Question: What are the sources of American Apparel's current difficulties?Advise the CEO on what American Apparel should do next and, in particular, whether it should replace its in-house Los Angeles manufacturing with outsourcing to contract manufacturers in low-cost locations?

Case 17 American Apparel: Vertically Integrated in Downtown LA The dismissal of American Apparel's founder, Dov Charney, as CEO in June 2014 did little to stem the company's decline in financial performance that had begun in 2010 (Figure 1). American Apparel's share price reflected the gloom that had engulfed the company (Figure 2). FIGURE 1 American Apparel sales and profits, 2005-2014 ($million) 700 Sales Operating profit 50 600 40 30 500 20 10 400 2010 2013 2014 2005 2006 2007 2008 2009 2011 2012 300 -20 200 -30 100 -40 50 -60 FIGURE 2 American Apparel share price, March 2006 to May 2015 ($) 16 14 12 10 8 6 2008 2010 2012 2014 Paula Schneider had been appointed CEO at the beginning of 2015. The turnaround strategy launched by the new management team emphasized operational improvements and substituting formal internal processes for Dov Charney's freewheeling management style. Initiatives included: . aligning American Apparel's product range with customer preferences; . closing unprofitable stores; expanding American Apparel's online presence, especially through opening online stores in additional countries (including China); * growing wholesale sales; . improving production planning; improving manufacturing capabilities in order to be faster in introducing new products and reacting to changing trends; . upgrading distribution logistics to improve wholesale, retail, and online order fulfillment.- However, American Apparel's results for the first half of 2015 (Table 1) revealed a continuing deterioration of the company's performance. On October 5, 2015 American Apparel filed for Chapter 11 bankruptcy protection in order to implement a financial restructuring. The existing stock, including that of Mr. Charney, would be wiped out and creditors would swap their debt for new equity.TABLE 1 American Apparel: Financial results for the first six months of 2015 and 2014 ($million) 2015 2014 Net sales 258.7 299.5 Cost of sales 149.6 145.1 Gross profit 109.0 154.4 Selling and distribution expenses 90.9 106.5 General and administrative expenses 50.9 52.0 Operating profit/(loss) (35.9) (4.9) Interest expense 20.2 20.0 Net income/(loss) (45.8) (21.7) Source: American Apparel Inc. 10-Q Report, August 17, 2015. Under Dov Charney's leadership, American Apparel had defied the conventional wisdom of the rag trade. Instead of outsourcing production to low-wage countries, it had followed a Los Angeles-based, vertical integration strategy. Charney believed that the higher costs of manufacturing in the US could be offset by the price premium from superior quality, styling, and image, and by the benefits of speed to market. CEO Paula Schneider had initially embraced American Apparel's vertical integration strategy: "The beauty of what we have is we have all of our own manufacturing .?.?. The competitive advantage that American Apparel has is there is no one else that can do what we do. We have it right in our house. We have the ability to look at what's selling ... and make sure we create more of it or different colors of it or ... sister versions of it, that then can drive market share." However, the opportunity for strategic change that financial restructuring under Chapter 11 offered, Schneider wondered whether American Apparel should follow almost every other US supplier of leisure apparel by outsourcing production to contract manufacturers in Asia or Central America. The T-Shirt Business T-shirts, like denim jeans, are quintessential items of American clothing. About 1.4 billion cotton T-shirts are sold in North America annually with a retail value of about $20 billion. Originally underwear garments, T-shirts are the most common summer outerwear garment for weekend Americans. The designs and words they carry are statements of personal identity, indicating affiliation with a sports team, college, political movement, religion, charity, or specific social event. Yet despite the T-shirt's place in American culture, the vast majority are imported (Table 2). Major US producers, such as Gildan Activewear, Hanesbrands, and Delta Apparel, supply the US from plants in Central America and the Caribbean. Many imported T-shirts are made from cotton grown in the US, the world's