Description

Iconic is global licensing company that owns 35 brands that have $13B in global retail sales. The company is a rollup, and relies on purchases of new brands to supply growth. Iconic stock fell 20% yesterday on concerns of the unexpected departure of the COO. The COO had only been in place for 1 year and follows recent departures from two CFOs (one in March 2015, and one in March of 2014). While a CFO search is being conducted, the company announced that it will not be replacing the COO.

Along with the alarming management changes, the company has high leverage ($1.4B net debt), has seen changes in how it accounts for free cash flow (regarding payables from JV formation payments), and concerns that its portfolio of generally aged lesser quality brands are rapidly declining.

Despite these valid concerns, I think ICON represents a good value at recent prices of $25.41/share. The company’s ~$150-200M free cash flow generation should continue to fuel long term value creation like it has since Founder/CEO Neil Cole started the company with only one license.  From 2005-2014, company has grown from $30M in licensing revenue and $2.84 in book value per share to $407M licensing revenue and $18.44 BVPS

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Background and Business Model:

ICON was written up twice before on VIC in 2009 at $8.90 and 2010 at $13.09. Those write-ups proved to be profitable and provide a good background of the company. I think ICON is also a good long today, although it is not as cheap as when it was originally written up and leverage has increased considerably.

Icon has an asset-light, cash generative business model. It purchases the IP of an established brand and receives a royalty payment based on a % of gross sales (usually about 3%). There is no involvement in production, inventory, or retailing facilities, so the company has very little PPE and employees. This allows for very limited operating risk, high margins (~60% operating margins), and incredible returns on tangible capital (>100%). The overall returns on capital are of course weighted down by the purchase price of acquisitions, but are still very respectable (~16% ROE) given the limited operating risk the company takes on. The company is involved with the approval of fashion direction and marketing activities of the brands in partnership with the licensees and retailers.

The Company’s brand portfolio includes Candie’s ® , Bongo ® , Badgley Mischka ® , Joe Boxer ® , Rampage ® , Mudd ® , London Fog ® , Mossimo ® , Ocean Pacific/OP ® , Danskin/Danskin Now ® , Rocawear ® /Roc Nation ® , Cannon ® , Royal Velvet ® , Fieldcrest ® , Charisma ® , Starter ® , Waverly ® , Ecko Unltd ® /Mark Ecko Cut & Sew ® , Zoo York ® , Sharper Image ® , Umbro ® and Lee Cooper ®; and interest in Artful Dodger ®, Material Girl ®, Peanuts ®, Ed Hardy ®, Truth or Dare ®, Billionaire Boys Club ®, Ice Cream ®, Modern Amusement ®, Buffalo ®, Nick Graham ® and Hydraulic®.

The company has a variety of brands and retailer relationships, with no single license representing more than 10% of revenue. Although 1/3 of the company’s sales are international, most of the license deals are in dollars so the company faces little FX risk. For some of its licenses, the company has exclusion distribution relationships with retailers where ICON’s license act as a kind of in-house brand. This arrangement seems to beneficial as the retailer receive better margins by cutting out the distributor, and ICON receives higher sales as the retailers are incentivized to promote the brands and give better shelf space.  Wal-Mart is the biggest direct-to-retail (DTR) relationship, accounting for 11% of the company’s sales from OP, Starter, Danskin, and Waverly brands. Total DTR sales with major retailers account for 26% of the company’s sales (Wal-Mart, Target, Kohl’s, Sears). Renewals of DTR relationships are a risk as brands typically only have 2-5 year deals with the retailer, but historically DTRs have been renewed.

Fashion risk and economic risk are a risk to declines in revenue and cash flow, but ICON’s royalty model protects it much more than the traditional brand/retailer companies that have high fixed costs and operating leverage. Fashion risk is probably the largest risk with ICON owning a lot of mature, out-of-date brands (especially it’s men's brands like Ed Hardy, Ecko, and Rocawear), although ICON somewhat protected as the majority of its license agreements include minimum guaranteed royalty revenue, and in some cases royalty rates increase as volumes decline.  The company states it expects 15% international and LSD domestic organic growth this year, for a stated organic growth rate of 10%. I expect organic growth to be around zero long term as declines from aging brands in existing markets are offset by increases in new/international markets.

Acquisitions and Debt

Cash flows from operations are higher than net income due to intangible asset amortization for tax purposes (a non-cash expense), stock based comp, and amortization of convertible note discounts. The company has very little capex (~$2m/yr) requirements so free cash flows are high, and are used to fund new brand acquisitions along with increases in debt. In order to be a believer in this stock long term, you have to think that acquisitions are done at a return higher than the company’s cost of capital. I think the amazing 10 year results prove that has historically been the case, although the future obviously won’t be as good.

