Sunday, November 19, 2006


Nathan Mayer Rothschild, the oldest of the five Rothschild brothers who established the venerable commercial bank in the late eighteenth and early nineteenth centuries, is said to have remarked, "I never buy at the bottom and I always sell too soon." This sentiment is echoed by the American financier (I believe it was JP Morgan), who, when presented with an investment offering 100% returns, remarked, "Well, you can have the first 30% and the last 30% and I will just take the nice safe 40% in the middle." In other words, he wasn´t interested in buying before he was certain that the return would be positive.

I have recently read that the essence of investing is not managing returns, it´s managing risk. First you want to be reasonably sure of a positive return (capital preservation), only then do you want to consider the potential magnitude of the returns. Too many people look at the magnitude of returns first, and only then consider the probability of achieving these returns. This is why the lottery is so popular - it offers a huge return, for essentially nothing. Of course, most purchasers are simply incapable of appreciating the remoteness of the probability that their return will be positive. So they lose 100% every week, occasionally winning a minor pot of $5 or $10 to desensitize them to the dififculty of the odds they face.

This post isn´t about the lottery, however, it´s about TRLG. I mentioned in a prior post that I had left the temple of True Religion. Actually, I left a few weeks too early. I sold at $22.60 on a day when the high price for the day was §22.80. A few weeks later, the stock actually made new all-time highs in the $24.65 range. I lost out on an extra $800 by "selling too soon". But as my calculations from my DCF model suggested, the stock was near its highs at $22.60, and the probability of further gains were remote. Earnings would have to rise even faster than the 50% I projected for this year (35% for next), or operating margins would have to increase. While the first event was possible, I held out no expectations of the latter.

I work for a manufacturer. Like all companies with independent distribution, we regularly consider whether we wouldn´t be better off if we could capture more downstream revenue. Since pricing is usually based on cost-plus margining, capturing retail sales would significantly increase revenue, without actually capturing market share (we would benefit from selling at the retail price, which , for spare parts, is usually 65-100% greater than the wholesale price). The problem is that in order to do this, we would also have to absorb retail inventory, which would significantly increase working capital. We would also have to pay the expenses at retail that the distributors bear, personnel, rent and overhead. Worse, as a manufacturer, we would only really have one product line, whereas most distributors can amortize expenses over a wider product assortment available to them (since they can sell products from many manufacturers). This is essentially the difference between a specialty retailer and a department store. The department store also finds it easier to attract new customers, since it can easily cross-sell shoppers in the store for other promotions or products.

In fact, what we have begun to see from True Religion is that sales outside of the US are flagging, or at least, not increasing. Sales in the US are increasing, but primarily due to growth in the retail segment (i.e. the company is capturing that downstream revenue). However, this means that revenue is increasing faster than product volume, which raises serious questions about the acceptance of the brand on a broader scope. Worse, they are seeing increasing overhead, which management insists is required for future product introductions, but managing a retail chain is difficult. The company has brought in experience for this. The current management team has demonstrated success with retail, but what we are seeing is collapsing operating margins. For a company whose primary value is in future earnings, lower operating margins have to terrify investors.

In fact, while I was in Mexico on a business trip (I was in the buffett line at lunch actually), two other attendees started talking about the collapse of the stock price of TRLG, which has since declined to the mid $15 range. At this price, you might very well be able to round-trip the stock back up to $20, if management can find the new revenues to justify the ramp-up in expenses. But for the first time, management has failed to deliver the goods and so their ability to win converts on the street will come much harder.

At this point, I am sitting on lots and lots of cash. Buffett notes that this is no fun, and I concur, but at the same time, its better to sit on cash than watch your positions collapse. I am still looking for another investment that I find as attractive as TRLG. Right now, the only investment I consider worthwhile is BAC. I am even beginning to doubt the CL. Since I purchased in October 0f 2004, I have watched the stock price rise 50%, from $44 to $66, at the same time, I have earned nice dividends, which have been hiked twice, from 24 cents to 32 cents a share (for a 33%) increase over the same period. My shareholdings have increased by nearly four percent, giving me a total return of over 56% for the period (If you are wondering why my return isn´t 54%, the sum of the two, the reason is that the shares purchased from dividend reinvestment have also benefitted from rising prices, so my total return exceeds the price increase plus dividend payments).

Generally speaking, your return should reflect the dividend yield plus the rate of increase of dividends. (I have another post explaining why this is so, but essentially, with dividend paying stocks, prices tend to increase at the same rate as dividend increases). With CL price increases have outstripped dividend increases, so the dividend yield has fallen. This suggests lower returns going forward. Indeed, to return to the dividend rate of Oct 2004, when I purchased, dividends would have to increase about 17% or 5 cents per share, from here with no increase in the stock price. This would then offer a return of about 2.6% (the dividend yield at 37 cents per share, per quarter). Such a dividend increase is actually quite probable. The company tends to maintain a dividend payout ratio of around 50% of earnings, with much of the remaining money going to repurchase stock, both preferred and common. In the latest quarter the company earned $0.73 per share. With forward earnings expected to run about $0.80 per share per quarter the company could raise to 38-39 cents per share per quarter. Organic growth, plus benefits from the company´s restructuring make these very reasonable projections. But even with this strong dividend increase rate, the stock should have only moderate price appreciation. Of course, as I have suggested many times, I own the stock because it offers a reasonable return with a high degree of safety, but even stocks like KO can take big dives (granted, at its all-time high Coke was trading at a ridiculous 45 times earnings).

The real kicker with CL is that it trades at 27 times earnings, but that is before the stock is fully diluted. There are 39 million options on the stock. While repurchases are easily oustripping option issuance, redemptions and forfeits are reducing the overall stock of ourstanding options, but with all options exercised, the stock trades at over 30 times earnings. There have to be better options. Unfortunately I haven´t had the time to find them.

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