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

Based upon 10-Q filings for the first quarter of fiscal year 2011, "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 their "Core Services Segment." Due to space constraints, I'm quoting only the relevant parts in this article. You are welcome to see their filings at the 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 Services 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."

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 their Wholesale segment.
3. What about the impact of reclassification on UNconsolidated numbers? For example, segment 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:



Sales, gross profits 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 metrics for net sales, gross profit, SG&A and operating income. Please take a look. It's an easy read. What's not so easy and can be missed by the casual observer is the big picture when you coalesce the numbers into one unconsolidated metric, like the following:



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 the Wholesale segment.

I'm sure you remember that their U.S. wholesale segment has been 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, Armani and such premium brands. Despite steep unit prices, premium denim is a very crowded marketplace with deep-pocketed competitors like VF Corp. Unbelievable competitive pressure in securing and more importantly retaining shelf space, combined with the ongoing macroeconomic situation affecting consumer sentiments, a few fashion missteps by them especially 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 $1 million and cost of goods sold equals to zero dollars which means a gross profit of $1 million (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 the "core services segment" has SG&A of $17 million? Excuse me, it takes $17 million of SG&A to produce $1 million in sales, that too for a product with 100% gross margin. That cannot be right. Off course it is, if you believe True Religion's filings. Hmm!

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:



Notice all "NM" for "Core Services." Believe me, management is fully aware of the impact this allocation of SG&A to the "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 are the metrics:


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.



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

NOTE: Q1 FY2010 numbers above are based upon the 10-Q 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 10-Q filings of previous years. Here they are:



I see two problems:

1) They appear to be using "Core Services" (previously known as "Other") as a punching bag for a 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 the "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 and 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 two to three 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 roll back the effect of this SG&A move, based upon the trend, you would probably move $8 - 9 million from "Core Services" to "U.S. Wholesale." Even without the "Reclassification," "U.S. Wholesale" business has been declining and looks bad. After you roll back the "reclassification" shenanigan, you are looking at a horrible business segment.

I want the company I invest in run by real management, not a 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 a very generous severance package for the outgoing executives. For example, the exit of the president last year had substantial impact on quarterly and annual earnings.

A minor irritant could be the concentration of AR. Net accounts receivable from one customer ranged from 25% - 15% during the fourth quarter of fiscal 2010 and the first quarter of fiscal 2011. I will have to wait and see the trend but since it improved in the last reported six months, I consider it minor issue.

Another thing to notice is that founder and CEO has cut down his stock holdings in the company almost by half. People sell stocks for variety of reasons, but cutting a stake by half and by a 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, especially 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.

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