True Religion Still Worth A Look

| About: True Religion (TRLG)
This article is now exclusive for PRO subscribers.

There's nothing like being consistent. Over the past three years, excluding a small amount of charges, annual earnings per share for True Religion Apparel (NASDAQ:TRLG), have been $1.87 (2010), $1.88 (2011), and $1.84 (2012).

The market reaction to those earnings has been anything but consistent. Q4 2011 earnings led to stock to fall 28 percent, based on weaker-than-expected guidance. At the time, the company forecasted full-year earnings of $1.88-$1.95, projecting limited year-over-year growth. Last week, the company offered almost identical guidance for 2013 of $1.89-$1.95, once again projecting limited year-over-year growth.

This time around, the stock rose 22 percent. Of course, the difference was likely the market's expectations. TRLG closed at $36.74 the day before its disastrous 2011 earnings release; before last week's big gain, the stock traded at just $23.75, well below the level reached even after FY12 guidance came in so weakly. The drop is even more disconcerting given the strength in the broad market and the gains at many of True Religion's peers.

But that drop explains why projections for modest growth caused the stock to plunge in February 2012 and soar a year later. Over that time, True Religion has gone from a growth stock to value play, as revenue growth has slowed and the earnings plateau has extended. Net sales did grow 11 percent in 2012, but the gains came mostly from expansion; same-store sales rose just 2.7%. At the midpoint of FY13 guidance for $509-$513 million in sales, revenue will grow less than ten percent, again due largely to new stores and new markets; comps "are expected to be in the range of flat to up in the low single digits," according to the company's release.

The company's fundamentals put the stock squarely in value territory as well. At the midpoint of 2013 guidance, and Tuesday's close of $27.37 (TRLG has seen some profit-taking since last week's beat), the stock trades at 14.3x forward earnings. But the company also has about $217 million in cash and investments, representing about $8.50 per share. Cash flow has been solid and consistent as well, dipping in 2012 to $42 million (due mostly to an increase in inventory) but averaging $47 million over the last four years. That figure is nearly 10% of the company's current enterprise value of about $486 million.

Of course, when a company is generating only single-digit top-line growth and reporting almost eerily consistent earnings year-over-year, it's not going to see much in the way of multiple expansion, whether in relation to earnings per share or free cash flow. The lack of growth can hardly be blamed on external factors; True Religion has had several missteps over the years, with its designers missing out on a number of trends such as last year's popularity of colored jeans. International expansion, particularly in Asia, has proved troublesome.

To its credit, management has repeatedly owned up to and promised to fix its errors on previous conference calls. This time around, executives did sound more confident about the company's position. President Lynne Koplin noted "a indigo denim" which "is really going to benefit us quite substantially for next year." In Korea, where True Religion's initial entry into the market was beset with partnership issues and a flood of supply, CEO Jeffrey Lubell noted "we've done the cleanup that we needed we feel like we're headed in the right direction." In response to a follow-up question as to whether any other international problems materialize, Koplin said, "I think we finally got it under control." Indeed, with the company having nearly doubled its international store count in 2012, True Religion expects the International segment to be a key earnings driver in 2013, as the SG&A investments made last year bear fruit, particularly in the back half of the year.

So there is hope that the company can re-create the growth that led to create half a billion dollars in annual sales just ten years after its founding. And there are reasons to remain patient. The first is TRLG's dividend, which yields nearly 3 percent. The dividend is well-covered by the company's cash flow, with the over $8 per share in net cash adding additional protection.

The second is the company's internal review of strategic alternatives, which commenced in October. On the Q2 conference call -- held before the review was announced -- Lubell revealed that "there is a lot of M&A [mergers and acquisitions] interest in my brand." In November, the New York Post reported that a number of private equity firms were "kicking the tires," including a consortium led by board member Marcello Bottoli. Lubell specifically declined comment on the process in the Q4 call, noting only that the review was continuing.

Such a bid could come in at a substantial premium to TRLG's current price. 2012 EBITDA (earnings before interest, taxes, depreciation, and amortization), a figure favored by many buyout firms, was $91.5 million. As such, TRLG is currently trading at just 5.3x its trailing EBITDA ex-cash.

But, as commenter NYCdrew pointed out on my October piece on TRLG, other brands in the sector have attracted far higher multiples. J. Crew was sold for 8.6x its EBITDA to two PE firms, while PVH Corporation (NYSE:PVH) bought Tommy Hilfiger for a multiple of 8x. To be fair, documents reviewed by the New York Times showed substantial projected growth in free cash flow for J.Crew, while PVH's valuation of Tommy Hilfiger no doubt included cost savings from standard merger synergies. In addition, both buyouts were announced in 2010.

Still, even a discounted multiple to either transaction could easily result in a buyout price well over $30; at 6.5x EBITDA, TRLG would be taken over at $31.58, while a 7 handle would result in an offer of $33.36.

There is no guarantee of a deal, and it's clear that if a deal were thought to be imminent, or even likely, TRLG would be trading at a higher level. It's also likely that should a deal not be consummated, True Religion's share price would see a potentially substantial decline. As volatile as the stock has been -- it's had five weeks with double-digit percentage moves since February 1, 2012 -- an announcement that the company's special committee was being dissolved could cause a sharp one-day downturn.

Longer-term, the key risk facing True Religion is fairly obvious; it remains a smaller-tier, but higher-cost, player in the intensely competitive denim industry. It must stay ahead of trends -- a feat it has not always been able to perform as of late -- and must justify its often steep price tags. The company's average selling price for jeans fell from Q4 2011 to Q4 2012, thanks to higher promotional activity, but still stood at $223. The company is attempting to diversify from its traditional base through the development of outerwear, designing lower-price merchandise specifically for outlet stores, and expanding its assortment of jeans priced below traditional levels. But, at the end of the day, the company and its brand are predicated on highly stylish, flattering denim that can command a higher cost.

But it's important to note that, among the company's missteps over the past few years, True Religion has still maintained a pristine balance sheet, solid earnings, and excellent cash flow. It instituted its dividend a year ago and has plenty of room to raise its payout should it so desire. Management has taken responsibility for its errors and proactively attempted to fix them. There are new merchandising executives, new international partners, and a new operation in Italy to focus on the European market. And there remains what I called in October "a free call option" in the form of the private equity interest in the stock.

The lack of recent growth remains disappointing; but if the company spends yet another year earning $1.85 or so per share, it's not the end of the world. But if the company can execute on its plans -- or if a buyer swoops in -- there's plenty of upside in True Religion.

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.