ICONIX BRAND GROUP INC ICON
January 14, 2010 - 5:09pm EST by
rainman1080
2010 2011
Price: 13.09 EPS $1.24 $1.33
Shares Out. (in M): 74 P/E 10.6x 9.7x
Market Cap (in $M): 970 P/FCF 7.6x 6.5x
Net Debt (in $M): 374 EBIT 158 193
TEV ($): 1,344 TEV/EBIT 8.5x 6.9x

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Description

 

I recommend a long position in Iconix (ticker ICON), the second largest licensing company in the world with around $10 billion of underlying retail sales.  ICON was written up in late 2008, during the credit crisis, by baileyb, and his writeup is worth reading.  At that point, the stock was screamingly cheap (along with many other stocks) at around $9.00.  Although ICON is up over 40% since then, the world has obviously improved greatly, the business has improved and de-levered, and credit markets have improved to enable acquisitions and recharge the prior growth story.  As a result, I think the risk/reward may be even more favorable, and I see roughly 100% upside over the next 2 years to $26 per share.  At around $13, ICON offers the chance to purchase a very high quality business at a juicy 15% free cash flow yield (despite limited leverage of less than 2x net debt to EBITDA).  And, with the acquisition model poised to ramp up again, I think ICON provides strong growth prospects and FCF yield at a value price.

Valuation

Given the sizeable Mark Ecko acquisition announced early November, 2009 numbers understate the EBITDA generating power of the Company by around $20 million.  2010 numbers are therefore appropriate, and it should be noted that 2010 numbers assume virtually no organic growth and essentially equal the 2009 numbers plus the roll-on of the acquisition.  No additional future acquisitions are assumed.

I think a major issue for the stock is that the sell-side analysts group ICON in with more traditional operating companies, are too focused on P/E and EBITDA (not the best metrics for ICON) and seem uncomfortable assigning a premium multiple for the higher quality business model.  Many sell-siders do not even include a cash flow statement in their models.

Also, this is a stock that traded for 20x earnings or more pre-credit crisis, then fell to serious value territory.  Despite a healthy cash balance and enough "dry powder" to do $350 million of 100% cash-funded acquisitions over the next year (cash on hand + free cash flow), the market is not currently assigning any value for that potential growth.  As a result, I think we are getting a growth company at a value multiple, and given the low risk inherent in the ICON acquisition model, I am willing to assign some value to that future growth.  (But to be clear, even in the absence of future acquisition growth I think you make money from here.)

ICON would trade at $20 with a 10% FCF yield, as it now generates around $2.00 per share of FCF.  If ICON were to successfully execute typically accretive acquisitions funded with a reasonable cash and debt balance, 2011 FCF could easily approach $200 million or $2.70 per share, leading to a $26+ stock price at a 10% yield.

Capital Structure  Est. 12/31/09   Valuation on 2010 Numbers (estimates per Lazard 12/22 Report)
Share Price  $    13.09   P/E Multiple    $      1.35 9.7x  
FD Shares 74.1   EBITDA Multiple   197.5 6.8x  
Equity Value 969.6   EBITDA less Capex Mult. 193.5 6.9x  
Total Debt 574.3   Free Cash Flow Yield 150.0 15.5%  
Cash   199.9              
Net Debt   374.4              
   Mult.of EBITDA 1.9x              
Enterprise Value 1344.0              

ICON's historical and projected 2010 financials illustrate the beauty of the business model, with almost unprecedented profit margins and almost zero capex requirements.  FCF exceeds net income due to a combination of recurring factors: tax shield afforded by faster intangible amortization for tax purposes, non-cash interest expense, and stock-based comp.  The historical numbers are per Factset, and the projections are primarily from Lazard.  Note that the 2010 numbers are slightly higher than management guidance, as given the recent earnings miss management is viewed as being quite conservative at this point.

