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How Rising Cotton Prices Could Doom American Apparel

American Apparel's (APP) late filing of its 2010 annual report shows that CEO Dov Charney may be beginning to understand how much financial trouble he's in, although it's still not clear how committed he is to doing anything about it. Time may be running out: Even if the company can get its act together internally, the spiraling price of cotton may spell doom for the retailer.

American Apparel had 2010 revenues of $533 million, a decrease of 4.6%, and saw a net loss $86 million.

The operational problems at AA are not news: Charney spends too much on advertising, "selling expenses" and administrative costs. They are easy line items for any company to cut. But the 10-K says that did not happen last year. Selling and admin costs were all up. Even advertising costs -- at $18 million -- returned to the level they had been in 2008, up from $11 million in 2009. Ask yourself: Who increases their marketing costs when they know their revenues are declining?

Charney also needs to close many of his stores and charge higher prices at the ones that remain. There was a 13 percent decline in same-store sales for full year, a greater decline than AA's overall revenues. That suggests diminishing returns have set in for each new store that is opened. (AA currently has 273 stores, down from 281 in 2009. It closed 14 but opened six new ones last year.) Yet the 10-K repeatedly says AA's "growth strategy" is to open more stores.

That strategy will be sorely tested by the one thing that is not in Charney's control: The price of cotton, which has doubled in the last six months:

That increase is reflected in AA's gross profit, which is being crushed by the rising cost of yarn. AA's manufacturing costs rose 6 percent last year to $234 million; as a percentage of revenues they increased from 42.7 percent to 47.5 percent. Gross profit was down 13 percent as a result, to $280 million:

The problem is that advertising, new stores, and admin costs are all within Charney's control -- and he should have cut them last year. The price of cotton is not, leaving Charney in the worst of all worlds: Sales are declining, raw material costs are rising, and thus Charney will have to cut even more than he expected.


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