largest exporter of cotton fiber. The average import price of a T-shirt in 2013 was $3.10. Imports from low-cost overseas production centers have caused employment in the US garment industry to shrink from 1.4 million in 1974 to 151,800 in 2011. TABLE 2 Major sources of US Imports of knitted shirts, 2014 Source country Value of imports, HTS codes 6105 and 6106 ($million) Vietnam 625 China 501 Indonesia 281 India 236 Pakistan 147 Cambodia 114Source country Value of imports, HTS codes 6105 and 6106 ($million) Jordan 114 Guatemala 89 Sri Lanka 68 Honduras 59 El Salvador 50 Philippines 44 Other countries 672 Total from all countries 3000 Source: US International Trade Commission, Interactive Tariff and Trade Data Web. The US T-shirt market features a wide variety of suppliers. At the wholesale level, blank T-shirts are sold by major suppliers (such as Gildan Activewear, Hanesbrands, Russell Athletic, and Fruit of the Loom) to screen printers that add their own designs or corporate and club logos. At the retail level, many different types of retailer supply T-shirts: independent specialty stores; department stores; and chains such as Gap, Urban Outfitters, H&M, and American Eagle; and market stalls. The price dispersion is wide: at Walmart, a Hanes T-shirt retails at $4.45, while at Nordstrom, a Versace Collection T-shirt sells for $395. Table 3 shows some leading suppliers of casual clothing. TABLE 3 Sales and profits of leading fashion apparel companies, 20142 Sales ($billion) Operating margin(%) Return on equity(%) Inditex (Spain) 23.7 17.6 25.4 H&M (Sweden) 17.9 16.8 40.1 Gap (US) 16.4 16.8 40.1 VF (US) 12.3 11.6 Next (UK) 6.2 10.6 Hanesbrands (US) 5.3 jok 19.5 29.2 31.4 Abercrombie & Fitch (US) 3.7 3.0 3.2 American Eagle (US) 3.3 5.7 9.9 Esprit Holdings (China) 13.0 oria 10.6 1.0 J. Crew (US) 2.6 (22.7) (73.0) Gildan Activewear (US) 2.4 11.0 13.6 American Apparel (US) |0.6 (7.2) (57.2)4 Note: " The data are for the financial year that most closely approximates calendar year 2014. Shareholders' equity was negative, hence ROE was not calculable. The figure shown here is for ROCE. Source: Financial Times. Dov Charney and the Development of American Apparel The Early DaysDov Charney has been described as "a brilliant entrepreneur," "an exhibitionist," "a champion of social liberation," "a sleaze-ball," and "a pervert." In other respects he was a traditionalist: emphasizing his Jewish roots, his affection for the shmata business, and his desire to recreate America as a manufacturing nation. Charney was born in Montreal in 1969. He started his first T-shirt business in 1990 and in 1997 moved to Los Angeles, where he joined Sam Lim and an associate of Lim's to form a garment company named "Two Koreans and a Jew." This later became American Apparel. Under Charney's leadership, American Apparel developed as a vertically integrated T-shirt manufacturer whose activities extended from knitting cotton yarn, through cutting and sewing, to dyeing and finishing. The main customers were screen printers who printed their own designs and logos and retailed the products. Compared to blank T-shirt giants Hanes (owned by Hanesbrands) and Fruit of the Loom. American Apparel differentiated itself by quality and design. In contrast to the standard loose-fitting, heavy-knit T-shirts, American Apparel offered closely fitting women's and men's T-shirts with finer thread and a denser knit. In October 2003, American Apparel opened its first retail store in Los Angeles. Within 14 months, American Apparel was operating 34 stores in North America and three in the UK. By 2005, American Apparel was the largest garment manufacturer in the US-a position it has held to this day. In December 2007, American Apparel was listed on the New York Stock Exchange. During 2008, American Apparel expanded rapidly opening 80 stores and entering five new countries (Austria, Belgium, Spain, Brazil, and Australia). It also won a number of awards as a trendsetting brand and an innovative retailer. The Controversial Mr Charney Dov Charney's key fashion innovation was in turning T-shirts into garments that enhanced the physical attractiveness of the wearer. Sexuality also played a wider role in the marketing and culture of American Apparel. In addition to its sexually provocative advertising, the company had a culture that acknowledged the sexual drives of its customers and its employees and embraced sexual conduct and sexual content as part of openness and creativity. Charney's sexual openness provided the basis for multiple sexual harassment lawsuits from former employees and triggered a wider investigation by the Los Angeles office of the Equal Employment Opportunity Commission into sexual harassment at American Apparel. Charney attributed the lawsuits to disgruntled employees seeking personal gain by exploiting California's litigious culture." As a result of the lawsuits, American Apparel required employees to sign a document that acknowledged the "sexually charged" character of the company's products and marketing and sales activities.