Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

True Religion Apparel: The Emperor Has No(t many) Clothes

|Includes: JOEZ, KATE, True Religion Apparel, Inc. (TRLG), VFC

(Reposting since previous update was not showing tables properly)

Based upon 10Q filing for Q1 of FY2011, "True Religion Apparel, Inc. and subsidiaries designs, markets, sells and distributes premium fashion apparel, centered on our core denim products using the brand name “True Religion Brand Jeans.... We operate in four primary business segments: U.S. Consumer Direct, U.S. Wholesale, International, and Core Services. We selectively license to third parties the right to use our various trademarks in connection with the manufacture and sale of designated products in specified geographical areas for specified periods. The licensing business is included in the Core Services segment. Our corporate operations, which include the design, production, marketing, distribution, credit, customer service, information technology, accounting, executive, legal, and human resources departments, are also included in the Core Services segment."

Note: My focus is going to be on what they call "Core Services Segment". Due to space constraints, I'm quoting only the relevant parts in this article. I've also added some formatting (e.g. Italicized, boldface or use of color, subscripts etc) to highlight the point. You are welcome to see the filings at SEC for more description.

Having said that, let's go further to the section called:

Reclassifications

We reclassified certain prior period segment information beginning in the fourth quarter of 2010 to conform to the current year presentation. We reclassified our reportable segment formerly titled “Other” to include the functions which support the overall business that were previously classified in the U.S. Wholesale segment as of March 31, 2010. The functions that were reclassified include the design, production, marketing, distribution, credit, customer service, information technology and accounting departments.1 In connection with this reclassification, we renamed the segment “Core Services”. As a result of this change, we have reclassified certain selling, general & administrative expenses (SG&A) previously presented in the U.S. Wholesale segment to Core Services2 in order to conform to the revised presentation. We made the change to our reportable segments to more closely align them with how management reviews and monitors the performance of our operating segments. Total consolidated SG&A expenses and total consolidated operating income were not changed as a result of these reclassifications. The reclassifications had no impact upon previously reported consolidated net sales and consolidated gross profit by reportable segment. Additionally, these reclassifications did not impact the condensed consolidated balance sheets, statements of income, or statements of cash flows.3

Note the highlighted portions. What strike me are the following:

  1. It appears they are allocating corporate wide expenses such as design, production, marketing, distribution, credit, customer service, IT and accounting departments to just ONE of the four segments (Core Services).
  2. In fact they are admitting doing this for Wholesale segment.
  3. What about the impact of reclassification on UNconsolidated numbers for example Segment wise numbers. Did they use the word "consolidated" just like that, innocent choice of words, you would think. I don't think so.

Let us examine the numbers more closely. Here are the consolidated numbers from income statement:

CONSOLIDATED DOLLAR FIGURES

 

Q1'11

Q1'10

Net Sales

93762

77872

COGS

33017

27897

Gross Profit

60745

49975

SG&A

45890

36628

Operating Income

14855

13347


Sale, gross profit and operating income grew quarter over quarter. Cost of goods sold shot up by 18% and SG&A shot up by 25.3%.

In ITEM 2, under "RESULTS OF OPERATIONS" they have broken up these figures by segment. They have provided separate segment wise metrics for Net Sales, Gross Profit, SG&A and Operating Income. Please take a look. Here is the link. It's an easy read. What's not so easy and can be missed by casual observer is the big picture when you coalesce the numbers into one unconsolidated metrics like the following:

INTRA SEGMENT - DOLLAR FIGURES

 

US Consumer Direct

US Wholesale

International

Core Services

 

2011

2010

2011

2010

2011

2010

2011

2010

Net Sales

53372

38774

20867

24152

18470

13782

1053

1164

COGS

14829

10293

9683

11322

8505

6282

0

0

Gross Profit

38543

28481

11184

12830

9965

7500

1053

1164

SG&A

19893

15953

1907

2228

6770

2779

17320

15668

Operating Income

18650

12528

9277

10602

2662

4721

-15734

-14504


Do you see what I see? Let me help. Remember the beginning of this article, where I said it appeared they're allocating expenses to Core Services segment. In fact they admitted doing that for Wholesale segment.

