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Based upon the company's description on its website, True Religion Apparel, Inc. (NASDAQ:TRLG) is a growing, design-based jeans and jeans-related sportswear brand. The Company designs, manufactures and markets True Religion Apparel products, including its premium True Religion Brand Jeans. Its expanding product line, which includes high-quality, distinctive styling and fit in denim, sportswear, and licensed products, may be found in the Company's branded retail stores as well as contemporary department stores and boutiques in 50 countries on six continents.

Based upon the latest 10Q filing, as of June 30, 2012, the company operated 83 full price stores and 33 outlet stores in the U.S. and its International segment operated 14 full-price stores and nine outlet stores.

True Religion Jeans are one of the hottest premium jeans around, worn by a long list of celebrities, both nationally and internationally. Despite the steep price point (generally $200-$300+ for a pair of jeans), True Religion's trend setting jeans are making quick inroads in the middle and upper middle class population, worldwide. In fact due to their steep selling prices and relative difficulty in being caught by law enforcement agencies, counterfeit True Religion Branded Jeans seems to be fast replacing laptops and netbooks as preferred items to be smuggled.

The company has been growing revenue at 25% annually during the great recession. Investors, though, have not had a pleasant ride during these years. Despite the sales growth and the slight growth in the gross margin, both the operating and the net margins have been declining. Every bad result or a result not meeting the expectations reminds the investors about the chronic margin problems. Similarly, every good result or a result meeting or beating the expectations makes the investors optimistic, albeit temporarily as the cycle repeats pretty soon.

For a company which has been aggressively increasing store count, it's normal for the operating expenses and capital expenditure to remain elevated during the growth phase. After all, you have to do all the ground work for the new stores, sign the leases, invest in dealing with the local rules and regulations, create/strengthen the supply chain, invest in the inventory, IT, the new staff etc., basically the whole nine yards. So when you invest in a company in the (hyper) growth mode, you should be ready for the higher expenses until the economies of scale and the accompanying maturity finally kicks in. The question, however, is: "Are the expanding operations only thing which are causing the margin compression in True Religion's case or is there more to the story?" Let's take a look.

The following table shows compounded annual growth rate (OTCPK:CAGR) for True Religion during the last 5 years. The first row shows the CAGR for reported line items. The last column shows CAGR for weighted average shares outstanding, post the dilutions. The second row shows per share figures for these line items, based upon the diluted WA shares outstanding in respective years.

CAGR for True Religion Apparel, Inc.

Revenue

Gross Profit

SG&A

Operating Income

Net Income

Free Cash Flow

Weighted Average Shares Outstanding - Diluted

24.76%

28.78%

39.76%

12.16%

12.73%

18.21%

1.11%

Per Share

23.40%

27.37%

38.24%

10.94%

11.50%

17.01%

Sources:

  1. morningstar.com
  2. SEC filings for True Religion

Note on True Religion's low cash flow from operations and free cash flow in 2007: FY 2007 was an outlier for True Religion's cash flow as noted by the following quote from 10K (Part II, Item 7 under Management's Discussion and Analysis of Financial Condition and Results of Operations): "Net cash provided by operating activities was $9.8 million in 2007 compared to $32.1 million in 2006. The $22.3 million decrease was primarily due to increased receivables of $11.6 million (both trade accounts and due from factor) and increased inventory of $11.5 million. The increased wholesale sales in the fourth quarter of 2007 drove the receivable growth, and the growth in our order backlog and the expansion of our consumer direct segment drove our inventory increase." For this reason, CAGR for TRLG is calculated for last 3 years which is more reflective of the trend.

What I observe is the following:

  1. True Religion's revenue as we know is growing at 24.76% per annum. The gross profit is growing at 300 basis points higher. In other words, True Religion's cost of revenue is coming down and it is able to mark up the products higher. This is good.
  2. Its share count is growing at 1.11% annually. Increasing share count is generally not good.
  3. Due to the common share dilution every year, CAGRs for per share figures for True Religion are 100-200 basis points lower than their whole numbers counterparts. This is not good. This means that the pie is getting smaller every year for the shareholders.
  4. True Religion's selling, general and administration (SG&A) expenses are growing at a rate which is 14-15% higher than the revenue growth rate. This is definitely not good, although some part of this may be justified due to the costs associated with the expansion.
  5. True Religion's operating and net income are growing much slower than the revenue. In fact, they are growing close to half the rate of the revenue growth. The large operating expenses are causing a significant dent in the operating and the net margins.