- American Apparel also reflected Charney's social and political beliefs-notably his support for immigration reform and the wellbeing of illegal immigrants within the US. However, in 2009, American Apparel was found to be employing illegal immigrants and was forced to dismiss 1,500 workers. Problems Mount, 2010-2014 American Apparel's reversal of fortunes in mid-2010 was sudden and sharp. In July 2010, the company's auditor, Deloitte & Touche, resigned after discovering "material weaknesses" in the company's financial controls. Amidst warnings of declining sales and an operating loss, American Apparel's share price crashed: it hit 66 cents in September 2010, down from a high of $16.80 in December 2007. Mounting losses during 2010 resulted in the company breaching its loan covenants, forcing American Apparel to issue a bankruptcy warning. The result was a sudden shift of strategy from expansion to retrenchment and cost cutting. During the latter part of 2010, experienced senior managers were hired from Gap, Ralph Lauren, and Blockbuster Entertainment; turnaround specialist FTI Consulting was hired; and new sources of finance were sought. Cost reduction involved store closures, staff reduction, logistical improvements, and cuts to overhead costs. The financial weakness of the company was reflected in its cost of debt: an interest rate of 15% on its senior secured notes and 17% on its loan from the hedge fund Standard General. Despite some success at expanding sales and cutting overheads, the effectiveness of the turnaround strategy was undermined by increasing rancor in the top ranks of the company. As American Apparel's finances deteriorated, so did the board's tolerance for Mr. Charney's eccentricities. In June 2014, after an internal investigation found evidence of "misconduct" by Charney, the American Apparel board replaced him as chairman and CEO. However, Mr. Charney did not go quietly: during the summer of 2014 he sought to regain control of the company and in May 2015 began legal proceedings against the American Apparel board for defamation. Table 4 shows American Apparel's waning financial performance.TABLE 4 Selected financial data for American Apparel, 2008-2014 ($million) 2014 2013 2012 2011 2010 2009 2008 Income statement items Net sales 608.9 633.9 617.3 547.3 533.0 558.8 545.1 Cost of sales 299.8 313.1 289.9 252.4 253.1 238.9 245.9 Gross profit 309.1 320.9 327.4 294.9 279.9 319.9 299.2 Total operating expenses 318.2 330.0 295.5 263.1 Selling and distribution costs 212.6 241.7 227.4 209.8 218.2 198.5 168.5 General and administrative 121.4 107.0 97.3 104.1 103.2 93.6 78.9 Income from operations (27.6) (29.3) 1.0 (23.3) (50.1) 24.4 36.1 Interest expense 39.9 39.3 41.6 33.2 23.8 22.6 13.9 Net income (68.8) (106.3) (37.3) (39.3) (86.3) 1.1 14.1 Balance sheet items Current assets 199.0 215.3 224.4 230.7 216.5 186.3 187.0 Inventories 147.6 169.4 174.2 185.8 178.1 141.2 148.2 Total assets 294.4 333.8 328.2 324.7 328.0 327.6 333.0 Current liabilities 162.3 162.0 161.7 143.4 213.2 64.9 74.3 Overdraft and current bank debt 40.0 38.0 60.6 52.3 141.8 3.7 3.8 Accounts payable 35.6 38.3 38.2 33.9 31.5 19.7 26.3 Long-term debt 217.4 213.5 110.0 98.9 5.6 71.4 100.0 Total liabilities 409.9 411.2 306.1 276.6 252.9 170.2 196.6 Stockholders' equity (115.5) (77.4) 22.1 48.1 75.0 157.3 136.4 Cash flow items Net cash from/(used in) operations (5.2) (12.7) 23.6 2.0 (32.0) 45.0 21.2 Net cash from/(used in) investing activities (9.6) (25.1) (24.9) (10.8) (15.7) (20.9) (72.2) Net cash provided by financing activities 15.6 34.2 4.2 12.6 48.2 (25.5) 41.2 Source: American Apparel Inc. 10-K Reports. American Apparel's Strategy and Operations American Apparel was a leading supplier of T-shirts to the US market, both blank T-shirts sold to screen printers and final products supplied through its retail stores. Its Los Angeles manufacturing plant was by far the biggest