service company," after a long night in Tijuana.

Some signs of things to come lurked early in the 8-K:

American Apparel’s products are designed to be more tapered and tighter fitting and with bolder colors than similar offerings in the market and are promoted using provocative marketing and branding. Another important aspect of American Apparel’s marketing and branding is its adherence to environmental and employee friendly operating policies. (Emphasis mine).

Endeavor wasn't the first firm interested in American Apparel. In early 2006, Plainfield Asset Management considered a bite at AA, and, as buyers are likely to do, requested an outside audit. Having apparently never conducted an audit before (in fact, the Wall Street Journal reports that the interim CEO hired to replace the late Mark Schlein in 2005 quit after a week, leaving junior bookkeepers at the financial reins) AA wisely elected to conduct their own before opening the books to outsiders. This revealed what was reportedly a 30% inflation in 2005 earnings. Shockingly, Plainfield demurred to pursue a transaction.

And how do we address these other issues... better, I think, to let the Wall Street Journal do that:

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.

Mr. Charney found himself at the center of four lawsuits from former employees, all alleging sexual harassment. One was dismissed and two others were settled out of court.

The fourth, filed in 2005 by former employee Mary Nelson in Los Angeles County Superior Court, persisted. She asserted that Mr. Charney had referred to women as "whores" and "sluts" and solicited sex acts from her. Mr. Charney says Ms. Nelson was simply a disgruntled employee, but his defense did little to contain the damaging reports circulating in the media.

By the time Endeavor got involved, AA had seen another significant financial restatement, the acceleration of debt by lenders, the collapse of a refinancing deal and then of a deal which would have brought in a private investment firm. Doubtless, an IPO would have floundered.

The Endeavor was pretty good for AA. Designed to leave Charney with majority control, inject about $125 million and, after a brief spat, it was agreed that Charney would also retain the CEO slot. The proposed investment sailed through Endeavor's shareholder vote. And how could it fail with this cover sheet?:

A CFO, CIO and COO would be brought in from outside. And here, a particular nuance of negotiating with SPACs emerges. Signing a letter of intent extended the time before liquidation for Endeavor to 24 months from the IPO, or around December 2007. Charney resisted the addition of the "suits" around this time and Endeavor, against the wall, had little choice but to give in.

In the months that followed, the image of a firm without much adult supervision is hard to shake. Insurers are apparently balking at paying AA's sexual harassment liabilities, insisting AA hadn't fully disclosed prior sexual harassment issues, Woody Allen is suing for $10 million over the unauthorized use of his image on billboards, it seems that at one point all four Chicago stores were shut down for failure to have ever even applied for local business licenses, and U.S. immigration officials have asked AA to submit I-9 forms for its employees in its Los Angeles facility, prompting AA to file with the SEC materials to the effect that the company "could experience very substantial turnover of employees on short or no notice, which could result in manufacturing and other delays."

This is before we even talk about their loan arrangements.

As of December 31, 2007, American Apparel failed to meet the provisions of certain covenants as set forth in its credit facility and loan agreement. On February 29, 2008 American Apparel obtained waivers from its bank and private investment firm for violations of these covenants. If American Apparel is determined not to be in compliance with covenants or other terms of its credit and loan facilities in the future and/or is unable to receive any necessary waivers or consents, this may result in additional fees being assessed against American Apparel or acceleration of the outstanding debt in its entirety and may adversely affect the ability of American Apparel to continue operations. American Apparel has reviewed the terms of its current credit and loan facilities and believes that another default is likely to occur during 2008 unless the terms of its credit and loan facilities are re-negotiated.

But most of this is noise.

The reality is that the clothing line is immensely popular, controversy only propels its success in its anti-establishment (in so far as the under-thirty today are motivated enough to be anti-establishment) demographic, and despite the distractions, the firm has fairly strong financial results. International sales are a huge part of revenue and the weak dollar is likely to make that segment an equally huge part of earnings in the next reporting period.

The company is addicted to around $115 million in expensive debt at the moment, given its ravenous need to finance its unchecked growth, and, in this connection, probably shouldn't even really a public company. The entire focus of the Endeavor transaction was to cope with the debt issues AA had accumulated prior to 2007. They are headed back in that direction quickly.

While their "no sweatshop" line and their dedication to the social benefits of manufacturing in one of the most expensive states in the Union is a nice marketing piece, it is also very expensive. Expect it to get more so if immigration officials continue to sniff around.

Steve Cohen owned almost 9% of Endeavor as early as December 19, 2006, pretty much the day Endeavor filed the 8-K announcing the acquisition, he continues to hold a position today, though he does so under a SC 13G, so if he plans to be irritating he will have to wait until he amends to a SC 13D.

