When it comes to stocks, it’s unwise to depend on hearsay. A reporter from a media outlet may be relying on dubious sources, or an analyst’s conjecture may simply be “thinking out loud.” Still, I pay close attention when a report emerges about a company I really know. And I think I have a duty to weigh in if that report doesn’t fully explain the issue.
 
#-ad_banner-#So when I awoke Wednesday morning (Jan. 11) and read an article in the New York Post alleging deep troubles at retailer American Apparel (NYSE: APP), I knew I could make the issue more comprehensible to readers.

Here’s what’s going on…

Back in mid-November, I suggested bankruptcy was looking like an increasingly likely outcome due to the company’s financial troubles, perhaps as soon as this spring.

A lot has happened since then. Shares first began to drift ever-lower as an increasing number of investors realized the company’s cash was running out and that the retailer would likely be a “terminal short,” which means it’s probably going to zero.

But short-sellers began to get nervous in mid-December when it appeared as if sales trends were picking up nicely ahead of the holidays.

Sure enough, in the week of Jan. 2, the company announced sales in December spiked a whopping 15% to $56 million compared with the year-ago period. That was not what short-sellers wanted to hear, and their short-covering helped propel the stock up sharply.

But shorts should have stayed the course. And for those who haven’t sought to short the stock before, this may prove to be an especially fruitful entry point.

I base this assumption on the New York Post article.  What did the Post have to say? The only reason American Apparel saw robust sales strength in recent weeks is due to a decision to heavily utilize Groupon (Nasdaq: GRPN), the group-buying site that offers hefty discounts. This likely means the higher-than-expected sales yielded lower-than-expected profit margins.

If the newspaper is correct, and I have no way of verifying it, then this stock is in big trouble. (For the record, the New York Post has broken many scoops and is often the first media outlet to uncover important news in the investment end of the retail sector. They’re not always 100% right every time, but I trust their information much more than an anonymous Internet blogger, for example.)

For many retailers, heavy promotions to move merchandise are an unfortunate aspect of the trade. But for a company that absolutely needs to generate cash, it can be the worst move to make. That’s because lenders want to know that a business can generate the cash needed to meet debt obligations. If a company struggles to do so in the all-important holiday season, then lenders become quite dubious that debt-service obligations will be met in future quarters.

We won’t know what American Apparel’s December quarter results will look like for another month. Prior to the holiday season, the company predicted it would generate $20 million in EBITDA in the quarter. As a point of reference, American Apparel’s EBITDA was -$2.3 million in the December 2010 quarter, and the company has never generated more than $4 million in quarterly EBITDA at any point in the past three years. If you connect the dots from the New York Post report, then you can assume American Apparel’s EBITDA likely fell far short of its internal targets.
 
Risks to Consider: The biggest risk is if the report is simply wrong and that American Apparel had a good old-fashioned blow-out quarter devoid of any tricks. This business has so many challenges, especially in terms of its balance sheet, that shares are unlikely to rise much further from here even if this was the case, unless it falls prey to a massive short squeeze.

Action to Take –> This is a tricky play. There is no assurance that the New York Post report is correct, so it may be prudent to wait further news from the company about December EBITDA.  That said, shares could deteriorate very quickly as the New York Post article makes its rounds among fund managers and short-sellers. Any move to short this stock should only be done by those with a high-risk tolerance, but the payoff could be rewarding.