Tuesday, September 26, 2006

I've left the temple of True Relgion

On Thursday, I unloaded my entire position in TRLG at $22.60. The stock hit an eight month high, near its all time high of $24.61, and this time I became concerned about valuation, and decided to take my 66.7% gain and run. The stock may head higher, but I believe that it will go lower again; indeed, it closed at $21.45 yesterday.

It should be noted, however, that evaluating an investment is an art, and not a science. While the math is straightforward, you have to make many estimates, because there are many possible outcomes. Buffett speaks of the need to have a range of values for a stock (and then watch developments and re-handicap the possible outcomes as events unfold). The quality of these estimates and the ability to estimate the probability of one of the outcomes over the other are the keys to success. So let’s break down my rationale for believing that the above estimate is approximately correct.

Reason 1: Valuation

The primary reason I sold was that my numbers told me to. I ran the numbers and concluded that the fair value of the stock is about $21-$22, so I sold at a slight premium to that value. As you can see from the embedded Discounted Cash Flow analysis, I estimate pretty strong revenue growth going forward, with ten years of growth above 15%. At the moment, the company is growing 50% over the prior year, but this is already a slower growth rate than 2005 was over 2004 (you can only compare the fourth quarter). As the revenue base continues to grow, I expect that in percentage terms revenue growth will continue to slow.

Revenue growth is the key to this company’s share price. The company’s price has almost nothing to do with the assets on its books. The price is entirely dependent on the expectation of future earnings growth. Thus, if earnings falter, even a little bit, the stock price is going to be hurt. Of course, that happens for all companies, but companies that have a market cap closer to their book values have a natural buoy to their share price – the fact that the assets on their books have value, and could be sold.

As of the second quarter, TRLG has $57 million in assets, against $7 million in liabilities. This is enough to get any investor’s attention. Better yet, $50 million of that is in current assets. The company has far more money in cash and short term investments than it has in liabilities. In short, the creditworthiness of the company is tremendous. In fact, almost none of its assets are actually used in the business. The company has about $20 million in working capital, and $2 million in property plant and equipment, substantially all of which is leasehold improvements at its corporate offices, warehouse and retail locations. In fact, the company appears to require no long term assets to run its business. This is a wonderful thing, in my mind, because its return on capital employed (ROCE), the capital actually used to run the business, is about 125%. These are the kind of numbers that had me buying at $13.50. But at that time, I estimated that the stock was conservatively worth $20 per share. While intrinsic value has grown somewhat (to almost $22), the market has come to value the company at that level, too. I don’t want to speculate on the market now overvaluing the company substantially, as betting on the market’s irrationality also requires me to bet on which direction that irrationality will take. Since by its nature the behavior would be irrational, it’s a fifty-fifty bet. I look for better odds.

The problem is, with $50 million in net assets, the company trades at over $500 million – for a price to tangible book of 10 times. The market is offering this company a tremendous amount of goodwill, because it is very well managed, but if there is even a small slowdown, Jim Cramer will be shouting “CLEAR!” as the price drops painfully. Since even well managed companies tend to miss “whisper” numbers on the Street (sometimes their very good management is actually the problem, as the Street gets too optimistic about management’s ability to deliver). I think this could happen in either the 4th quarter of this year or the 1st quarter of 2007.

It is also true that if revenue grows faster than I project, particularly in 2007 and 2008, the stock’s value should be higher. If operating margins were to increase, the company should also have higher intrinsic valuation. I don’t expect higher revenues (see reason three below) and I also don’t see higher operating margins (see reason four). It is also worth noting that there can be no assurance that the company’s products will remain fashionable for the next ten years, so future revenue growth could be negative, which would have a significant negative impact on the shares. Is the risk worth it?

Reason 2: Me

A successful investor has to control his own emotions. He also needs to know the limits of his competence – his circle of knowledge where he can make decisions better than others. In my case, TRLG does not fit that profile. This stock is really outside of my area of expertise. I purchased the stock not because I saw great visions for True Religion (though the company’s management does). I purchased the stock because I loved the growth rate and the balance sheet (check out the balance sheet on Yahoo or at your broker’s research site. It is as pristine as can be, with more cash than liabilities).

Back in early 2006, about 75 days after I purchased my shares, the stock hit an all-time high of $24.61. I decided not to sell, because I let the market convince me that I should trust my most aggressive estimates that showed an intrinsic value of $27-$30 a share. I was the fool in this case, since the stock then took a major dive, back down to $15. Had I sold, I could have bought back in when the stock hit that price point, which was a significant discount to my low-range value of $17 per share. I don’t want to make the same mistake again.

For what it’s worth, my lack of special knowledge means that I may be underestimating the company’s prospects. But I would rather underestimate them than overestimate them.

