True Religion's Problems More Than Priced In

| About: True Religion (TRLG)

True Religion Apparel (NASDAQ:TRLG) reported mixed third quarter results on Monday, with earnings for the September quarter beating analyst estimates, while guidance for the fourth quarter disappointed. The stock fell some 4% in early trading before rebounding and closing down modestly at $26.30.

It has been a difficult 2012 for True Religion, which has seen its share price fall over 22 percent year-to-date. The stock is still trading nearly 30% from its 52-week high despite a 22 percent jump in October after announcing it was considering a potential sale of the company or other "strategic alternatives."

At the time, I argued that the announcement essentially gave TRLG shareholders "a free call option," with analysts pegging a potential purchase price for the company at $32-$35 per share. Should a sale not materialize, TRLG's low valuation - backing out the company's roughly $8 per share in cash, it trades at just 10x the midpoint of 2012 EPS guidance - could comfort long-term value investors.

Of course, there are valid reasons for that low multiple, as True Religion is facing a number of challenges. Many of the issues facing into the company came into focus in the quarterly earnings release and the Q3 conference call. As noted, Q4 guidance disappointed and showed how difficult earnings growth has been for the company. Excluding a small amount of one-time charges, EPS was $1.87 in 2010 and $1.88 in 2011, but guided at just $1.80-$1.86 in 2012. The company has shown modest top-line growth, but mostly through expansion; same-store sales fell 4.7% in the third quarter, in large part because the company's legacy jeans did not sell as well, according to the Q3 management commentary [pdf]. International sales fell as well, due to struggles in Korea and Germany. The only strong sales growth came in the US Wholesale segment, with much of that merchandise sold through discount channels.

For a company that sells jeans for an average price of $253, according to the conference call, the weakening growth is naturally leading to fears that True Religion's brand is struggling and its fashions failing to connect with consumers. True Religion is actually seeing strong success with its men's business, which is seeing positive comps, but it has missed badly with its female customers as of late. Bright colors have been in fashion this year, and True Religion appears to have missed the boat. It has been a costly mistake; Gap Inc. (NYSE:GPS) has seen its stock double in large part because it anticipated the bright-color trend and positioned itself accordingly.

Still, the news at True Religion isn't nearly as bad as many make it out to be, and it certainly doesn't seem to justify an earnings multiple below most of its peers. Comp sales fell in Q3, but are still up over 3 percent year-to-date. The men's business is surging; the company is creating revenue and margin growth in its outlet stores by replacing discounted clearance merchandise with products specifically designed for those outlets. Meanwhile, non-denim products such as sportswear and T-shirts are selling well; they obviously have a far lower selling price, but they have diversified the company away from a pure focus on high-priced jeans.

Meanwhile, the problems True Religion does have appear to have potential solutions. To its credit, TRLG's management, notably CEO Jeffrey Lubell, have consistently owned up to mistakes they've made and shown a refreshing level of honesty in their commentaries and on earnings calls. On the Q3 call alone, Lubell noted that the company needed to "fix the women's business"; said that he would "call a dog a dog" in admitting that True Religion has "had nothing but problems with Japan"; diplomatically said its licensing department was not "top tier"; and mentioned the need to better control seasonal inventory.

And management noted, repeatedly, initiatives taken to improve its areas of weakness. To boost international sales, they have hired new management in Japan and Korea, while creating a brand-new manufacturing operation in Italy that True Religion expects to cut costs and value-added taxes in Europe. They've hired a new head designer to re-boot the women's businesses, and a new head of licensing to boost partnership revenue there. In the Q&A portion of the call, CFO Pete Collins dismissed the move to colored jeans as a short-term fad driven by lower-cost brands. "I think that you are going to find in 2013, the shift back to really premium denim," he told Telsey Advisory Group's Janine Stritcher. "I think this whole color situation [which] has been prevalent in the market for the last couple of years, is going to come to a standstill because you are finding that it's in the lower tier brands at this point," he added, specifically mentioned the revived Jordache brand, which is sold exclusively at Wal-Mart (NYSE:WMT).

If Collins is correct, and if the company's plans to boost international and women's sales prove fruitful, True Religion should return to its late 2011 highs of $34 to $36 per share. If the company is bought out by a private equity firm or a larger clothing maker, the stock should breach $30 per share. If the company's turnaround takes longer than expected, or a sale doesn't materialize, investors would still own a company with an extremely low multiple that has a strong brand, room for growth domestically and internationally, and should post revenue growth at or near 10 percent this year. They also have a strong balance sheet, with the aforementioned $8 per share in cash and a dividend yield over 3 percent. There are macro risks due to economic fears, and company-specific risks due to its high prices and reliance on being ahead of the fashion curve. But at just 14x 2012 earnings, a multiple lower than most of its peers, the potential rewards easily outweigh those risks.

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.