An Arbitrage Bargain Or Value Trap
True Religion (TRLG), which went public in 2003, has been a leader in the premium denim market over the past decade. The business is involved in the design, manufacture and sale of premium denim clothing, primarily its jeans which retailed for $255.00 on average in 2011.Though hollister jeans in recent years the company has expanded to offer a full line of both men and women's attire, the majority of the company's sales are in the denim bottoms category, accounting for on average 59% of all sales each year since 2009.In terms of profitability, the company has had a stellar performance since 2004 and has managed to internally finance its rapid expansion. darlings, the results of the business have not always mirrored the performance of its equity. For the long term hollister london holder, the ride has been a rollercoaster one to say the least, swinging from a lofty multiple of 25x earnings in 2007 to 4.5x in the depths of the recession. What's worse, the stock has had a dismal 2012. This recent performance is largely attributed to declining margins and slowing sales growth.Just last week, the company announced publicly that it would be exploring opportunities to sell itself. This caused the stock to rally an impressive 23% to $25.88 as of Friday's close. Until this recent announcement, the stock was down almost 39% in 2012.At Friday's closing price of $25.88, using a fully diluted 25.310m shares outstanding, I calculate a market capitalization of $655m. With roughly $200m of cash and long term investments (in treasury securities) on the balance sheet, I compute an enterprise value of $456m. Using a trailing 12 months FCFE of $35.27m represents an attractive CF/EV ratio of 7.73%. EBITDA/EV ratio is 16.88% not too shabby.For me, a valuation like this begs the question whether this is a fundamentally strong company or merely the victim of Wall Street's addiction to growth and impatience with anything that doesn't exceed its expectations? The statistical showing of the past five years certainly hints at this conclusion, but looking closer, a number of factors give me pause.”A small leak may sink a great ship” Benjamin FranklinDigging deeper into TRLG, one of the first things that caught my eye was the rather generous compensation of named executive officers. Especially its CEO / founder Jeffery Lubell.I am no expert on executive compensation practices, but the compensation table below taken from the 2011 proxy statement should serve as a sufficient introduction to the types of figures we are discussing:Disregarding for the moment the amount of other incentives being granted, I would like to focus on the significant equity dilution taking place.The table below shows that the three year average burn rate since the 2009 equity incentive plan was adopted has been above the Institutional Shareholder Services target rate of 2% [1], but not above the maximum 3.44% targeted at the inception of the plan.In administering the long term equity incentive compensation component of our compensation program, we actively manage our awards in accordance with a target “burn rate.” The burn rate measures the potential dilutive effect of our annual equity awards. In May 2009, we committed that with respect to shares of our common stock reserved under our 2009 Equity Incentive Plan, the burn rate of equity awards would not exceed an average of 3.44% per fiscal year through our fiscal year ended December 31, 2011.[1] IN EVALUATING AN EMPLOYEE STOCK PLAN PROPOSAL, ISS WILL LOOK AT A COMPANY'S HISTORICAL USE OF EQUITY COMPENSATION.For a more detailed look at how excessive executive compensation has diluted equity holders, please see a great article in Seeking Alpha by Rabish.But is this compensation all bad? Big equity incentives mean strong ownership, which in theory should lift all boats as the company strives to maximize shareholder value over the long run, right? True, but only if the executives hold on to their shares and in this case Mr. Lubell in particular has done the opposite. From owning 38% of the outstanding common stock at fiscal year end 2006, he now owns less than 2.5% of the company. Both of which are awarded using a metric defined below as Adjusted EBIT. Based on whether or not the company performed up to a hurdle rate of Adjusted EBITDA, as set by the compensation committee, the named executives could expect to earn many multiples of their salaries in both cash and restricted equity compensation.Performance Metric for 2011For 2011, the Compensation Committee set performance targets for our annual cash and equity performance awards based on Adjusted EBIT (as defined below). The Compensation Committee used Adjusted EBIT to set targets after taking into account the advice of SH regarding measures of performance used by the companies in the Comparison Group and after taking into account the compensation philosophy of the Company. The Compensation Committee set the specific performance targets for fiscal 2011 so that the Named Executive Officers would be eligible to receive the target level awards if the Company achieved Adjusted EBIT of 101% of 2010 Adjusted EBIT, taking into account that, at the time 2011 performance goals were set, the Company continued to face a very difficult retail and wholesale environment that would require outstanding performance to achieve the targeted goals. By setting this target level for performance based awards in 2011, the Compensation Committee believed the performance targets were challenging in light of industry and market conditions and trends in the general economy.For purposes of our annual cash and equity performance awards, “Adjusted EBIT” means the sum of the following determined on a consolidated basis, without duplication, for us and our subsidiaries in accordance with GAAP: A) net income, plus B) the sum of the following to the extent deducted in determining net income as reflected on the Company's statement of consolidated net income (I) taxes based on income or capital, including franchise and similar taxes, (ii) interest expense, amortization or write off of debt discount and debt issuance costs and commissions, discounts and other fees and charges associated with indebtedness, (III) any extraordinary, unusual or non recurring losses or expenses that are extraordinary or unusual in nature or infrequent in occurrence (including, without limitation, expenses for severance, non recurring retention bonuses, inducement payments to newly hired executives, employees of acquired entities under stock option plans or similar incentive plans, relocation and restructuring costs), (iv) charges resulting from foreign exchange losses; V) all payments to directors of the Company other than our chief executive officer; (vi) any charges for litigation or other dispute or claim resolution in excess of amounts included in the Company's operating budget; and VII) any reasonable expense related to any equity offering, acquisition, recapitalization, divestiture, asset sale or indebtedness (whether or not successful); minus C) to the extent reflected as income or gain in the Company's hollister clothing statement of consolidated net income, any income or gains resulting from foreign hollister jeans exchange gains.The compensation committee set the 2011 hurdle for incentive based compensation at an Adjusted EBIT of 101% of 2010 and 108% of 2009 for 2010. And just in hollister online shop case that proved too difficult, executives could be reassured by the precedent set in 2011, when the compensation committee did the following (emphasis mine):On February 10, 2011, the Compensation Committee certified the Adjusted EBIT achieved by the Company for fiscal year 2010. In determining whether the performance goals were achieved in 2010 the Compensation Committee excluded certain expenses related to the termination of the Company's former President and expenses related to the Company's international expansion efforts.