The following article was submitted to me by my friend, Bobby. It's his analysis of True Religion and the prospects from here. He makes some very good points. I will post some of my thoughts later this week. Enjoy.

After reading the Q4 and 2006 earnings release, and after listening to the conference call, I must admit that I have mixed feelings about True Religion.

On the one hand it is hard for me to deny that this company is a cash machine… The company has gross margins over 50%, they are piling up cash every quarter, and there are almost no depreciable assets on the company’s balance sheet. Book value of $67 million consists almost entirely of working capital. There is no debt. There is no goodwill. Tangible book is the same as shareholder’s equity. Return on equity is around 36% and the EBIT returns on tangible capital are around a staggering 150%. (This is why TRLG makes the list at www.magicformulainvesting.com)

But on the other hand…

TRLG is in the beginning stages of refashioning themselves as a “lifestyle brand”. This means they are creating (and licensing) lots of non-denim clothing for high end consumers to buy. (It’s important to remember that this isn’t going to be GAP or Abercrombie & Fitch priced sportswear. This stuff is going to be marked way up and it’s going to be expensive.)

TRLG’s CEO, Jeff Lubell, stated on the Q4 conference call that “our goal long-term is to be 50% sportswear, 50% denim.” This is the main driver behind their claims for future growth. They’ve already guided for 20% growth in 2007.

The problem of course is how are they going to convince their jeans customers to buy the pricey sportswear? And before we even get to that problem, how are they going to even get the sportswear out to customers? How are they going to distribute the sportswear?

50% of True Religion’s sales take place through approximately 650 locally owned boutique stores around the country. (Another 25% take place in U.S. department stores, 20% takes place internationally, and 5% in a small number of company owned stores.)

In order for TRLG to get their sportswear distributed, they are going to have to convince the U.S. boutique stores to carry these new lines. Frankly, I think this is going to be a difficult process. Why would boutiques take the risk of stocking non-returnable TRLG sportswear? They take this risk with TRLG jeans, but they already know that True’s jeans are popular.

The real home for the non-denim product quite frankly is going to be True’s own stores. I don’t believe that the department stores and the boutiques are interested in carrying “lifestyle brand” items from True Religion. They know they can sell the jeans, and I think it will be difficult to convince them to go out on a limb. I just don’t see why the boutiques would take this risk.

If my thesis is correct that the boutiques do not pick up the non-denim products, you can pretty much kiss a major part of the growth story goodbye over the next couple of years. The thing that will grow is the TRLG’s company-owned store base, and that’s not worth buying TRLG for its current market cap of about $360 million.

The current and projected store count is as follows…
2006 2007 2008
4 12 27

At about $1.6 million in sales per store and 40% operating margins, that should come to about $600,000 in annual operating income per store. I’m not sure why I would pay $360 million today for trailing net income of $24 million plus slowly ramping post-tax income from stores of, what, about $4 million starting 10 months from now?

As mentioned, TRLG management is projecting 20% growth in 2007. From what?

When TRLG rolls out all their 2007 denim products to the boutiques and department stores, how is this any different from what just happened in 2006? Is denim going to sell more in 2007 than it did in 2006? Why? When I walk into boutiques in my own city, I see a lot of hot jeans brands on the market right now. I see people looking at a lot of “cool” labels. Rock & Republic is particularly coming on strong at the moment. How is True Religion going to sell more denim domestically in 2007 than it did in 2006? I really want to know.

It’s pretty much a given at this point that the boutiques and department stores aren’t going to sell any non-denim in 2007. It’s mid-March and there’s not one scrap of non-denim TRLG product in any boutique store in the United States. Not a scrap. So again, where does the growth in 2007 come from?

These are the tough questions that I don’t really see being asked at the moment. Everyone seems to just be taking growth as a matter of faith. But without some empirical explanation of exactly where the growth is going to come from, I am skeptical.

TRLG will add eight company owned stores in 2007, but that will barely move the needle on overall sales for the year.