True Religion jeans are very expensive. Also, they happen to be the best jeans I have ever owned. I love the style and the fit. No matter what socioeconomic level an individual may be, it is hard to justify paying $250 to $300 for a pair of denim jeans. Yet, 10 years later, California-based True Religion (TRLG) continues to generate strong free cash flow. We started buying True Religion at $21 per share for our clients and the stock has been in the mid 30s several times shortly after earnings, but there seems to be a ceiling on this stock relative to the fundamentals. Before we can outline why there seems to be a threshold on the stock, let's examine what the company has going for it.
Relative valuation - Compared to its competition, True Religion sports a P/E of 15.94. Its closest competition - Michael Kors (KORS) with a 55.96 P/E, Lululemon Athletica (LULU) with a 43.78 P/E, Gap (GAP) with a 17.15 P/E, V.F. Corporation (VFC) with a P/E of 16.74, and Abercrombie & Fitch (ANF) with a 28.16 P/E - are all more expensive.
Declining Price of Cotton - As with all commodities, the price of cotton has declined substantially in the last year. There was worry on Wall Street that the price of denim above $2.15 per pound would hurt the earnings of all jean makers. However, I have never bought that argument. If you are selling jeans for $60 a pair, it could affect your profit per unit; at TRLG's price point, I doubt it. My primary concern is that we could see a slowdown in worldwide consumer spending, which could lead to less discretionary dollars being spent on fashion-related products. Some consumers could trade down to BKE or Big Star jeans rather than "pony" up for a trendy pair of True Religion. This declining price of cotton should help offset any lower volumes TRLG could experience.
Increased distribution - In the past, True Religion has relied heavily on boutique stores or Saks to promote its product, but the inclusion of bricks and mortar should help management better control pricing, promotion, and shelf space. Also, the revamped website is really neat and should help streamline operating costs.
But, despite this optimism, there are two things holding this stock back from being around its proper valuation of $35 per share. The first is the notion that True Religion could ultimately become out of favor. This cannot be ruled out as their shirts, hoodies, and shorts have not been near as successful as their jeans. Unlike Under Armour (UA), which has been able to expand successfully into shoes and equipment, True Religion still has a fairly limited product line. Even the recently announced dividend and no outstanding debt to speak of can outweigh the need for True Religion to stay "fashion forward". The second, and probably the most significant, is the high level of short interest in the stock that has sometimes reached as high as 25%. With a smaller market cap, it is easier for hedge funds to manipulate the price by selling short a large volume of shares. Thus, creating both an opportunity and a risk. If TRLG's earnings and guidance continue to mimic past history, the shorts will have to cover and the stock will continue to rise. However, if TRLG stubs its toe, the stock could move down to the low 20s fairly quickly.