Tuesday, May 16, 2006

TRLG - I still have True Religion

In my last post, I suggested that small cap stocks are reaching the end of their run. As an asset class, I continue to believe this, but, obviously, there are exceptions, and True Religion (TRLG)is one such stock. Now, today was NOT a good day for owners of TRLG, but it represents an opportunity for anyone looking for a fast money investment with great fundamentals.

I was first introduced to this stock through Gualberto and NYC Cashflow. When I first heard about it, I ignored it, because (I said to myself) I do not purchase fashion stocks. I remember what happened to Donna Karen a few years ago, huge runup after the IPO, and then, squat.

But eventually, I was encouraged to take a look at the stock, and the numbers were simply eye-popping. At the time (Nov 2005) the company was earning 108% on shareholders equity. The most important measure of any company's performace, ROE tells you how efficiently a company is using the shareholders capital. Most companies with high ROE (above 20-25%) have undertaken major stock repurchases (like another holding CL, Colgate-Palmolive), and have therefore returned most of shareholders money to them. Companies with high ROE sometiemes have high leverage (like the financials), and you have to be careful about this, but they are also the best companies - they can take on the leverage because their cash flows are both regular and predictable. Because they are earning big bucks on every dollar invested, they are very often companies that need very little capital investment to increase revenues and profits, and can instead return their cash to shareholders . They are also usually mature businesses: "cows" in the parlance of the Boston Consulting Group.

TRLG, however, is not a cash-cow in BCG terms; it is definately a star. As a new company, it has huge growth, which usually requires lots of capital investment, but at TRLG they generated $35 million in revenue in the first quarter, and had only $193 thousand in cap-ex, or 0.65% of revenue! Consider this carefully - at this rate, we would anticipate about $1 million in cap-ex for the year. In order to maintain 85% return-on-capital-employed, the company would have to increase net income by $850 thousand in 2007 (and that assumes no depreciation!), in fact, the company will have much stronger growth than this. Usually, increasing ROCE is extremely difficult, thus, if you wish to see earnings increase, you have to see the capital base increase with it. At TRLG ROCE is trending higher, but ROE will not increase, because cash and equivalents are piling up on the balance sheet. This, my friends, is a very good thing. How the company will use cash in the future is the next test of management. If they begin purchasing things, beware. If they discuss shareholder-friendly initiatives (dividends, which they have pretty much ruled out, and share buybacks) rejoice. In all likelihood, they will use that cash to grow the business, but as long as they do so carefully, I can be satisfied as a shareholder.

When it comes to leverage, to boost returns, unlike CL, TRLG has more cash and equivalents than liabilities! This DOES NOT include receivables or inventories!

Ok - so we know the balance sheet is awesome, what about the income statement? Well, revenues were up to $35 million in Q1 from $20 million in the year ago period, an increase of 77%. Margins INCREASED, from 50 to 52%, and according to management this is the outlook for 2006:

We have begun to demonstrate our leadership position to the market, both in the United States and overseas. The premium denim market remains highly competitive; however, we are beginning to increase our market share. Certain of our competitors have exited the higher end of the premium market and have announced lower prices and are targeting the low $100 range. In contrast, we have held our prices in the $170-$200+ range with no wholesale price erosion. Our brand continues to have strong broad-based appeal and has captured increased shelf space and square footage in major department and specialty stores.
We plan to continue selling denim and non-denim products under the label True Religion Brand Jeans. We plan to continue to broaden our product line during 2006 introducing a broader selection of skirts, t-shirts, knits and other sportswear, cotton twill pants for Summer. Later in the year, we will be showing a collection focusing on a down-filled parka and vests with corduroy-contrast yokes. We forecast 25% non-denim product sales for full year 2006 and achieved 22% for the three months ended March 31, 2006. For the full year 2006, we forecast that U.S. sales will account for approximately 60% of total sales, and international sales for approximately 40%, with our gross profit margin remaining in the 50-52% range. (Form 10Q, May 15,2006)

Management remains fixed on its strategy, and is gaining share of the premium market, which will help insulate it if there is something of a retail downturn (the premium end of the market usually holds up best, because high-end consumers have the deepest income streams).

Net margins did decline, due to higher Selling, General, and Administrative expense, but this is due in large part to staff increase to prepare for this year's growth (especially at the retail store).

Final question (though it is usually one of the first I ask) - what about equity compensation. If the company is supressing costs by handing over "non-cash" compensation in the form of stock and options, you have nothing (ask your friend who is wondering why his CSCO is stuck in the mud). Check out the footnotes in the the 10K. Fortunately, at TRLG, things are pretty reasonable. The company has ceased awarding options, since the mid of 2005. They are awarding restricted stock, but the 300 thousand shares awarded vest over the next three years. 1.5% dilution is a high price for a company with such numbers, but fair.

So, any downside risks? Absolutely. Fashion, obviously, is fickle. The death of premium denim is rumored regularly. If companies reversed the trend toward more casual attire, killing jeans Fridays and the like, the market for such denim could decline. But this is also a company that had just $100 million in revenue in 2005, it has room to run, and denim is not going away. Gualberto, ever the king of fundamental research, started chatting up a fabric saleswoman, and found out that denim is still moving, so the imminent demise of denim is perhaps not so imminent.

The bigger risk, in my mind is the opposite. If premium denim remains as hot as it is, potentially other companies with deeper pockets may try and enter the segment and buy shelf space at the stores that carry True Religion Jeans. TRLG is taking some steps to prevent this by diversifying to other product segments, including premium fleece and others. Management is trying to have 25% of its sales come from outside of the denim segment, and again, they seem poised to deliver, thru March 2006, 22% of revenue comes from other sources.

Growth to $400-$500 million in revenue in the next five years does not seem unreasonable. This is a compounded annual growth rate (of revenue) of 38%. Even if net income increases more slowly, and dilution takes EPS growth to 25%, the company's stock would triple in five years without any multiple expansion.

In short, this is one of the most incredible investments I have ever come across. It remains that today, and I will likely take this opportunity to increase my position. Many readers of this blog already have a position in this stock. I am interested to hear what you all are thinking.


  1. Really good analysis Doug. We were discussing the balance sheet yesterday, and at the conclusion of our discussion we had decided that everything does seem to be going well with the company's financials.

    Like I stated in the thread on my site, the fabric salesperson told me denim sales are strong through Spring 2007. As far as bigger competitors coming into the arena to take away market share, I wouldn't be too concerned. I think they would rather buy the company than compete with it.

    Something that concerns me right now is the same thing that concerned me when the company hit $11.80 a share back in October. A company or fund can come in and buy this company at a 50% premium and still get a value deal. That's something I'm not going to want to deal with.

  2. When it comes the sale of the company, isn't it mostly in the hands of Jeff Lubell, who, together with his wife, functionally control the company? They could both sell control or, potentially just as bad, prevent a sale, even at an attractive price.