True Religion Now Comes With A Free Call Option

| About: True Religion (TRLG)

True Religion Apparel (NASDAQ:TRLG) jumped over 22 percent in trading Wednesday after the Wall Street Journal reported the company was putting itself up for sale, information the company would confirm later in the day.

The jump was badly needed for TRLG shareholders, who had seen the stock fall some 40 percent from highs in early February. The main catalyst was disappointing FY12 guidance issued in conjunction with fiscal 2011 earnings, which knocked the stock down some 28 percent. A Q1 earnings beat -- coupled with the initiation of a dividend -- offered some hope, but Q2 earnings again disappointed as the company lowered full-year guidance; TRLG fell 12 percent.

In fact, Wednesday's leap only re-gained the ground lost after the second quarter earnings release; True Religion is still down 24% year-to-date and 30% off its 52-week high. The catalyst has been the company's slowing growth rate; after tripling sales and better than doubling net income between 2006 and 2011, True Religion is guiding for modest growth in FY12. At the midpoint of guidance, sales are expected to rise just 7.8%, and net income less than 2 percent. On the second quarter conference call, CEO Jeffrey Lubell noted the challenges facing the company:

My overall read on the company's results for the second quarter is mixed. While our largest segment, U.S. Consumer Direct, had a same-store sales increase, we did not achieve our sales plan for the segment. Many factors contributed to this outcome: a weaker response toward our spring and summer merchandise assortment, a more promotional shopping environment and negative economic news which impacted consumer spending.

On that call, management clearly took responsibility for the below-expected sales numbers, noting that an increase in merchandise sold through the company's outlet stores and a newly instituted semi-annual sale led to revenue and margin pressures.

Of course, there are larger issues in play as well. The fickle nature of fashion, and the intense competition in the denim space, means that a company can fall hard -- and fast -- if it loses its ability to maintain its brand and satisfy its customers. That risk is exacerbated by True Religion's high-end appeal -- its average selling price is in the $250 range, making its customers more careful and more demanding.

All that said, True Religion's situation is not nearly as dire as its stock price -- and some of its analyst coverage -- would suggest. US same-store sales still were positive for the quarter -- up 2.4 percent -- with full-year comps expected to be in the "mid-single digit" range according to CFO Peter Collins. International retail sales rose 114% year-over-year, as the company opened 14 new stores overseas over the last twelve months. While foreign comps disappointed, and the expenses of new stores pressured gross margins, the investments made have the clear potential to aid top-line growth. True Religion has struggled in the international market, notably in Korea, but again, management to its credit is actively working on turning that business around. If they can succeed, even modest comps should produce solid top-line growth.

Meanwhile, True Religion has a sterling balance sheet, with $201 million in cash and investments -- nearly $8 per share -- and no debt. Backing out the cash, TRLG is trading at less than 10 times the midpoint of its 2012 guidance, while offering a dividend yield over 3 percent. As I argued back in February after the Q4 miss, True Religion doesn't need to return to its days of soaring growth to justify its current valuation. If it does, the stock will appreciate strongly; but even with modest comp and revenue growth, the stock should be of interest to value and income investors. TRLG stock has simply been driven down too far; it is trading as if it is a business under attack, or facing a sea change in its business. It's not; it is a company facing a common -- and difficult -- transition from young, hip growth stock to a larger, more mature company. The weakness in the stock price seems overdone, and is more surprising given the multi-year outperformance in retail stocks since the 2008-09 financial crisis.

Wednesday's news only adds to the bull case for True Religion, despite the higher entry point. Citigroup (NYSE:C) noted a sale could potentially generate an offer of $32 to $35 per share, while Caris and Co. analyst Dorothy Lakner told the AP that after past speculation of a sale, she "believes this time it's for real," and maintained her own price target of $32. If True Religion agrees to a buyout -- whether by a larger clothing maker, a retailer, or a private equity firm -- it certainly won't be at a price lower than Thursday's close of $25.83. Indeed, shareholders should see a nice return. If the company is not bought out, it's likely the stock will take a short-term dent; but for patient, long-term investors, $26 is still a solid entry point for a company that generates cash and offers a 3.1% dividend yield. Disappointment on the acquisition front could easily be used to dollar-cost average in advance of a potential turnaround internationally or in the women's segment (which posted "slightly negative" comps in Q2).

Interestingly, CEO Lubell was asked on the Q2 conference call about M&A activity in the sector. He opened his answer this way:

Yes, I think some of the larger brands out there see opportunity with the denim space on the M&A side where they could leverage their International experience. And -- so I think that's why there's opportunity for a lot of brands in our space. They can pick them up for 6x EBITDA and really roll them out with their infrastructure. You take a brand like True Religion, where we're doing it by ourselves and you make a hiccup, you make a mistake, you find out you over-distributed in Korea, you're in too many channels...

Lubell went on to add that "there is a lot of M&A interest in my brand," though he clarified that "I'm not currently up for sale." But he closed by pointing out that "if something does develop, we will bring it to the forefront." It's worth pointing out that 2011 EBITDA for True Religion was $86 million; based on guided net income growth, it is likely to rise slightly, to perhaps $88 million. At 6x EBITDA, True Religion's operating business would fetch $528 million. Add in the $201 million in cash, and an offer for True Religion might fetch about $729 million -- or $28.80 per share, a 15.4% premium from Thursday's close.

From recent comments by management, True Religion certainly sounds like it will at least listen to offers. And those offers essentially act as a free call option on the stock. If the offers come in, the stock will jump and shareholders will prosper. If they don't, TRLG's low valuation and 3% dividend will offer plenty of comfort.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.