garment- manufacturing facility in the US. This reflected the dominance of imported garments in the US market: most fashion clothing companies concentrated on design, marketing, and distribution, with manufacturing outsourced and offshored. The distinctive feature of American Apparel was its high level of vertical integration: not only did it undertake most stages of production at its Los Angeles headquarters but also it performed its own design, marketing, and advertising, and owned and operated all its retail stores, even its overseas stores. As a result, American Apparel's business system achieved remarkable speed and flexibility:Our vertically integrated business model, with manufacturing and various other elements of our business processes centered in downtown Los Angeles, allows us to play a role in originating and defining new and innovative trends in fashion, while enabling us to quickly respond to market and customer demand for classic styles and new products. For our wholesale operations, being able to fulfill large orders with quick turn-around allows American Apparel to capture business. The ability to swiftly respond to the market means that our retail operations can deliver on-trend apparel in a timely manner and maximize sales of popular styles by replenishing product that would have otherwise sold out. American Apparel's product development cycle-from design concept to store rack-took as little as two weeks. Within a day, a designer could come up with an idea, design a garment, create a pattern, cut it, and have it sewn together. By the evening, the garment could be photographed on a model and emailed for approval by the CEO. After test marketing in a few American Apparel retail stores, customer purchases were tracked and analyzed, and then, if successful, the garment would go into full production for shipping to the rest of American Apparel's retail locations. Product Development and Design Recreating the T-shirt as a fashion garment was at the heart of American Apparel's business proposition. Design required careful attention to fit, texture, shape-retention, and color. "We've fashionized and brought fashion to the commodity setting," Charney explained, arguing that his main achievement was "feminizing the blank T-shirt industry."-Previously, T-shirts were "bulky, one-size-fits-all" garments that were not gender specific. American Apparel employed an in-house team of designers at its Los Angeles headquarters. The team didn't read fashion magazines and paid little attention to catwalk fashion trends. It developed "updated versions of timeless, iconic styles" and took "inspiration from classic styles of the past, as well as the latest emerging fashion trends"- notably, style trends among young, urban bohemians in cities such as Los Angeles, London, and New York. The clothing represented a retro urban-chic style with a 1970s flavor. Designers often went to vintage clothing stores to find inspirations for new designs. Until his departure, the design team was led by Dov Charney, who hired each member on the basis of whether the designer had "an eye for what's next."II By 2009, the company had expanded its product range well beyond the T-shirt. It offered over 20,000 stock keeping units (SKUs), including fabric shirts, dresses, denim jeans, sweaters, jackets, swimwear, babywear, and a variety of accessories, such as bags, hats, scarves, and sunglasses-even sweaters for dogs. American Apparel intended to continue to introduce new merchandise to complement its existing products and draw in new customers. Manufacturing American Apparel's headquarters and main manufacturing facility comprised 800,000 square feet of floor space that occupied the former Southern Pacific Railroad depot in downtown Los Angeles. Dyeing and finishing were at a separate facility in California, Capacity shortage at its Los Angeles facility resulted in American Apparel expanding production to nearby locations. The company described its production operations as follows: Purchased yarn is sent to knitters to be knit into "greige" fabric, which is fabric that is not dyed or processed ... As of December 31, 2011, our knitting facilities knit approximately 85% of the total fabric used in our garments and had approximately 80 employees. Knitted greige fabric ... is batched for bleaching and dyeing and transported to our dyeing and finishing facilities, or other commissioned dye houses... Most fabric is shipped to our primary manufacturing facility