Small-cap companies are absolutely one of my favorite areas to research because you can often uncover hidden gems that analysts have neglected or simply not discovered yet. They can offer the ultimate risk-vs.-reward ratio, but are also not for the faint of heart.

This 10-week series is dedicated to finding the 10 small caps to rule them all. Here are the previous three choices:

This week I want to highlight premium denim retailer True Religion Apparel (Nasdaq: TRLG).

What it does
True Religion is a supplier of fashion jeans and sportswear apparel throughout the U.S., as well as internationally. In 2010, U.S. direct-to-consumer sales accounted for 52% of total sales, adding in its bricks-and-mortar locations. Its U.S. wholesale business accounted for 29% of total sales, while international sales increased to just shy of 18% of sales.

How it stacks up
One of True Religion's biggest challenges is transitioning from a wholesaler into a traditional B&M store. The costs associated with the transition require a healthy balance sheet since plenty of cash is needed to open new stores. In addition, the company must deal with rising input costs, particularly cotton, which is a primary component in its denim products.

Luckily for True Religion shareholders, the balance sheet is as clean as a whistle and cotton costs aren't hitting the company as hard as previously anticipated. True Religion is growing faster than its rivals, yet somehow manages its money very conservatively.


Gross Margin (TTM)

PEG Ratio
(5-Year Expected)

Cash / Debt

True Religion Apparel 63.2% 0.74 $153.8M / 0
Polo Ralph Lauren (NYSE: RL) 59.2% 1.73 $1.24B / $275.1M
Perry Ellis Int'l (Nasdaq: PERY) 35.7% 0.72 $18.5M / $228.4M
Guess? (NYSE: GES) 35.8% 0.78 $442.1M / $14.4M
Phillips-Van Heusen (NYSE: PVH) 51.7% 1.1 $491.4M / $2.5B

As you can see, quite a few of these fashion retailers are trading at low price-to-earnings multiples relative to their five-year projected growth rate, but none really compares to True Religion. Guess? has ample cash and a low PEG ratio, but falls short with a gross margin rate of 35.8% while Perry Ellis struggles under $210 million in net debt. Polo Ralph Lauren and Phillips-Van Heusen get close to True Religion's gross margin figures, but seem more than fully valued if you consider their PEG ratios; not to mention Phillips' more than $2 billion in net debt. On paper True Religion appears to be a winner, now let's see if it can help your portfolio.

How it could make you money
I've said before that the key to True Religion's success will be in its ability to transition into a B&M retailer. This year marked the transition whereby more sales came from the direct-to-consumer segment than the wholesale market. Why is this important you may wonder?

Well, True Religion's gross margins are more than 2,000 basis points higher from its direct-to-consumer segment than the wholesale market -- 72.4% vs. 50.9%. True Religion has done a good job branding its name into consumers' minds, seeing an 18% increase in international sales in 2010. The company can also grow considerably faster in the direct-to-consumer segment. Retail inventory per square foot increased only 1% for the year while same-store sales jumped 9.6% in that time, which proves it's doing a great job managing its inventory.

As the company continues its transition into a B&M retailer, I'd anticipate margins will continue to climb and that margin expansion could have shareholders dancing like they have ants in their pants.

What's your take on True Religion? Is it a passing fad or is this company the real deal? Share your thoughts in the comments section below and consider tracking my picks as well as creating your own personalized portfolio by adding stocks like True Religion Apparel to My Watchlist.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.