Description

Kenneth Cole Productions (KCP) is in the midst of a massive restructuring that repositions Kenneth Cole Reaction as a lifestyle brand and elevates Kenneth Cole New York to an affordable luxury brand. The transition has not been smooth, resulting in disappointing financial performance, especially at the company’s retail division. We believe the problems are not only addressable but also more than discounted into the current share price. We believe the market is overlooking KCP’s Licensing division, which has a nearly bullet-proof and growing income stream with triple digit returns on invested capital. At $23, KCP is essentially trading for the value of its this division plus cash, so the core wholesale and retail businesses are free. As turnaround and growth initiatives take hold, we see significant upside to the shares and think they could potentially double in three years, with minimal downside risk. Management realizes the shares are ridiculously cheap and recently increased their share repurchase authorization to 2 million shares, or approximately 10% of the outstanding float.

DISCLAIMER: Kenneth Cole is my cousin and because of the close relationship our attorneys have advised against our firm buying KCP stock.

***Business Description***

KCP designs, sources and markets a broad range of footwear and handbags and, through license agreements, designs and markets apparel and accessories. The company was founded in 1982 by Kenneth Cole and went public in 1994. Kenneth Cole still controls the company. KCP has three operating segments: Wholesale, Consumer Direct, and Licensing. Since the majority of Kenneth Cole branded products are sold pursuant to licensing arrangements, brand revenues are significantly higher than company-reported revenues ($1.7 billion versus $0.5 billion). Key consolidated financial highlights are as follows:

$ millions 2001 2002 2003 2004 2005 LTM
Net Sales $388 $433 $465 $516 $518 $511
EBIT $25 $45 $52 $58 $46 $39
EBIT Margin 6.4% 10.4% 11.1% 11.2% 8.9% 7.6%
ROE 11.4% 18.6% 19.8% 18.3% 15.5% 13.1%
ROA 8.0% 11.8% 12.7% 12.4% 10.4% 8.9%
ROIC (1) 32.9% 54.9% 54.6% 53.5% 37.0% 28.4%

The Wholesale division manufactures footwear and handbags under KCP’s four proprietary brands Kenneth Cole New York, Kenneth Cole Reaction, Unlisted and Tribeca, as well as under the licensed Bongo brand. Wholesale product is distributed through over 6,000 department and specialty stores, company-owned retail stores, as well as catalogs and e-commerce. Key financials for the Wholesale division (pre-corporate overhead) are as follows:

$ millions 2001 2002 2003 2004 2005 LTM
Net Sales $199 $237 $255 $279 $284 $280
EBIT $15 $23 $22 $21 $17 $15
EBIT Margin 7.3% 9.8% 8.7% 7.5% 6.0% 5.5%
EBIT/Assets (2) 10.0% 12.4% 10.2% 8.5% 6.3% 5.5%

The Consumer Direct division operates 53 specialty and 39 outlets under the Kenneth Cole New York name. KCP uses the stores to test concepts, build brand awareness, and offer exclusive product. The division also runs the KCP catalog, website and corporate gift program. Key financials for the Consumer Direct division (pre-corporate overhead) are as follows:

$ millions 2001 2002 2003 2004 2005 LTM
Net Sales $165 $167 $176 $194 $191 $186
EBIT $4 $5 $7 $12 $7 $1
EBIT Margin 2.6% 3.2% 3.9% 6.3% 3.6% 0.5%
EBIT/Assets 8.3% 11.1% 14.1% 24.5% 11.7% 1.5%

The Licensing division extends KCP’s offerings into clothing, watches, sportswear, outerwear, fragrances and home products. Licensees contribute a percentage of their net sales, subject to minimum amounts, to KCP for the ongoing marketing of the Kenneth Cole brands. Key financials for the Licensing division (pre-corporate overhead) are as follows:

$ millions 2001 2002 2003 2004 2005 LTM
Net Sales $23 $29 $35 $43 $44 $45
EBIT $16 $22 $32 $35 $36 $37
EBIT Margin 70.7% 73.8% 89.5% 82.9% 81.8% 81.6%
EBIT/Assets 479% 486% 375% 433% 273% 696%


***The Dual-Brand Strategy***

Approximately two years ago, KCP undertook a strategic initiative to reposition the signature label by elevating the Kenneth Cole New York label to one of affordable luxury. The rationale for this decision was to increase product quality and design, and more importantly, open up new channels for domestic and international distribution. The Kenneth Cole New York label can be sold to higher-end department stores like Saks, Nordstrom, and Neiman Marcus, as well as company-operated and other specialty stores.