QUESTION: If think my revenue projections too conservative, please tell me why.

Macro Trends

While I lack special knowledge of fashion brands, I can see how macroeconomic factors will likely impact retail – negatively. The economy, while still strong, continues to slow. With a stabilization, or even decline of home prices, and the imminent retirement of spendthrift boomers, we face a high probability of declining consumer spending, which should put the entire category at risk. While the high-end of any market usually holds up best in a downturn (wealthy folks have wide, deep income streams), strong growth rates mean acquiring new, “mass affluent” customers. Faced with the need to save more, these folks are less likely to splurge on $300 jeans, so I expect that more aggressive growth rates that would further lift intrinsic value (and ultimately share price) are less probable than the rates reflected in my DCF analysis.

Company specific issues

Apart from the foregoing, TRLG has some other company-specific risks. The stock is controlled by a single shareholder, who also happens to be the CEO. In fact, insiders control a significant amount of the stock, and therefore not only have control of management, they also control the board. While this is not necessarily a problem, after all, some of the best run companies in the world are controlled by single shareholders, it is even more important than with other companies to see if management is acting in the interests of all shareholders.

While management appears to be running the business well, they are taking steps that are not nearly as shareholder friendly. While they have stopped issuing options (the remainder of which will eventually be exercised, rest assured), they are instead issuing large amounts of restricted stock. Thus, as shareholders, we are seeing our slice of the pie get smaller. The pie is getting bigger at a very fast pace, so the size of our slice is getting larger, but it is doing so by getting thinner and longer. I like to look for companies that are net-repurchasers of stock. That is, the repurchase more than they issue (including options). That way, I know that my slices are getting wider as well as longer.

True Religion is not doing so. They are not repurchasing stock, nor are they issuing even a small dividend. While this is not uncommon among small fast-growing companies, TRLG has demonstrated that it doesn’t need additional assets to fund its growth. No where has TRLG indicated that it has definite capital plans that might require the cash to be reinvested in the business. So why not return cash to shareholders?

Likewise, why pay employees with stock? Why not pay them cash bonuses (from current year revenues). This will reduce the cash-hoard slightly, but again, the cash doesn’t seem to be required. Employees can purchase the stock in the open market if they consider it such a value.

Finally, when management controls a company like this one and cash starts piling up, management gets all sorts of ideas about various projects that would be interesting to undertake. Usually these ventures produce far lower returns than the business itself, and ultimately destroy value. With no real checks to prevent this, as a shareholder I must be concerned about the uses to which the cash will be put.

Market environment

TLRG has been a favorite stock of the shorts. As of August 10, it had nearly 40% of the float sold short. This, ironically, is often a bullish signal. Since the short shares have to be bought back, large short positions guarantee future purchase volume (though not higher prices). However, as the stock has been rallying in the last few weeks, various shorts have undoubtedly been closing their short positions by repurchasing the shares, potentially at a loss, as the stock market has rallied, rather than faltered, during this unusual third quarter.

Once that short-covering purchase demand dries up, however, we are likely to see a downward drift in the price. Some shorts, convinced that technical factors will drive the stock down to the mid-teens again, will start selling short again. Such a reversal is likely to see us head lower.

The bullish case

The bulls can argue that revenue growth will remain strong (the third quarter is the biggest, revenue wise for the company. If we see continued strong growth in the US coupled with a recovery of revenue in Asia, the stock should head higher.

However, the bullish case also relies on continued short squeezing, and potentially on a sale of the company. I believe that, at current valuation, no such sale is likely. An acquirer would get some cash, the trademarks, and a heap of goodwill. And that is BEFORE paying a takeover premium. Similarly, an effort to take the company private, which is possible because insiders could commit their stock, would still require significant amounts of debt, at least $300 million worth, which the company could probably pay, but would significantly impair net revenues, as the interest payments would be on a scale comparable to operating earnings.

In short

I still like the company, so if there is a significant pullback (below $15.50), I would consider repurchasing, indeed, I hope there is such a pullback. But at these prices, I’m an apostate from the church of True Religion.


  1. I too have sold most all of my TRLG shares with nearly the same analysis as yours Doug. I put the $500 million as being the "fair" value for a "NEED" to continue to grow at roughly 30% per year for at least the next 5 years. Fashion as we know is fickle.. so I'd rather take my $500 million and put it in the bank..for now. $350 million market cap would have me looking back to buying again perhaps.

  2. Jason, check the DCF in the next post. TRLG can grow a little slower than 30% per year and still be worth $22, but I agree that fashion is always difficult to project too far in the future.

    What makes $500 million in market cap the right number in your mind?