Still, even at $7 a share the company looks sort of expensive- unless you factor in some pretty aggressive growth assumptions. But, AA seems to enjoy meeting those kinds of expectations.

It is also a pretty small play. Something like $25 million will get you 5% of shares outstanding at today's prices and its a long slog to see returns. You'd have to be a smaller activist to want to play.

Then of course there is the fact that Charney holds a majority of common. Ousting him outright is unlikely to be particularly effective (he looks like a scorched earth kind of CEO to me). But the company doesn't need him removed, just the addition of some adult supervision and a better balance sheet. Not enough to stifle it, but to keep matters at least mostly in hand. After all, breaking covenants is very, very naughty- and its not the kind of rebellion that sells hot pants.

UPDATE: American Apparel responds:

Hi.

I saw your story called "Why Isn't American Apparel Beset By Activists."
In it you reiterate a number of mischaracterizations that appeared in a
Wall Street Journal article on April 12. I'm an executive at the company
and also a member of the company's board of directors. Our lawyers are
currently pursuing this matter with News Corporation, so we have not yet
issued a public statement.

1. Please note that American Apparel, even prior to exploring a loan
transaction with Plainfield Asset Management, had its financials audited
annually by Moss Adams LLP, a large public accounting firm. After Moss
Adams completed its audit for 2005 and uncovered misstatements in
American Apparel's unaudited interim numbers, Plainfield brought in
external auditors to verify the work of Moss Adams. They came to
virtually the same results as Moss Adams. Plainfield did not scuttle the
deal at this point.

2. "...on occasions walked through the factory in his underwear to model
new designs": Outside of a singular incident in 2004, which was shot for
the purposes of a promotional video, Mr. Charney has never walked around
the workplace in his underwear.

3. "Billboards springing up across the country": American Apparel only
has three billboards in the United States -- one in New York, one in Los
Angeles, and one in Chicago.

4. US Bank never accelerated their debt. The financing by a private
investment firm referred to as "collapsed" in the article actually
closed in January 2007. Plainfield tried to get a deal done with
American Apparel up through October 2006, at which point American
Apparel approached the private investment firm through which it closed a
$41 million secured second lien loan.

5. It is incorrect that Mr. Charney "resisted the addition of the
'suits.'" As I was involved in the renegotiation of the merger agreement
in October and November of 2007, I can tell you that this provision was
dropped from the amended merger agreement because Endeavor had not
identified any executives for these positions, and it did not make sense
that the hiring of these individuals be a condition of closing to the
merger which was a month away at that point. Endeavor agreed to an
amended deal and set aside an additional 10 million shares as
transaction consideration in November as American Apparel's business
began to significantly outperform the rest of the retail sector, having
finally gotten financing earlier in the year in January.

6. One Chicago store was shut down for licensing reasons. During this
time, we installed a new floor at the location, which had been planned
for some time.

7. "The company is addicted to around $115 million in expensive debt at
the moment" -- note that the compay has $65 million of fresh cash on its
balance sheet from a recently completed warrant redemption. So the net
debt is much lower. Leverage is on the order of 2.0x debt to EBITDA, and
about 1.0x on a pro forma basis for the warrants.

8. "The entire focus of the Endeavor transaction was to cope with the
debt issues AA had accumulated prior to 2007." This is not true. The
company was properly financed before the Endeavor transaction closed,
due to the aforementioned financing by a private investment firm in
January 2007. The point of the Endeavor transaction was to fund the
buyout of Mr. Charney's 50% partner in American Apparel.

9. The bank defaults you point out are for the most part violations of
maximum capex covenants and fixed charge ratios, which relate to the
company's rapid expansion. The company has gotten waivers of these
covenants from its banks.

The Wall Street Journal doesn't mention, though they were aware, that
American Apparel had been in discussions with a number of large,
prestigious private equity firms in 2006 about taking a minority stake
in the company. Those discussions fell apart over disagreements on
valuation, not concerns abot the company's business prospects.

Given that our lawyers are currently working on this Wall Street Journal
matter, you may want to think about whether you want this article on
your blog. We were very disappointed by the slapdash job on the part of
the young, 23-year old Wall Street Journal reporter who wrote the
article. Everyone who had played a role in American Apparel's financing
to this point, whether at the company, at our former or current lenders,
or other service providers, was disappointed over how inaccurate a
portrayal the WSJ story was.

Feel free to call me on this.

Adrian Kowalewski
Director, Corporate Finance & Development
American Apparel