In order to execute the brand restructuring, KCP undertook a two-step strategy which we’ll call “replace and refine.” First, KCP reduced distribution of the Kenneth Cole New York brand by eliminating it from lifestyle department stores and replacing it with Kenneth Cole Reaction product. As a result, 75% of licensed and wholesale product is now Kenneth Cole Reaction, up from 35% two years ago. Second, Kenneth Cole New York was refined into an affordable luxury brand. The brand elevation is still a work in progress and has only caused problems to date, but the future looks bright.


***The Opportunity***

KCP’s brand transition strategy has been fraught with merchandising mistakes and management turnover. After several years of impressive growth, recent sales and earnings have been disappointing and investors have lost faith in the company. We believe the recent weakness in the shares presents a compelling investment opportunity.

The most pressing corporate problem is Consumer Direct. KCP lacked an effective strategy for the elevation of Kenneth Cole New York in their company-operated retail stores, creating product mix issues and alienating customers. The Consumer Direct business has been experiencing double-digit comparable store sales declines and depressed operating margins due to increased clearance activity. We expect the bleeding to continue until later this year, but are excited about the long term prospects for this division. The company recently introduced a smaller “Jewel Box” store format, which will consist primarily of high end Kenneth Cole New York accessories. These stores have much higher four-wall profit than KCP’s regular stores and represent a future growth driver for the division, with long-term potential to more then double the current specialty store base to 200 stores. Kenneth Cole himself is spending most of his time turning around the retail operation. As KCP’s founder and largest shareholder, we are confident that he will get the merchandising right.

In the last six months, KCP management has undergone a major transformation. Richard Olicker, Henrik Madsen and Joel Newman joined as President of Wholesale, General Manager of International Operations, and Chief Operating Officer, respectively. Olicker joined from Steve Madden, Madsen from Jones Apparel, and Newman from Tommy Hilfiger. KCP’s Paul Blum, Michael Newman and Carol Sharpe are no longer with the company (formerly President, Vice Chairman and Senior Vice President of Consumer Direct, respectively). Blum left to become CEO of jeweler David Yurman, Newman returned to consulting, and Sharpe, we presume, was let go following the merchandising problems at Consumer Direct. Kenneth Cole assumed Blum’s position and is temporarily running Consumer Direct while KCP searches for a replacement for Sharpe. We view these changes as disruptive but necessary.


***Valuation***

We value KCP on a sum-of-the-parts basis. The Licensing division has 82% EBIT margins and triple digit returns on capital. We argue that this income stream alone is worth 17-20x after-tax earnings. On this basis, the Licensing division is currently worth $400mm or $18 per share, and growing. KCP has $5 of cash on the balance sheet, so Licensing + cash = $23 per share, the current share price. The Wholesale and Consumer Direct businesses are both experiencing temporarily depressed sales and operating margins. Both were adversely impacted by the brand restructuring. In addition, Wholesale had a distribution glitch last quarter, and Consumer Direct botched its merchandising and is still in triage mode. We believe that on a normalized basis, today, the Wholesale division is a $300 million revenue business with 8.5% EBIT margins and Consumer Direct is a $200 million revenue business with 5% EBIT margins. So at KCP’s current price, we are getting about $500 million in sales and $36 million in normalized EBIT for free. By 2009, we think the licensing business will have sales approaching $60 million as new products are licensed and international growth initiatives take hold. With the rollout of Kenneth Cole New York, we assume that by 2009 the Wholesale business can grow to over $350 million in sales, and Consumer Direct will grow to $215 million in sales. We assume corporate overhead grows from $14 million today to $16 million in 2009. Applying 18x after-tax to the Licensing and 15x after-tax to the remaining divisions, plus cash build, we get a target price of $45 in three years time.


***Notes***

(1) ROIC is defined as EBIT / Average Invested Capital. Invested Capital is Total Assets – Excess Cash & Investments – Non-Interest Bearing Current Liabilities.

(2) The Wholesale EBIT/ Assets appears to include corporate assets, so this segment arguably has much better metrics than presented.


***Risks***

- Failure to turnaround Consumer Direct.
- Failure to elevate the Kenneth Cole New York brand.

Catalyst

- Turnaround of the Consumer Direct business.
- Additional Licensing opportunities and international growth.
- Share repurchase.