Description
ICON is a stealth play on expected 2009 strength at Wal-Mart. Wal-Mart is really the one consensus long in consumer discretionary (but not a value name at 16x 2008 eps) as they continue to benefit from consumer tradedown and economizing. ICON’s 2009 growth is hitched to new initiatives at Wal-Mart, which gives it a much better 2009 outlook than most consumer cyclical companies, yet it is still a cheap stock trading at an extremely low multiple of free cash flow
Company Description
ICON owns brands, which it then licenses out to retailers (DTR, or direct to retail model) or wholesalers. ICON holds no inventory and enters no leases. It is a true intellectual property company with less than 100 employees, who provide marketing support and direction to licensees, look for new brands to acquire and new licenses to sign for existing brands, and monitor the performance of existing licenses and monitor royalty collection for them. The expense structure is entirely SG&A and relatively fixed, leading to operating margins around 67%. Around 2/3 of revenues are subject to guaranteed minimums as outlined in licensing agreements, which gives a fairly high degree of visibility to the topline relative to other companies in the apparel space. Over 50% of revenues are in DTR arrangements, with well-known companies such as Wal-Mart, Target, Kohl’s, and Sears. While certainly challenged by the economy, none of ICON’s DTR licensees are going anywhere, with the exception of possibly Sears, and if something were to happen to Sears, they would be free to re-license the Sears/Kmart exclusives (Joe Boxer and Cannon). Major DTR licenses include Starter, Ocean Pacific/OP, and Danskin Now for Wal-Mart, Mossimo and Fieldcrest for Target, Royal Velvet for Bed, Bath and Beyond, and Candie’s for Kohl’s. Brands that are licensed to wholesale makers of apparel, accessories and other soft goods include Rocawear, Bongo, Rampage, Mudd, London Fog, and Badgley Mischka.
Since the company was a roll-up, built on acquisitions, there is high leverage here. Many value investors pass on this company after only a cursory look because of the fact it is financially levered and a consumer cyclical operating in a recession. I think this is short-sighted because the company has a free cash flow yield exceeding 20%, which compensates you for the risk of leverage. In addition, ICON has good interest coverage, is not close on any covenants, has ample cash available/liquidity, and a high percentage of revenues guaranteed by financially reliable licensees such as WMT, TGT, and KSS. Obviously, as a roll-up, financial market gridlock will limit ICON’s ability to grow aggressively through acquisition as it has in the past. The company had placed debt in the past in using the guaranteed revenue streams of various deals to secure the debt, allowing it raise debt at low rates. This avenue is for the moment closed, and getting additional unsecured debt would be very costly. But at 20%+ free cash flow yield, the company is no longer priced for the acquisition-fueled growth of recent years. When acquisitions were part of the financial model, the stock traded in the low $20s, about 2.5x the current quote. At a forward PE of around 7 (based on achievable guidance of $1.20 in eps) and a free cash flow yield of 21% (based on $1.90 in free cash flow), the stock is cheap, especially given its realistic outlook of stable to slightly up earnings in 2009, which will prove to be very good relative to its retail and apparel peers where declines should be expected, whether modeled yet or not at sellside firms. Note that the large difference in free cash flow versus earnings is largely related to the differing treatment of trademark amortization on the tax books versus the GAAP books.
Investment Points:
- ICON’s 09 guidance is for very modest overall growth driven by high single digit growth at Wal-Mart due to 3 new product launches at the retailer (OP, Starter and Danskin Now); at its October annual shareholder meeting, Wal-Mart emphasized its commitment to these initiatives. Wal-Mart has long trailed Target in execution on the apparel side, so it makes sense for them to try to make progress in mind share and market share in apparel right now, as they have the market share wind at their back with the advantage they have in consumables pricing.
