Cash Conversion Cycle Sends Misleading Message

By Will Ashworth | August 31, 2010 AAA

Premium denim manufacturer True Religion Brand Jeans is, in my opinion, the best bang for your buck in apparel stocks these days - especially after shedding 29% of its value in the month of August alone. However, some don't see it that way. Jim Mueller wrote an article for Motley Fool.com on August 27, discussing True Religion's deteriorating cash conversion cycle. He reckons it's slowed by as much as 60% in the past five years with most of the damage inflicted since 2007. I'd be worried if I wasn't familiar with the wholesaler-turned-retailer's history as well as the misleading nature of this financial metric. To understand where I'm coming from, I'll examine some of True Religion's biggest competitors. It's clear to me that a mountain is being made out of molehill.

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True Religion is in the midst of a transition from strictly wholesale to a combination that includes its own retail stores in North America, U.S. wholesale, an international division with both wholesale and retail and a small licensing business. In 2005, it opened its first company store in December, generating $200,000 in sales, a small part of overall revenue. By the end of 2009, retail represented 41.5% of the total and 70 stores were open for business. It's a drastic change in its business model for sure but a necessary one. Sales to department stores like Nordstrom (NYSE:JWN) and Saks (NYSE:SKS) were dropping significantly as the recession took hold. The writing was on the wall. It could control its own destiny or leave its future in the hands of other retailers facing a similar problem of growing in a difficult economy. I believe it made a wise decision.

Cash Conversion Cycle
This is the number of days it takes to move inventory plus the number of days it takes to collect on the sales from the inventory less the number of days it takes to pay its suppliers. Adding it all up, it's supposed to tell you how fast a company is converting cash into product and back again. It's simple enough in theory. However, the world is never this clear cut. In a previous article, I wrote about True Religion, comparing it to other apparel manufacturers using traditional valuation metrics like price-to-earnings, etc. The evidence was rather one-sided in True Religion's favor. However, in light of this damning evidence, I thought I'd compare the same businesses from a cash conversion perspective as well as return on capital employed. While it's important for a business to manage its inventory, it's even more important to profit from the capital it employs. Cash conversion doesn't necessarily translate into profits, although it is an important aspect of the business proccess. True Religion appears to know the difference.

True Religion and Competition

Company Cash Conversion Cycle Return on Capital Employed
True Religion (Nasdaq:TRLG) 124.5 days 37.3%
VF (NYSE:VFC) 109.7 days 13.7%
Ralph Lauren (NYSE:RL) 92.9 days 18.1%
Lululemon (Nasdaq:LULU) 65.4 days 35.1%
Phillips-Van Heusen (NYSE:PVH) 91.2 days 12.3%

Return On Capital Employed
Several things are apparent from the table above. True Religion and Lululemon both sell higher priced products than the other three and their operating margins reflect this. More importantly, both do it employing less capital. Lululemon's cash conversion cycle is twice as fast as True Religion but there's a simple explanation. Lululemon has almost no wholesale business. In fiscal 2009, it sold $10.4 million to third parties compared to $177 million for True Religion. Therefore, its accounts receivable are much smaller and thus the days its sales are outstanding are lower. As for inventory, Lululemon turns its inventory approximately 5.2 times a year compared to 3.4 for True Religion. The difference can be attributed to Lululemon's industry leading sales per square foot, making it rather easy to make the extra turns. I'm not a fan but they do seem to be able to move the merchandise.

Bottom Line
If you were thinking of buying True Religion, I wouldn't let the cash conversion cycle stop you from pulling the trigger. The stock's too darn cheap. However, articles about subjects like this one remind investors to analyze companies from all sorts of different angles. After all, if you were buying a house, wouldn't you look in every room? Stocks are no different. (Find out how a simple calculation can help you uncover the most efficient companies. To learn more about the cash conversion cycle, read Understanding The Cash Conversion Cycle.)

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