Maybe it's all fine. Maybe the abnormally high operating expenses are normal for a brand growing so aggressively.

Before we close the case, though, since SG&A also contains compensation for the management and the employees (SEC filings show the compensation only for the top management), let's take a quick look at this part of SG&A too.

So in the following table, I've added the CAGR for the executive compensation also.

CAGR for True Religion Apparel, Inc.

Revenue

Gross Profit

Executive Compensation

SG&A

Operating Income

Net Income

Free Cash Flow

Weighted Average Shares Outstanding - Diluted

24.76%

28.78%

41.82%

39.76%

12.16%

12.73%

18.21%

1.11%

Per Share

23.40%

27.37%

40.27%

38.24%

10.94%

11.50%

17.01%

Now, this is interesting; the executive compensation is growing at 42% as opposed to revenue growth rate of 24%. Could it be the reason, why SG&A is growing at such a higher rate vs. the revenue?

Needless to say as a shareholder i.e. the owner of a growing company, you would prefer the management in the following order:

  1. When the management is able to grow the revenue faster than their compensations. This is an extremely desirable situation.
  2. When the management is able to grow the revenue at a good clip and its compensation growth closely follows the revenue growth. This is an acceptable situation.
  3. When the management is able to grow the revenue but the compensation growth exceeds the revenue growth. This is not so desirable situation if it persists for long.

Now let's compare the compensation growth, relative to the revenue of True Religion with similar companies to see where True Religion stands.

The following table compares the last 5 years CAGR of True Religion with that of some comparable companies. The companies I used for the comparison Deckers Outdoor Corp (NYSE:DECK), PVH Corp (NYSE:PVH), Ralph Lauren Corporation (NYSE:RL), Coach Inc. (NYSE:COH), Guess' Inc. (NYSE:GES) are either in the similar domain, have popular brands, premium products or are affected by the consumer behavior or the macroeconomic factors in more or less similar fashion. Obviously there are hundreds of companies which can be compared in this domain, but these are the top companies which compete for my investment dollars if I have to invest in True Religion or similar companies.

PER SHARE CAGR COMPARISON

DECK

PVH

RL

COH

GES

TRLG

Revenue

32.4%

24.8%

8.9%

16.4%

11.9%

23.4%

Gross profit

34.6%

26.6%

11.0%

15.2%

10.6%

27.4%

Sales, General and administrative

40.3%

29.5%

10.8%

17.4%

12.0%

38.2%

Operating income

28.3%

16.1%

12.3%

12.7%

7.0%

10.9%

Net income available to common shareholders

31.7%

14.8%

12.9%

12.9%

9.8%

11.5%

Free cash flow

29.1%

26.3%

6.4%

14.1%

34.2%

17.0%

Executive Compensation

-3.1%

11.8%

4.7%

14.4%

12.7%

40.3%

Executive overpayment over revenue [ (Exec Comp CAGR - Revenue CAGR)/Revenue CAGR ]

-109.7%

-52.6%

-46.9%

-12.1%

7.0%

72.1%

Source: morningstar.com

The last row in the table shows the extent of compensation over-payment vs. the revenue. In this row, the negative numbers are better than the positive numbers because a negative number means that the compensation is declining and at the same time, the revenue is growing. A positive number means that the compensation is growing faster than the revenue.

Based upon the desired compensation growth, relative to the revenue growth, the desirability of the companies in the left most columns is the highest and it decreases as you move towards the right side. Every company in the list scores above True Religion in this regard.

Whatever True Religion's proxy filings say it does (however it does it in regards to determining the executive compensation), to me, is all noise and smokescreen. I like to keep it simple. The simple fact remains that True Religion is growing its revenue at a spectacular rate, but the executive compensation is growing even more spectacularly. The money is gushing out of the business faster than the money coming in. This difference is not sustainable for long. I hope that someone calls the plumber to fix the leak and does it soon.

I also do not like the way True Religion breaks up its segment wise (SG&A) numbers. Despite all this, I firmly remain a buyer of True Religion at this level. At a price of $20.70 today, I find the shares deeply undervalued.

Source: True Religion: Leaky Executive Compensation, Someone Call The Plumber