- The Martha Stewart licensed home product comes out of Kmart next year (Martha is at Macy’s going forward), so Kmart will be making a big push to replace that lost business with the Cannon home textile brand that they license from ICON
- The business has less income statement risk than most companies in retail/apparel since 1) 2/3 of their revenues are from guaranteed royalty minimums, 2) they hold no inventory, 3) they don’t have leases or a lot of employees
- Great free cash flow characteristics…cheaper on free cash flow than earnings because of a number of non-cash items in the income statement (tax shield-generating trademark amortization, non-cash stock comp, depreciation, deferred financing fees, etc.) – it’s about $1.90 per share in FCF (versus $1.20 earnings) so it’s a 21% free cash flow yield currently, a yield typically reserved for companies in secular decline or deep cyclicals at times of peak earnings…ICON is neither of these things
- This retail and credit environment could lead some smaller, private companies into distress, and ICON may be able to make acquisitions of good brands on the cheap
- Announced a $75 mm share repurchase program in early November, which was essentially an acknowledgment that their own stock may be the best investment at this time, especially given current financing markets
- International is only 6% of revenue but could contribute to longer-term upside as a JV in China was recently established and there are plans for similar ventures in India and Central/South America
- Return of Jay-Z to the ad campaign for RocaWear thought to be helping that brand which had been languishing
- 17% of the float is short and it’s 10 days to cover...when they beat Q3 estimates in November, there was a pretty decent short squeeze that day
Investment Risks:
- Leveraged balance sheet…debt to total cap is around 50% although interest coverage is pretty healthy at 4.7x…I am generally avoiding anything with debt but making an exception here because of the high coverage combined with the high proportion of revenues that are guaranteed
- Risk that some of their smaller wholesale licensees could get in financial trouble and stop paying them or go away…mitigated by diversification of wholesale licensees combined with the higher credit-worthiness of major retail licensees like WMT, TGT and KSS
- Until credit conditions loosen, capacity to do deals will be limited and it will be hard to get back to double digit eps growth without deals…they can still do small deals as they have around $100 mm available…they most recently bought home brand Waverly for $7 mm from NEXC which went into financial distress on account of fraud (this was a drag on ICON because NEXC is one of only two other companies with the same business model as ICON)
- Negative pressure on eps by proposed changes to accounting for convertible bond interest…it will be all optics because it would not impact free cash flow
- 40% of their hedge on their convert was provided by Lehman and therefore might not be honored, but since this hedge is in effect from $27.56 to $42.40 and the stock is $9, this will only become a relevant issue if the stock triples
- Organic growth outside WMT will clearly be challenged (especially the brands at SHLD and brands like Rocawear and Bongo which sell through department stores)
- Long-term, the existence of SHLD (10% of revenue customer) as a going concern in question, but their financial distress is likely 1-2 years out and those concerned about Sears’ viability can hedge out the Sears exposure either with Sears stock or a number of mall REITs that will get hit hard if Sears goes down
Target:
$19.00 – which is a 10% free cash flow yield and 113% upside potential
Risk Price:
$6 – a draconian scenario of 33% downside. $6 is a 25% free cash flow yield on $1.50 of FCF, which is the possible downside if the non-Wal-Mart businesses decline more than expected, a scenario which would likely only be realized in the event of several wholesale licensee failures. $6 is also close to the November low of $5.80. Even in the worst case scenario, the risk/reward of an investment in ICON at these levels is still above 3 to 1.
Catalyst
• Starter re-launches at Wal-Mart in Spring 09, a male sports figure spokesman (paid for by Wal-Mart) should be announced soon…by mid-year 09, WMT growth will be real and not theoretical
• Danskin Now re-launches at Wal-Mart in Spring 09…again, theoretical growth becomes real growth
• Ocean Pacific/OP goes from current 1K domestic doors to all WMT doors by April 09 and starts getting rolled out internationally as well in 09…again, theoretical growth becomes real growth
• Small acquisitions of distressed brands
• New Direct to Retail announcements…JCP is a possibility: Waverly sells product to JCP so this acquisition gets ICON in the door at JCP, where they are currently doing no business…this isn’t imminent because JCP has its hands full with American Living at the moment, but a DTR deal between ICON and JCP could happen eventually