I'm sure you remember that their U.S. wholesale segment is under pressure for some time. This segment includes the channel (department stores such as Nordstrom, Bloomingdale's, Saks Fifth Avenue and Neiman Marcus) where they share shelf space with brands such as 7 for Mankind, Citizens of Humanity, Joe's, Lucky, Hudson, Not Your Daughter's, D&G, J Brand, Armanis and such premium brands. Despite steep unit price, premium denim is a very very crowded marketplace with deep pocketed competitors like VF Corp. Unbelievable competitive pressure in securing and more importantly retaining shelf space, combined with ongoing macro economic situation affecting consumer sentiments, a few fashion missteps by them specially in Women's clothing, are all recipe for a very gloomy situation in their U.S. wholesale segment.

NOW, do you notice something funny in the metrics above? Our favorite little segment called 'Core Services' has net sales of approximately $1M, cost of good sold equal to ZERO dollar which means gross profit of $1M (100% gross margin). That means your input cost and cost of producing goods are both zero. WOW, what a fantastic business. But wait, do I see 'CORE SERVICES SEGMENT' has SG&A of $17M. EXCUSE ME, it takes $17M of SG&A to produce $1M in sales, that too for a product with 100% gross margin. That can not be right. Off course it is, if you believe True Religion's filings. Hmmm !!!

Let's go further in the "results of operations" section, where the company summarizes SG&A as a percentage of segment net sales (“SG&A rate”), by segment. Here is what they show:

 

2011

2010

% Change

U.S. Consumer Direct

37.3

41.1

-3.8

U.S. Wholesale

9.1

9.2

-0.1

International

36.7

20.2

16.5

Core Services

NM

NM

NM

Total SG&A rate

48.9

47

1.9


NOTICE all "NM" for "Core Services". Believe me, management is fully aware of the impact this allocation of SG&A to "Core Services" segment has on its segment wise reporting.

Let's express the numbers in another form. Let's check out how various line items stand against sales in that segment. Here is the metrics:

INTRA SEGMENT - PERCENTAGE OF SALE

 

US Consumer Direct

US Wholesale

International

Core Services

 

2011

2010

2011

2010

2011

2010

2011

2010

Net Sales

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

COGS

27.78%

26.55%

46.40%

46.88%

46.05%

45.58%

0.00%

0.00%

Gross Margin

72.22%

73.45%

53.60%

53.12%

53.95%

54.42%

100.00%

100.00%

SG&A

37.27%

41.14%

9.14%

9.22%

36.65%

20.16%

1644.82%

1346.05%

Operating Margin

34.94%

32.31%

44.46%

43.90%

14.41%

34.25%

-1494.21%

-1246.05%



Notice from the metrics above, for CORE SERVICES Segment SG&A is 1645% of net sales and operating margin is -1494%.

Now let's examine percentage contribution of various segments to overall company numbers.

INTER SEGMENT - PERCENTAGE CONTRIBUTION IN OVERALL NUMBERS

 

US Consumer Direct

US Wholesale

International

Core Services

 

2011

2010

2011

2010

2011

2010

2011

2010

Net Sales

56.92%

49.79%

22.26%

31.01%

19.70%

17.70%

1.12%

1.49%

COGS

44.91%

36.90%

29.33%

40.59%

25.76%

22.52%

0.00%

0.00%

Gross Margin

63.45%

56.99%

18.41%

25.67%

16.40%

15.01%

1.73%

2.33%

SG&A

43.35%

43.55%

4.16%

6.08%

14.75%

7.59%

37.74%

42.78%

Operating Margin

125.55%

93.86%

62.45%

79.43%

17.92%

35.37%

-105.92%

-108.67%



The metrics above shows that "Core Services" segment which brings in 1% of total revenue, consumes 38% of SG&A.