The company typically purchases brand licenses at a multiple of around 5x annual royalty revenue. Incremental operating profits are around 80% (marketing and SGA). After assuming 30% for taxes, cash flow would be around 56%, for the purchases having a 9x multiple or 11% return on capital assuming flat sales. Assuming 50% leverage at 6% interest, ROE would be 18%. Assuming only 60% flow through to operating income, ROIC would fall to 8% and ROE 13%. Assuming an 80% flow through and -3% organic growth rate, the ROIC would be 9%. I think on average acquisitions will continue to add value and create more than a $1 in market value for every $1 in capital spent.

ICON relies on acquisitions for growth. Slowing acquisitions would equate with slowing growth and remains a risk to the stock. This is especially true as the company’s leverage is high in an absolute sense (about 4.5 net debt to EBITDA) and relative to its own history, and as the economy appears to be closer to a peak than a trough. This is somewhat mitigated by the companies policy of evaluating share repurchases against new acquisitions. It has been a bought 29.1 million shares of its stock (40% of original balance) at an average price of $26.57 since 2011. Over the last 3 years, share repurchases have been $754M, while acquisitions have been $512M.

The high 4.5x leverage position is somewhat mitigated by the companies high FCF conversion to EBITDA. So unlike an industrial company that might only convert 50% of EBITDA to free cash flow due to high capex requirements, ICON converts about 75% of EBITDA to FCF. The company continues to have high interest coverage and says that it is comfortable with its leverage and can continue to increase its securitization facility to add new brands. The company says it is continuing to see a lot of potential opportunities globally, but asking prices are higher than what they traditionally pay.

$300M of converts are due June 2016 and $400M are due in March 2018, so the company has no immediate liquidity risks, but will need to re-finance large portions of the converts as they come due. The conversion price is around $31/share.

The Peanuts franchise (Charlie Brown/Snoopy) has been growing and although it has a lower EBITDA margin, the company remains positive about its growth prospects with a movie coming out in 2016 and potential for future TV shows.

Recent acquisitions include the Strawberry Shortcake character from American Greetings for $105, which is expected to generate around $18-$20M in annual revenues, and the PONY sports brand for $37M, expect to generate around $7-9M in annual revenues.

Accounting/Free Cash Flow

The company routinely forms international JVs to provide local partners to bring the company’s brands to market more quickly than the company could build out operations itself. It also often sells partial ownership of a certain brand in an international territory. The controversial thing here is that the company will book the sales price as other revenue and include the gain on sale (often with a de minimus book value assigned to the location) in income and cash from operations. This has gone from essentially zero in 2010 to $54M in 2014.

The bear case is that the company is using this account to manage sales/income growth in order to mask declining domestic revenue. The counterpoint is that as the increase in other revenue has supported a healthy increase in international licensing revenue.  I think the truth is somewhere in between. The company recently revamped its calculation of cash flow to exclude any JV formation payments that are not paid in the current period (example a note receivable payable over several years). That change seems warranted although the company still has aggressive accounting in regards to recognizing partial license sales cash flow as revenue. The 2014 10-K was just realeased in March so there does not see to be any imminent headline risk of accounting restatement news, although it does seem to warrant some adjustment when calculating sustainable FCF.

Assuming a 5x license revenue purchase multiple, organic growth does look like it has been negative to the tune of -3% over the last 5 years (less so if you net Other Revenue against Acquisitions), although management guidance calls for increased licensing revenue in 2015+ on the back of strong international growth.

Executive Changes

The recent personnel changes are a big reason for the recent stock drop and are a cause for concern. It could mean executives are looking to leave before operations/accounting issues get worse. Unfortunately I don’t have any good insight into this. It looks bad, I just think this is now more than priced into the stock. I think a large portion of yesterday’s 20% price drop should reverse in the coming months.

Valuation

Despite all the negatives, I think the stock is a buy because of the high FCF nature of the business. Management is calling for $208-$218M in free cash flow for 2015. Take off say $40M for the other revenue issue and $13M for SBC and adjusted FCF is about $160M. This puts the equity at a 12.5% FCF yield. The stock is currently about 10x EBITDA-Capex. While this is not an insanely attractive valuation, I think it is relatively attractive in today’s market,  and the stock should be able to compound at double digit rates into the future.

While there may be more near term price declines, I think the stock should provide attractive long-term returns if the companyis able to manage through its executive and leverage issues.

A company that generates a large % of revenue as free cash flow and invests that cashflow at double digit rates of returns should experience pleasant long term growth. While the situation is risky, I think over time the share price should appreciate respectively given the strong free cash flow generation and growth created by acquisitions. In a downturn where the company no longer has access to debt markets to fund acquisitions (or prices required do not represent a good use of capital), the free cash flow generation could still be put to good use through buybacks, debt pay downs, or dividends (in order of likelihood).  

Catalyst

Reversal of market sentiment

Time and FCF deplolyment