Year   2006 2007 2008 2009 2010        
                       
Revenues   80.7 160 216.8 229 261.2        
  % Growth     98.3% 35.5% 5.6% 14.1%        
SG&A (incl D&A)   24.7 44.3 73.8 76.5 86.9        
  % of Revenue   30.6% 27.7% 34.0% 33.4% 33.3%        
EBITDA   39.8 104.4 147.9 167.0 203.2        
  % Margin   49.3% 65.3% 68.2% 72.9% 77.8%  Note margin higher due to equity income
  % Growth     162.3% 41.7% 12.9% 21.7%        
Diluted Operating EPS    $    0.57  $    1.01  $    1.14  $     1.24  $    1.33        
  % Growth     77.2% 12.9% 8.8% 7.3%        
Capex   0.7 0.1 6.3 2.3 4.0        
  % of Revenue   0.9% 0.1% 2.9% 1.0% 1.5%        
Acquisitions   175.9 585.0 33.8 83.7            NA        
                       
Free Cash Flow   42.4 100.6 109.5 128.5 150.0  Calculated as Funds from Ops less Capex
  % Margin   52.5% 62.9% 50.5% 56.1% 57.4%        

Clearly ICON has been an acquisition machine historically, and those acquisitions have been the primary growth driver.  Organic revenue growth is not formally disclosed but is sometimes discussed on earnings calls.  I have organic growth of 5% in 2007 (including 11% on DTR relatinoships), flattish in 2008, mid single digits in 2009 (after thinking organic growth would be quite weak at the beginning of the year it came back strong), and projected at "low single digits" for 2010.  Organic growth continues to be driven by the growing DTR segment which has proven very successful for both ICON and retailers (as discussed below).

 Business Overview

  • Owner of 17 apparel & home furnishings brands. Growth via acquisition model.
  • #2 licensing company in the world (behind Disney and in front of Phillips Van Heusen/Calvin Klein & Warner Bros. Consumer Products)
  • Asset-light business model whereby IP is only asset
    • Paid royalty rate based on % of revenues
    • No inventory, production facilities, or bricks and mortar. Limited operating risk
    • Diversified by brand and retailer (largest concentration is 9% of revs- Mossimo/Target)
    • Exceptional profit margins (70%+ EBITDA margins), virtually zero capex, high return on tangible assets
    • Less than 100 employees
  • Key business activities include:
    • Approval of fashion direction and marketing activities
    • Marketing/advertising of brands in partnership with retailers and wholesale licensees
    • Evaluation of additional brand acquisitions
  • Two types of licensing relationships, both of which result in royalty payments to ICON
    • Direct to Retail ("DTR"), whereby ICON licenses a brand exclusively to a mass retailer
      • This is now over 50% of revenue and is a major growth focus
      • Relatively new concept in which the wholesale "middleman" is eliminated, resulting in superior economics to both ICON and to the retailer
      • Retailer see this as a replacement for private label with better economics and no direct price competition. Retailers typically decide to give great shelf space and spend promotional dollars to support brand.
      • Examples: Candies in Kohls, Starter & Ocean Pacific/Walmart, Mossimo/Target
    • Traditional Wholesale License
      • License to wholesaler for royalty
      • Best suited for higher end brands, where a single mass retailer could not match total volume of brand distributed through multiple, smaller, higher end retailers
      • ICON has successfully transitioned several traditional licenses to the DTR model
  • Royalty terms.  Overall, ICON receives about 2.8% of total underlying retail sales
    • Typically 2-4% of retail sales for DTR licensees
      • Guaranteed minimums
      • Stepdowns allow retailer to pay lower marginal royalties with greater volume (incentivizes retailers to grow brand)
    • Typically 8-11% of wholesale sales for traditional licensees, with minimums
  • Competitive advantages
    • Essentially unique business model (only peer is smaller, undiversified, non-acquisitive Cherokee-ticker CHKE)
    • Rolodex of CEO Neil Cole
    • Track record and experience allows ICON to line up licensing deals before acquiring brand

Acquisition Model

  • Pursue diversification by brand (none greater than 10%), retailer, target market (income, gender, style), product (apparel, home furnishings)
  • Often purchase for 4-5x royalty revenue
  • Never purchase brand without a license agreement in place that guarantees minimum lifetime royalties in excess of purchase price
  • ICON typically is able to generate 80%+ incremental profit margins on acquired brands
  • ICON has acquired 16 brands since 2003 (when it transitioned core Candies brand to licensing model), and has not had a notable failure
  • Given the lack of operational risk associated with acquisitions and the guaranteed minimum royalties already in place, this acquisition model is about as low risk as they get.

