True Religion Going for Gold

Is it right to sell jeans for $200-and-up? Better yet, is it right for someone to be paying that much for a pair of jeans? I mean, it’s still cotton right? Moral concerns aside, True Religion Apparel (Nasdaq:TRLG) is doing just that. And doing it darn well.

After the close of the markets yesterday, True Religion, whose jeans can be found on the shelves of Urban Outfitters (Nasdaq:URBN), Bloomingdales, and more recently their new flagship store in Manhattan Beach, CA, announced that they had increased sales nearly 40% year over year for the second quarter, bringing in $30.7 million. In addition, they grew net income over 40%, putting up $0.26 per share after adjustments for a non-recurring legal settlement cost. This compares to Wall Street estimates of $27.3 million in sales and $0.22 earnings per share. Not bad at all.

Even more significant in their earnings release, though, was the announcement that they have engaged the investment bank Goldman Sachs “to explore strategic alternatives.” Which, in plain language, typically means that they are thinking about selling the company. Why in the world would they do this?

The bull case for this is pretty straight forward. Often times the executive team of a company will just get fed up with the way the market is valuing their company. For one reason or another they believe that the company is worth more than the current stock prices gives it credit for. By working with an investment bank, they hope to come up with a reasonable valuation for the company and find another party, whether it’s a larger player in the industry or a private equity or leveraged buyout fund, that is willing to pay that price - if not more.

This, of course, works out well for pretty much everyone. The acquiring company gets an asset they see as valuable, the shareholders see a quick upward re-valuation of their shares, and management sees the same uptick in the shares they hold - which in this case is pretty significant as management owns over 35% of the shares outstanding.

The bear case here (also known as the “cynical case”) is that the company isn’t doing quite as well as the financials and the outperformance suggest - or at least management is concerned that they can’t keep up such a torrid pace. In this case, the thought process would be to take the company out to bidders while there is still a lot of excitement and momentum behind the company in hopes that it will drive a high price.

Of course, the obvious risk here is that they don’t find a bidder willing to pay the price they want and the deal falls through. This is bad for two reasons: first, the stock price tends to run up when a company announces that they are exploring options, and these opportunistic buyers will leak back out pretty quickly. And second, if the company does in fact have a slowdown in growth after the process dies it will compound the exodus out of the stock.

Bulls and bears aside, I like to keep my eye on the underlying fundamentals of a company and not divert my focus to hopes of the company getting acquired for a big price. True Religion happens to be one of the premier premium denim brands and has some really impressive sales and earnings growth to back it up. The stock also still trades at a relatively low valuation of 16.5x trailing earnings, even after running up 2.8% in the after market. Combine all of that with a nice return on equity and a very clean balance sheet, and this is a stock that I'm keeping in my portfolio regardless of whether they decide to sell the company.

As a disclosure note, I do hold shares in True Religion.

-AvgJoe