in downtown Los Angeles, where it is inspected and then cut on manual and automated cutting tables, and subsequently sewn into finished garments ... Garments are sewn by teams of sewing operators typically ranging from five to fifteen operators, depending on the complexity of a particular garment. Each sewing operator performs a different sewing operation on a garment before passing it to the next operator. Sewing operators are compensated on a modified piece-rate basis. Quality control personnel inspect finished garments for defects and reject any defective product. Retail and Wholesale Distribution In May 2015, American Apparel owned and operated 252 retail stores in 20 countries (Table 5). The company described its retail operations as follows:Our retail operations principally target young adults aged 20 to 32 via our unique assortment of fashionable clothing. accessories and compelling in-store experience. We have established a reputation with our customers who are culturally sophisticated, creative, and independent minded, Our product offerings include basic apparel and accessories for men and women, as well as apparel for children. Stores average approximately 2500-3000 square feet of selling space. Our stores are located in large metropolitan areas, emerging neighborhoods, and select university communities. We strive to instill enthusiasm and dedication in our store managers and sales associates through regular communication with the stores. TABLE 5 American Apparel: Number of retail outlets at year-end 2014 2013 2012 2011 2010 2009 2008 2007 2006 US 136 139 140 143 157 160 147 105 93 Canada 31 32 35 37 40 40 37 30 26 International 75 77 76 69 76 81 75 47 30 Source: American Apparel, 10-K reports. American Apparel favored locations away from traditional main streets using nontraditional retail buildings with unique environments. Store selection and design had been undertaken by Jordan Parnass, a lifelong friend of Dov Charney, whose location scouts searched cities for areas that were populated by artists and musicians and for the hangouts of young adults. Store designs sought to incorporate the location's "regional flavor" together with the characteristics of the building's structure. - Stores included a converted movie theater and a former auto-garage. American Apparel's wholesale business sold to about a dozen authorized distributors and over 10,000 screen printers. The latter printed blank products with corporate logos, brands, and other images. Wholesale customers were served by a call center at its Los Angeles headquarters. The company prided itself on the fast turnaround of orders: orders received before 6 pm were shipped the same day. American Apparel offered online retail sales through its www.americanapparel.com website. There were localized websites for the US, Canada, the UK, Europe, Switzerland, Japan, South Korea, Australia, Mexico, Brazil, and, from late 2014, China. Table 6 and Table 7 show American Apparel's sales and profits by segment and by country. TABLE 6 American Apparel: Financial results by business segment ($million) 2014 2013 2012 2011 2010 2009 2008 US wholesale Sales 208.9 201.3 185.4 156.5 149.0 141.5 162.7 Gross profit 60.2 49.9 53.2 42.6 32.0 36.2 46.9 Operating incomea- 31.1 12.0 27.9 22.4 11.2 15.5 21.0 Capital expenditure 2.4 10.1 9.8 3.6 4.7 4.6 7.1 US retail Sales 191.4 205.0 198.9 174.8 177.6 191.3 168.7 Gross profit 123.7 131.9 130.5 117.2 117.5 136.4 127.9 Operating incomed (0.8) (2.7) 4.2 (4.7) (18.5) 17.3 33.5 Capital expenditure 4.0 11.2 6.6 4.9 7.6 11.2 30.9 Canada Sales 51.5 60.1 63.7 61.9 65.6 69.0 67.3 Gross profit 28.0 34.7 37.5 35.8 43.3 43.2 40.12014 2013 2012 2011 2010 2009 2008 Operating incomed 3.8 3.7 (0.1) (3.7) 5.1 14.0 10.8 Capital expenditure 1.7 1.2 1.6 0.4 1.5 1.4 4.7 International Sales 156.9 167.5 169.4 154.2 140.7 156.9 146.4 Gross profit 97.2 104.4 106.2 99.3 87.1 104.0 84.2 Operating incomed (1.4) 3.6 10.7 8.4 (5.1) 15.3 8.0 Capital expenditure 3.0 4.6 3.6 2.1 2.0 3.8 18.3 Note: a Before corporate expense, interest, other income, and foreign currency adjustment. Source: American Apparel, 10-K reports. TABLE 7 Geographical distribution of sales, 2009-2014 ($million) 2014 2013 2012 2011 2010 2009 United States 400.4 406.3 384.2 331.3 326.6 332.8 .com Canada 51.5 60.1 63.7 61.9 65.6 70.0 Europe (excluding UK) 64.8 70.3 66.9 68.1 69.0 81.3 United Kingdom 42.6 44.2 47.7 40.0 32.5 34.2 Japan 12.8 18.1 20.3 14.2 10.7 14.1 South Korea 12.7 10.4 10.7 9.7 9.5 9.4 Australia 9.3 10.2 11.5 11.6 9.5 9.1 China 7.6 6.9 5.3 n.a. n.a. n.a. Other foreign countries 7.1 7.4 7.0 10.5 9.5 8.8 Total net sales 608.9 633.9 617.3 547.3 533.0 558.8 Note: n.a. = not available. Source: American Apparel, 10-K reports. Employee Relations: A "Sweat-Shop" Free Environment American Apparel summarized its approach to human resource management as follows: We view our employees as long-term investments and adhere to a philosophy of providing employees with decent working conditions in a technology driven environment which allows us to attain improved efficiency, while promoting employee loyalty. 