Thursday, March 15, 2007

TRLG Update

I have always read that you should forget about stocks after you sell them. It is true that after you sell, you need to let a stock go (selling, I find is the hard part and the place where I am likely to get emotional, particularly if I have picked a winner. It can be like letting go of a good friend).
But occassionally, I cannot resist "checking in" to see if I made the right call. If you don't, how can you judge your analysis.

A while back, I decided to unload my TRLG stock. Generally, I had been impressed with the company's cash flows and balance sheet. But in 2006 they started changing their strategy. Their traditional strengths are brand and product development. The contracted all of the product production and eliminated all of the major capital investments that hamstring other manufacturers. Production involves large upfront capital costs. By comparison, unit costs are relatively small. This phenomenon, called operating leverage, tends to encourage producers to cut prices in order to amortize fixed costs over as large a production run as possible. As a premium manufacturer, TRLG needs to avoid those decisions. By ensuring that production is outsourced, the company has higher variable costs, but no operating leverage the company can hold prices high. If there is less demand, they simply order less product. (Operating leverage is different from financial leverage, which involves using debt instead of equity financing. It tends to have a similar effect, on business decisions, however. Debt payments mean that there are high fixed charges. The difference is that operating leverage involves depreciation whereas financial leverage involves actual cash payments).

So I was somewhat disappointed when I saw the company turn to retail operations to improve sales. As I mentioned in an earlier post, retail operations are difficult to manage profitably. Unlike the contract manufacturing business, retail has high fixed costs, including salaries, rent, electric and the like. Retail is a high operational leverage business. This is why stores tend to run clearance sales. Worse yet, the company has no specific competence or advantage in running retail outlets. That is not their core strength, which is marketing, branding and design. The worst negative side effect will be the impact on distributors and other retailers who must now seriously question the company's commitment to their success.

My concern was that the company feared lower revenue growth and had decided that the best way to achieve it was to open retail stores to capture the downstream revenue. I began to be concerned that revenue growth would not hold up. My fears appear to be validated.

Using a DCF model I developed, I valued the company at around $22.60 a share. At the time, the stock was trading at $22 so I put in a limit order at $22.60 which was filled that day (the day's high was $22.61). The stock subsequently rose to $24.61, so I missed out on several hundred dollars in further appreciation. Oh well, Nathan Mayer Rothschild, who founded the London branch of the eponymous bank, said that he always sold too soon.

TRLG released its earnings today and the numbers were less stellar than even my projections. Revenue increased only 35% and not the near 50% I projected. Worse, operating margins were even lower, so earnings for the year were only $24.4 million, not the $27.6 million I expected. Plugging these numbers in dropped the share price to just over $20. It gets worse, however, as I also assumed that these new lower operating margins are permanent. When I change the operating margin, the stock drops to $18. Then there is the revised growth rate. If the company is only growing earnings at 35% per year, and this includes downstream retail capture, I have to assume that volume growth is tailing off and therefore, I have to revised my future growth projections as well.

Taking all of this into account, it seems likely that a fair value of the stock is between $16 and $17.50, which is where it is trading today.

Fortunately, I got out at the right time


  1. interesting post. however, i don't agree with you on the retail model. I believe TRLG will be able to scale its business nicely and profitably through retail and licensing (with minimum cannibalization). the co. is investing for the future with its retail model and extends its brand even further. the results of the manhattan beach store are very telling of the legitimacy of the retail model: higher gross margin; naturally a lower profit margin due to high upfront costs; and, an amazing ROA of over 60%. TRLG is a buy and should double in the next 18-24 months.

  2. Joe, thanks for the feedback. I would like to believe what you are saying, and I concede that it IS possible that after the raft of startup costs an established retail network might lead to higher overall profitability. But I have my doubts. Retail is a notoriously low margin business. It also changes their general operating model to one with low operating leverage (all contract manufacturing, so they can easily cut production if and when there is weakness in sales). Once they are operating these retail stores the pressure is on to move the product. That is how discounting starts. It is difficult to be a serious luxury brand if you are constantly disounting.

    Since they have now opened a store in the outlets at Woodbury Common in NY, (where discounting is the norm) I am very concerned that the intrinsic growth simply is not there. Sales overseas are weak, only in the US, where they can grow the topline just by selling through their retail outlets instead of wholesale (and at the moment, unprofitably), are sales increasing. This is not a good sign. When considered this way, sales growth is slowing. Perhaps this is why Lesser quit the firm earlier this year - the finances were not adding up.

    I realize that ROA is still strong, but it is declining. When I purchased in Nov 2005, ROA was a spectacular 108%. This is because of the power of contract manufacturing - all of their assets were intangible (and weren't on the balance sheet). While virtually any new project is likely to reduce ROA from 108%, I cannot say for sure what ROA these new projects are earning. 15%? 20%? 10%? Of course, the straight accounting method isn't a great measure anyway, the issue as point out is the long term cashflows.

    My concern is that this is a fashion company whose core product is going out of style and they may get hit very hard, particularly if there is a recession. Thus, while it is possible that the stock will increase, I don't believe it will be sharply. I believe that intrinsic value is considerably less that $20, rather than the $22 I estimated in the fall.

  3. Well said. Fashionistas are a fickle lot. I like to check the pulse of the current perception of the products by reading blogs and checking out sites like eBay. I believe the market is discounting the stock due to the uncertainty of the current transition phase: both to retail and the whole "lifestyle" brand vs. premium denim. I like where the company is going. To me, the stock represents a positive risk/reward scenario.

    What's your take on the retention of GS to pursue "strategic alternatives"?

  4. I am not sure what GS is doing at this point. Of course, when they were first introduced, I expected like many that we would hear about a sale of the company. I suppose that is still possible, but perhaps they are waiting to prove that the "lifestyle" brand conversion is going to make it. If it does, your valuation is probably not far off the mark - could be worth 20-22 per share if they can restore operating margins above 30%. So far, they are moving in the other direction. At the same time the company only projects 20% growth. Unless they can sustain that for a very long time, or can accelerate the growth it will be difficult to justify the valuation.

    Hey, I just reread my post - I meant to say that it changes the model from one with low operating leverage to one with high operating leverage.

    Don't know if you have checked out he has some interesting views on the stock as well. Definately more bullish than I. I will admit that if the stock drops below $15 I will consider purchasing, because at that point I would agree that it represents a reasonable risk/reward.