The Company's Jeans Aren't Cheap, But The Stock Is A Bargain!

By Timothy Green - September 18, 2012 | Tickers: GPS, KORS, JWN, RL, SKS, TRLG | 0 Comments

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Designer jeans, priced in the hundreds of dollars and using the highest quality denim, is an ultra-competitive industry. Many of the companies making these jeans are held privately, including Citizens of Humanity, Adriano Goldschmied, and Rock and Republic to name a few. Others are much larger companies making, in addition to high-priced jeans, a wide array of other products targeted at different markets, such as The Gap (NYSE: GPS), Ralph Lauren (NYSE: RL), and Michael Kors (NYSE: KORS). But there is one publicly traded company that stands out, focusing only on high-end merchandise with lucrative margins. I'm talking about True Religion (NASDAQ: TRLG).

Company Overview   

True Religion makes mainly high-end denim products, but also sells shirts, shorts, hoodies, jackets, and other clothing items. The company is split into four segments.

1. U.S. Consumer Direct - Operates retail stores, outlet stores, and sells products through the True Religion website. As of June 2012 the company operates 83 retail stores and 33 outlet stores.
2. U.S. Wholesale - Sells products to premium department stores, specialty retailers and boutiques, and off-price retailers. 
3. International - Operates 14 retail stores and 9 outlet stores internationally. Also sells to wholesale customers.
4. Core Services - Licensing trademarks to third parties. This segment also includes corporate operations. 

True Religion has seen substantial growth in both revenue and cash flow over the past five years, as is displayed in the table below.

Revenue has increased by 142% since 2007 while operating cash flow has risen from just $9 million in 2007 to $71 million in 2011. Comparatively, True Religion looks cheap compared to The Gap, Ralph Lauren, and Michael Kors.

With a P/FCF of just 11.2, less than half of the values for the Gap and Ralph Lauren and a small fraction of the value for Michael Kors, True Religion is clearly the better buy of the four based on current earnings. But is it a good buy in absolute terms? We'll have to delve into the numbers to find out. 

True Religion has been focused on increasing the number of direct retail stores, which have higher margins than selling at wholesale.

* Source: Wikinvest

In 2005 True Religion had almost no retail presence, relying mainly on wholesale distribution. By 2010 Direct Sales made up more than half of the total revenue of the company. This trend is encouraging, since the gross margin of products sold directly at retail is much higher than those sold at wholesale. Indeed, we can see this trend in the company's income statement.

Gross profit margin has increased from 57.22% in 2007 to 64.76% in 2011 as a direct result of increasing the percentage of revenue derived from direct sales. Another thing to note is that the financial crisis of 2008-2009 failed to have a material effect on True Religion's revenue growth or gross margin.

True Religion stock has been on a choppy ride over the last few years.

TRLG data by YCharts

At the beginning of the year the stock was trading above $35 per share. Since then the stock has dropped precipitously, currently trading at $22.47. This was largely due to disappointing guidance, but as we'll see, the dive in price has opened up an opportunity to pick this company up at a discount. 

Paying For Growth   

One thing that is interesting about True Religion is that the company is not using debt to expand. The company has absolutely no debt on the balance sheet and has about $200 million, or over $8 per share, of cash and investments. The operating cash flow of $72 million in 2011 easily covers the capital expenditures needed to expand, leaving about $50 million in free cash flow. The company uses this cash flow to both buy back shares and to pay a substantial dividend. This dividend is recent, starting only this year, but currently yields 3.49%. The total dividend payment will total $20 million per year, for a payout ratio of 40%.

Valuation 

For valuation purposes I prefer to use Owner Earnings instead of free cash flow. Owner earnings are the net income plus depreciation plus certain non-cash charges. It generally does not include changes in working capital since this doesn't affect the amount of cash a company generates. There are no interest payments since the company does not have any debt. I take the average capital expenditure, which is about $20 million a year, and subtract that from the total. The result is the owner earnings.

Growth in owner earnings has slowed, but still increased by 8.5% in 2011. The company is clearly reliably profitable.

One thing I like to look at is the CROIC, or the cash return on invested capital. This is a measure of how efficiently the company reinvests earnings into the business. The calculation is below.

In 2011 the CROIC was 14.29%. This means that every $100 that True Religion reinvests (through retained earnings) the company increases owner earnings by $14. Generally I like companies with a CROIC above 10%.  From this you can see that the company is highly efficient and generates plenty of cash.

To estimate the fair value of True Religion I will use a discounted cash flow analysis. I will attempt to be extremely conservative and project owner earnings to grow at just 3% per year. This is essentially no growth after inflation A common mistake when using this type of analysis is to be overly optimistic. Optimism has no place in valuation. I will use a discount rate of both 12% and 15% and use these values to define a fair value range. Adding the more than $8 per share from the balance sheet and performing the calculation using the above parameters I arrive at a fair value range of $25.84 - $31.73.  

Conclusion

If I had to use one word to describe True Religion it would be consistency. The company makes a luxury product with a high profit margin that saw strong sales even in the depths of the financial crisis. Even assuming no real growth going forward the stock is undervalued, currently trading 13% below the lower bound of my fair value range. With a substantial dividend and plenty of room for growth True Religion offers a very rare opportunity. Take advantage of the recent overreactions in the stock market and pick up this undervalued gem.   


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