Wednesday, April 28, 2010

Watch for the Explosion: A Short Analysis on True Religion


In a previous post, I talked about what a great find True Religion (ticker: TRLG) was.  For those of you unfamiliar with the brand, it makes high-end jeans that are worn by many Hollywood celebrities.  Two weeks ago (April 12, 2010), I decided that I was going to be a shareholder of this company.  What attracted me to the stock was its growth potential.  This post will focus on primarily looking through a company's annual report to see what management has in store.

What's in an Annual Report?
An annual report, similar to quarterly reports, is a document that is required by the SEC for all public companies to be submitted on an annual basis.  It is called the Form 10-K.  It contains information such as the business, its direction, risks, etc.  It also contains a financial report of the year and quarter (i.e. balance sheets and income statements showing how much money it made or lost, revenues, profit margins, etc.).  You can also find the executive compensation in this report.  Although not a tremendously exciting read, you can certainly find a lot of useful information in here.  Before you buy any stock, I would definitely recommend reading the latest annual and quarterly reports of the company.  Quarterly reports have somewhat less information.  So, yes, do have a read of the annual report even if the fiscal year is approaching the end (i.e. the last annual report would be almost a year old).  Wikipedia gives a brief but useful description of what is contained in an annual report.  You can find True Religion's annual reports under SEC filings at Yahoo Finance.

Developments at True Religion
If you are unfamiliar with True Religion and its business, much like I was when I found this stock, you should read the Part I, Item 1, Business section.  This gives you an overview of what the company does and its business strategy.  From here, I found that all of its denim products (large majority) and 80% of its sportswear products are made in the US.  Is that important?  Well, it depends.  If you are trying to build a brand that is able to sell jeans for $200+ a pair, a "made in USA" sticker is worth a lot.  More importantly, having products made in the US means that no sweatshops are used.  As an ethical/Catholic investor, this is an important factor when considering whether you want to support a particular business or not.

I rarely look at annual/quarterly reports for financial numbers, just because Yahoo Finance or MSN Money summarizes a lot of that for you in easily readable tables.  What I do look for is business direction and expansion plans.  In the case of True Religion, I was trying to see if I can find out the latter.  Under Item 7 of Part I, the report outlines the business strategic initiatives.  I want to direct your attention to the "Growth of Consumer Direct Segment".  By the end of 2009, True Religion had 70 retail stores, of which 28 were added that same year.  So, it grew from 42 stores to 70 stores in 1 year, a 67% growth in number of stores.  In 2010, it is planning to open another 28 stores, with 1 in Toronto (where I live!).

All of this expansion sounds great, but we need to verify that they are indeed profitable expansion.  The only way to find out is to look at the company's history.  A little farther down in the report, you will see a "2009 Compared to 2008" table.  This shows the 2009 vs. 2008 numbers.  As we recall, 2009 was a painful year for the economy.  Yet, we see the net sales number and more importantly, the gross profit margins increased during that year.  In that tough economy, True Religion was able to expand successfully.  Not only did it not lose money, it made even more money!  This tells me that the company has momentum and its execution is excellent.

Digging further, we see under the "Gross Profit" section that the "Consumer Direct" segment made up almost half of all gross profit, and its gross margins were highest at 73.8%.  By the way, not many companies can claim to have gross margins as high as 73.8%.  This is a clear indicator that True Religion has a brand moat.  That is, people are willing to pay a premium for its products.  As a result, the company's plan of opening more stores will only propel the itself farther ahead.

Now, I'm just doing some real rough guesses, but I would imagine a city like Toronto and its surrounding areas could probably eventually sustain 3 to 4 True Religion retail stores.  If you live around here, these are my guesses: 1 to 2 downtown (Eaton's Centre & Yorkville), 1 West End (Sherway Gardens maybe), 1 Yorkdale.  The Greater Toronto Area has about 4 million people in population and the US and Canada together have about 340 million people.  If 4 million people can support 4 stores, 340 million could probably support 340 stores.  If I were half correct, 170 stores would be feasible.  This is still 243% more stores than there were at the end of 2009.

Going back to the "Gross Profit" section, we can see that "International" gross profits grew by 56.4% in 2009.  So, the company's expansion plan into the UK and Japan is a continuation of those efforts and I'm hopeful that they will succeed there as well.  The international market for True Religion products are quite small (only 14% of net sales are from international sales).  So, there is definitely room to grow there.

What Else is Good?
Yes, the expansion plans look fairly optimistic, but is this a green light to buy?  No!  You must look at all of the fundamentals of the company.  From what I learned in Phil Town's book, Rule #1, the Big 5s we need to look at include: a minimum of 10% ROIC (return of invested capital), and minimum 10% yearly increase in sales growth, earnings growth, book value per share growth, and free cash flow growth.  The company satisfied all of these criteria with flying colours for the past 5 years, with the exception of a blip in the earnings growth last year (it increased by 4.9% rather than > 10%).  The company also has no debt.  The P/E is currently sitting at 16.4 while analysts estimate it will grow by 31% yearly over the next 5 years (translation: the stock is undervalued big time).

So, do your homework, and if you decide to join me in being a shareholder, we'll see you when the stock hits $100!  At that point, I may consider going to Winners to pick up a pair of last season's True Religion jeans!