Joe's Jeans – Small Cap Valuation

I recently noticed that a B. Riley analyst put a buy recommendation on Joe's Jeans with a $2.15 price target, so I've done some independent research on the company and came up with the following analysis.



Investment Thesis: Joe's Jeans ($114 million cap on June 7, 2013) may want to model itself after 7forallmankind and True religion (TR), which were bought out by VF Corp and a private equity firm for $773 million and $826 million, respectively. The problem is, the competition affected the upscale denim margins after people noticed the upstarts. Specifically, True Religion had the ability to mint coin in its growth stages, Joe's, still considered in the growth stage - can not. Buying at half the current price is appealing, but as is, expecting outstanding growth in intrinsic value is for the romantics. Unfortunately, as one of my professors in business school used to say "this is fin-ance, not rom-ance".


Joe's Jeans Company depends on sales to wholesale and retail markets. The wholesale market carries significantly more volume than retail sell-through but at lower margins. Company-owned retail store sales bring more awareness to the brand and carry potentially more profitability but also more risk due to operational expenses and inventory management requirements. The management is focusing on international expansion with an eye for 30% of sales coming from overseas (currently 5%). Japan is a large potential market, just like it was for True Religion, but Joe’s will need to sign up good agents/distributors in that territory. Europe is also interesting if Joe’s is to follow True Religion’s trajectory (TR). TR has substantial penetration in Germany.


The fastest growing segment of operations is men's jeans wear. However, I don't know if there is a cap on this growth considering intense competition from denim makers and limited shelf space in retail outlets. Joe Dahan controls 17% of shares; he is the chief creative designer. He also received a recent payout above $9 million with a non-compete clause until 2016. Seven for All Mankind was partially created by Jeremy Dahan who also formed Citizens of Humanity. Jeremy is not related to Joe, but his interest in two companies demonstrates that Joe may leave Joe's and start another firm when his non-compete expires. Overall, executive directors own 25% of the company and have a vested interest in the success of the firm.


Joe's doesn't hold a competitive market position in denim, fighting for retail shelf space and maintaining it requires reduction in margins and I’m afraid the high time for premium denim has passed as more competitors entered the market. Though Joe’s management claims their core customer is a very loyal 32 year old female making $140,000 per year and owns 7 pairs of jeans, I think these women are style conscious and would be easily swayed to another brand if it was trending. The exclusive "Else" brand in Macy's at a $68 price point for young girls is probably not a very profitable endeavor for Joe's considering it would have to generate substantial volume to reap net benefits compared to higher price point offerings.


Joe's competitive position is guided by pricing, R&D, product identity and brand awareness. Basically, this means they have no competitive advantage with the wholesale channel. I believe that’s partly why they are wisely building out their own retail store chain.


Sources of working capital include cash from operations, sales of AR at 85% of face value to a factor (CIT), and advances against inventory (50% of face value). Selling AR at 15% discount has a negative impact on the bottom line but assures liquidity as a going concern, and helps with working capital needs. Note that corporate and other expenses line item includes advertising and general expenses associated with running the operation, including professional fees. I am not confident if these are all indirect expenses because the proportion of corporate spending to overall sales seems high ($16.5 million to total $119 million revenues). This has the effect of seemingly increasing margins.


Valuation:


Out of the three valuation models, (sum of parts, DCF projection and comps) the DCF and comparable models are applicable. DCF on owner's earnings is a good metric of intrinsic value. Currently, the company's $6 million in FCF is growing at 10% and yields a $1.68 valuation (68 million shares). Buying at around $0.80 makes sense. I took 10% growth prospects based on increase in same store sales from the reports.

Comp valuation: Joe’s is worth $110 million based on an EBITDA multiple of 9x.


The question is: Do we value the company on EBITDA or sales multiples? If sales, Joez is undervalued based on a current price of $116 million in the market: sales $119 * 1.8 (TR's multiple) = $214.2 million. If, however, we look at EBITDA multiple, its value is in line with current market price and it is worth $110 million via 9x EBITDA. Joe's margins are lower than TR across the board, including annual sales growth rates almost half those of True Religion (chart below). EBITDA margin of 10% is really low compared to 20% of TR, and the same is true with OI and NI. Additionally, Joe's can't grow as fast as TR due to much lower working capital ($36.8 million) when compared to TR at the same growth stage five years ago ($113 million in 2008).












Bottom line:


In my opinion, the company is fairly valued in the market with both the DCF approach and the comparable transaction analysis, and there are no catalysts for clear valuation growth. Buy at $o.80 for an approximate 50% margin of safety. Sum of the parts valuation doesn't apply.


Wxhibit 1 - JOEZ annual results and how they compare to True Religion.