Description

KCP’s cash and licensing unit alone is worth $22 per share, or 25% above today’s stock price.  So for less than free, you’re getting its wholesale and retail units, with a combined half a billion dollars in revenues.  Things don’t go on sale for no reason, and the reason here is that profits have been cut in half since the 2004 peak because of the difficult industry environment and a major fashion faux pas.  I don’t know when industry conditions will get better or whether KCP will be able to fix its internal problems anytime soon, but that’s all gravy.

INVESTMENT CASE

Kenneth Cole Productions is a branded apparel and shoe company that throws off a lot of cash in good times and bad, since it is basically an intellectual property company, outsourcing the manufacturing of its products.  KPC reports in three segments – wholesale, retail, and licensing.  Wholesale is where KCP sells its shoes, handbags, and other accessories to retailers like Macy’s, Nordstrom, etc.  In Retail, KCP operates 90 of its own stores, selling directly to consumers.  In Licensing, KCP collects royalty payments from other firms that sell apparel and accessories under the Kenneth Cole name.  I assume most of you are familiar with the brand, and with previous write-ups available on VIC, I’ll stick to the relevant recent history.

Until 2004, KCP was doing just fine.  However, with consolidation in the department store channel intensifying, KCP decided to try to re-segment its business to protect its brand.  It took its core Kenneth Cole New York line further upscale, raised price points, and narrowed its sales channels to primarily its own retail stores and select high-end department stores.  To replace the New York line in the mass channel, it expanded its Kenneth Cole Reaction line.  So mid-market department stores all of a sudden found themselves with restricted access to the core New York line, and forced expansion of the Reaction line.  Consumers that walked into a Kenneth Cole store all of a sudden found that products sold under the New York label cost 20% to 100% more than the day before.  Naturally, the consumer got completely confused.  The department store wholesale channel actually made the transition without much of a problem, but sales through KCP’s own retail stores fell off a cliff.  Same-store sales fell 8% in 2005 and 10% in 2006.  Retail segment income went from a $12 million profit (before corporate allocation) in 2004 to a $13 million loss in 2006.  Retail sales have stopped going down this year, but the segment is still on track to lose about the same as last year.  Meanwhile, the wholesale segment is now seeing declining sales and profits with the difficult consumer environment in mid-market apparel.  Here are the sales and profits of the three segments, in millions of dollars:

                                                2004    2005    2006    2007e

  Wholesale                  317      326      354      310

  Retail                          191      187      177      174

  Licensing                    43        44        44        43

Total Revenue              516      518      537      489

  Wholesale                  19        14        27        12

  Retail                          12        6          (13)      (15)

  Licensing                    36        36        35        35

  Corporate                  (10)      (11)      (12)      (14)

Total Op Income          56        45        37        19

VALUATION

The most important takeaway from the above chart is that the licensing business is mostly unaffected by the difficulties of the other units.  While reported revenues and profits have been flat, underlying growth has been quite good.  In 2006, KCP decided to take the sportswear business away from its licensees and bring it in-house.  So starting in 2007, KCP began losing royalty income for its sportswear business – it is a $5-6 million revenue loss in 2007, and will be another $5-6 million revenue loss in 2008.  Once that headwind disappears in 2009, the licensing business should begin to display strong growth (and concurrently, should help growth in the Wholesale channel as well).  KCP is very strong in the U.S., but is just beginning to penetrate other countries, and with licensing a major avenue to penetrate overseas markets, this segment should grow nicely for a long time.  As you would expect, this unit has wonderful financial characteristics, with 78% pretax ROA in 2006 and minimal capital needs.  I think the licensing business deserves a P/E of 18x, and using that on estimated 2007 net income (after assigning one-third of corporate expense to this segment), that gets us to $16.68 per share value.  The 18x seems appropriate given where Cherokee and Iconix, two public pure-play apparel licensing firms have traded historically.

Since KCP should end 2007 with about $5 a share in cash and no debt, the licensing unit and cash together equal about $22/share in value, or about 25% above the current stock price.  The remaining Wholesale and Retail units have about $450 million sales, so I think they are probably worth something.  It’s too uncertain to pin down, but I think it’s clearly a lot more than zero.  KCP is closing several stores and looking to downsize several others, so I don’t think management will let this be a black hole.  It doesn’t hurt that CEO and Chairman Kenneth Cole owns 47% of the company.  If the two units were to ever get back to 2003-2004 levels of profitability, a P/E of 10-12x on this incremental improvement would mean another $8-11 a share of value.

Catalyst