16 Rates of pay exceeded the going rates for the job: even the lowest-paid workers earned around double the minimum wage. Workers were offered subsidized healthcare for themselves and their families, subsidized lunches, free parking, bus passes, and low-cost auto insurance. There were on-site massage therapists who provided regular services for all employees. Yoga classes were also available, along with a health-and-wellness specialist who provided counseling. Workers could take bathroom breaks at any time and use their cell phones for quick personal calls during working hours. Workers received training to improve their job and management skills as well as English and math classes. Theand amateurish quality to the images which served to heighten the impression that the ads were exploitative of women and inappropriately sexualized young women."10 American Apparel made heavy use of billboards but avoided mainstream media. Its advertising was directed mainly to online sites and alternative newspapers, such as The Village Voice, LA Weekly, and The Onion, and online fashion magazines. It also used its social and political activism in its marketing communications emphasizing its "sweatshop free" credentials, its support for immigrant rights, and its commitment to environmental sustainability. Under Paula Schneider, American Apparel sought to sustain its edgy appeal while toning down its overt sexuality. Britain's Independent newspaper commented: "Editing the photos of lingerie models on its website seems to be the first attempt by the brand to distance itself from the racy advertising it's well known for. However, by photoshopping out some of the models' exposed nipples and pubic hair makes them look like plastic mannequins." The Road Ahead While Chapter 11 offered American Apparel breathing space, Paula Schneider realized that its room for maneuver was limited. The most obvious way to cut costs was to offshore manufacture. Monthly wages for production workers in Los Angeles were about $1,500; in Bangladesh they were about $69. However, American Apparel's Los Angeles manufacturing base was central to its brand identity and its business model. Design too presented intractable problems. While still commanded a loyal following from many consumers, American Apparel's 1980s vibe appealed to less and less of the late-teens to early 30s demographic segment. The continuing decline in sales during 2015 suggested that Schneider had yet to articulate and convey a clear and appealing image for the American Apparel brand. Notes 1 "New CEO Paula Schneider: How I'll Fix American Apparel," Forbes (January 22, 2015). 2 Ibid. 3 P. Rivoli, The Travels of a T-Shirt in the Global Economy: An Economist Examines the Markets, Power, and Politics of World Trade, 2nd edn (John Wiley & Sons, Lid, Chichester, 2009). 4 The early history of American Apparel is described in A. A. Nieder, "The Branding of Blank Tees," https://www.americanapparel.net/presscenter/articles/20000818caapparelnews.html, accessed July 20, 2015. 5 American Apparel, 10-K report for 2008 (2009): 31. 6 "Living on the Edge at American Apparel," Business Week (July 27, 2007). Z J. Wolf, "And You Thought Abercrombie & Fitch Was Pushing It?" New York Times Magazine (April 23, 2006). 8 American Apparel, 10-K report for 2011: 7. 9 D. Charney, interview, "Worldwide," Chicago Public Radio (November 13, 2003). 10 American Apparel, 10-K report for 2011: 10. 11 D. Charney, interview, "Charlie Rose," KQED9 (TV broadcasting station) (July 2006). 12 American Apparel, 2011, op. cit.: 8-9. 13 Ibid. 14 A. DiNardo, "The Anti-Brand," Visual Store (December 4, 2006). 15 Ibid. 16 American Apparel, 2011, op. cit.: 11. 17 J. Wolf, op. cit. 18 "American Apparel Ads Banned for Using Overtly Sexual Images," http://www.theguardian.com/media/2013/apr/10/american-apparel-ad-banned, accessed July 20, 2015