NOTE: Q1' FY2010 numbers above are based upon 10Q filing of Q1' FY2011 in which Q1' FY2010 numbers have already been changed to reflect the said "Reclassification".

If you truly want to see the impact of "Reclassification", you would have to get the ORIGINAL numbers from 10Q filing of previous years. Here they are:

FROM Q1' FY2011 FILINGS

 

FROM ORIGINAL Q1 FILINGS of PREVIOUS YEARS

 

2011

2010

   

2010

2009

2008

 

U.S. Consumer Direct

19,893

15,953

 

Consumer Direct

15,953

10,077

4,456

 

U.S. Wholesale

1,907

2,228

 

U.S. Wholesale

10,350

8,267

8,487

 

International

6,770

2,779

 

International

2,779

922

163

 

Core Services

17,320

15,668

 

Other

7,546

6,400

6,658

 

Total SG&A

45,890

36,628

 

Total SG&A

36,628

25,666

19,135

 



I see two problems:

1. They appear to be using "Core Services" (previously known as "Other") as punching bag for major chunk of SG&A from other segments which is contrary to commonly used expense accounting and
2. With the recent "Reclassification", they have tried to benefit "U.S. Wholesale segment" much much more than other segments.

As a result of dumping the majority of SG&A expenses to "Core Services" (under the pretext of reclassification), operating income & operating margin of various segments get an artificial boost. Of all the segments, the weakest link, "U.S. Wholesale" segment which has been in decline for majority of last 2-3 years, gets the highest boost.

That is NOT the economic reality of the income of the company. I believe "U.S. Wholesale" segment is much weaker than it appears. Operating margins for other segments may be inflated too.

When you rollback the effect of this SG&A move, based upon the trend, you would probably move $8-9M from "Core Services" to "U.S. Wholesale". Even without the "Reclassification", "U.S. Wholesale" business has been declining and looks bad, after you rollback the "reclassification" shenanigan, you are looking at a HORRIBLE business segment.

I want the company I invest in, run by real management, not fake financial alchemist.

I also do not like the fact that stock compensation for management is a high percentage of the net income. Moreover they seem to have very generous severance package for the outgoing executives for example, exit of the president last year had substantial impact on quarterly and annual earnings.

A minor irritant could be the concentration of AR. Net account receivable from one customer ranged from 25% - 15% during Q4'FY10 and Q1'FY11. I will have to wait and see the trend but since it improved in the last reported 6 months, I consider it minor issue.

Another thing to notice is that founder & CEO has cut down his stock holdings in the company almost by half. People sell stocks for variety of reasons, but cutting it by half that too by founding CEO who is the chief designer and sort of evangelist for the brand is somewhat hard for me to digest.

In summary, True Religion is growing its brand name and presence nicely specially via its own showrooms but what I described above make me uncomfortable. You may disagree with me. In fact the market can disagree too and the stock can keep its upward momentum. Good luck to you.


Update: They announced Q2'FY11 earnings on July 28th. As in Q1, they beat estimates by wide margin. Both sales and profit grew reaffirming their position as a solid growth company. Having said that I still see the aggressive accounting in segment wise numbers.

In Q2, Core Services segment has net sales of 336 thousand dollar (0.34% of net sales) and despite being 100% gross margin segment, consumes SG&A expenses of $18M, which is 38% of total SG&A. As much as I know about accounting (which I'm still learning), if you're showing numbers by segments, common expenses have to be allocated based upon their actual (or good faith) usage.

Please note that I am not against the company. As an analyst and investor, you should be flexible to change your opinions if things change. I believe True Religion has the potential to become the next big thing in premium Apparel but right now I notice some accounting red flags, which for now don't seem to affect top or bottom line but as they say "old habits die hard". Who knows when the going gets tough, may be they become even more aggressive.

So even though market has really liked the numbers, I'll wait and see. I see few better value opportunities elsewhere.