Key Risks

  • Non-renewal of large brand license representing around 10% of revenue. Mitigating factors:
    • Has not occurred to date with any license
    • ICON would receive substantial notice in order to plan ahead
    • Assuming brand still generates significant volume, it would presumably have value to other retailers
    • After pouring millions into advertising, DTR retailers see these brands as "house brands" and would be unlikely to terminate. Furthermore, DTR retailers would need to replace the terminated brands.
  • Potential for lower organic growth on owned brands. Mitigating factors:
    • Diversification reduces risk (9% maximum concentration)
    • Royalty is "off the top", and about 70% of total revenue is guaranteed in 2010
    • With lower volumes, DTR licensees would "step up" to higher royalty rates
    • Decent organic growth historically:
      • 2007 organic revenue growth of 5% (including 11% on DTR licenses)
      • 2008 organic growth was flattish (no number provided)
      • 2009 expected organic growth of mid single digits
      • 2010 expected organic growth of "low single digits"
      • Ultimately however the brands need to remain vibrant and profitable for licensees.  This is obviously tough to assess given the whims of fashion.  I do think that the DTR focus, whereby mass retailers use the brands as private label replacements, is a winning model and might reduce this risk.
  • Failed acquisition. Mitigating factors:
    • None to date
    • ICON claims to follow extremely low-risk acquisition strategy, with guaranteed minimums in excess of purchase price
    • Acquisitions are operationally very simple compared to most industries
  • Reliance upon CEO Neil Cole
    • Apparently his retailer relationships are critical, so if he were to leave the acquisition capability could suffer
    • However, note that at current prices there is no growth expectation baked into valuation
    • Neil also appears to have a strong (but fair) compensation package with 1.2mm shares (not options) vesting over 5 years. This should presumably retain him.
  • Cost of debt will rise
    • Current all-in cost of under 4% will surely increase when capital structure is refinanced within 2 years.  This will not be material to the financials, however (maybe another $12mm of pre-tax interest expense assuming 300 bps higher cost, beginning in 2012)
  • Failure of major retail partner, such as Sears/Kmart
    • Risk could be hedged out (might be a good idea at current SHLD prices)
    • Presumably other major retail partners would benefit as a result
  • Perceived over-reliance upon "streetwear" brands Rocawear, Ed Hardy, Mark Ecko
    • Company believes these brands appeal to different consumer (Rocawear is urban, Ecko is suburban, etc)
  • Decent-sized short interest at 15% of float / 14 days to cover
    • I'm not clear on a good short thesis here and would be interested in others' thoughts.  Presumably some of the short interest is related to the convert, and perhaps some is based upon a cursory valuation focused on EBITDA (which is the least appealing metric for ICON).

So, why does the Company trade where it currently does?

  • Underappreciated business model
    • Lumped in with traditional apparel companies by sell-side, and such companies are relatively cheap
    • Virtually unique business model (only peer is non-acquisitive Cherokee-CHKE which is 10% of the size)
    • Growth investors not appreciating cash flow in excess of earnings (cash flow greatly exceeds book EPS primarily due to amortizing of acquisition-related intangibles for tax purposes)
  • Recent focus on DTR model, rather than traditional wholesale licensing model, is also underappreciated.
    • DTR % of revenue went from 20%ish to almost 60% in last 12-18 months (due to combo of acquisitions and transitioned brands)
    • DTR model seems powerful as retailers really put marketing dollars and prime shelf space behind brands
  • Recently stalled growth
    • Weak 2009 retail environment reduced organic growth
    • Limited acquisition growth in 2009 as Iconix focused on debt paydown
    • Question as to whether or not acquisitions will continue to be available at accretive prices given higher cost of funding relative to 2006/2007
  • Recent disappointment
    • Reduced 2009 guidance on 9/30, only two months after an equity raise at $15.00 per share. Reduction primarily due to lower than expected fall season Ocean Pacific volumes at WalMart.  Company in "penalty box" of sell-side analysts as a result.
    • Earlier in 2009, ICON accounced transition of Mudd brand from traditional wholesale license to Kohl's DTR brand. This entails short-term pain for longer term gain, but Street reacted poorly due to 1H 2009 impact.

Catalyst

Additional accretive acquisitions that underline growth story, leading to a multiple re-rating.

Earnings beats versus conservative forecast, and company is upgraded out of the penalty box by sell-side analysts.

Value creation from FCF generation (15% per year).

Valuation.

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