Iconix: The negative sentiment is FINALLY exaggerated

In 2015, the stock price of Iconix (ICON) declined from $34 to ~$6. The whole management team including long-time CEO Neil Cole has been replaced. The company had to restate its financial statements and it is still under SEC investigation for the accounting issue. The market painted a picture of a rogue CEO aggressively taking debts to buyback stocks and dump his shares before leaving the company. Investors began to question whether the whole brand management business is just part of the fraud. The biggest question I had after reading this story is why it took the rogue CEO 23 years to execute the fraud. He must be really patient. After digging deeper into the story, I found it is more complicated. The aggressive use of cheap convertible notes to finance the acquisitions during 2012-13 was the source of the problems. It forced management to buy back shares to counter potential dilution and eventually rig the accounting as things fall apart. There is no question that management did wrong things along the way, but the fear that the whole business is a fraud is also exaggerated at current valuation. With long-time turnaround expert Peter Cuneo in control as CEO, there is still value in this company.

Solid business model but poor capital allocation

Iconix is a brand management company with 35 brands categorized into Women, Men, Home and Entertainment. It licenses those brands to retailers and collects fees based on percentage of product sales. Here is a very brief idea about the business model:

Buying a brand -> Signing licensing contract -> Collecting cash and buy another brand

Almost half of company’s brands were licensed exclusively to one of the big retailers (Walmart, Target, Seas/Kmart, Macy’s or Kohl’s). The business model is actually very sticky. When a retailer has involved and co-invested in a brand for several years, it is unlikely to give the brand away. There are two important things to succeed in this business. First, management needs to find undervalued brands and build long-term relationship with the big retailers. Second, a good capital structure and efficient capital allocation can amplify the return. Neil Cole, as the founder of Iconix and one of the pioneers in the industry, is definitely good at the first. But he failed miserably in the second and almost brought down the company.

Acquisitions supported by $700m convertible note

From 2011, management team has frequently talked about cheap financing options like securitization, high yield bond and especially the convertible note in the conference call. The company took $700m note during 2012-13 at cash interest rate of 1.5%-2.5% with convertible options at the price of ~$30 per share. (ICON was trading at around $18 at that time). In my opinion, the pressure to get to $30 stock price was behind the buybacks and the eventual accounting issue. With the huge stock price decline in 2015, the once cheap convertible note becomes an unbearable liquidity problem in 2016. Neil Cole’s strategy to expand globally and enter entertainment segment was a correct move to diversify from the core licensing to US big retailers. He actually built the diversified global presence with the brands like ‘Peanuts’, ‘Strawberry Shortcake’ and ‘Umbro’ in addition to the core US brands. The company now generates ~$400m annual license fee with a ~50% EBITDA margin. But his choice to build it quickly with cheap convertible notes rather than slowly with internal resources has put the company in great danger.

What is left for the equity holder?

The Iconix stock is currently trading at $5.7 with a market cap of $280m. A valuation based on earnings and FCF does not make sense anymore because of the heavy debt burden. The company was historically traded at 13x EV/EBITDA and 8.5x EV/Licensing fee. Private acquisitions of brands were usually considered reasonable or relatively cheap at 5x licensing revenue. If the company’s brand is still of relatively good quality (which I think is the case), the current valuation can be very attractive considering the track record of the interim CEO Peter Cuneo, a turnaround expert who led Marvel from bankruptcy to $4bn sales to Disney. A sale of the whole company at 5x EV/Licensing fee will generate an 88% return for equity holder.

Moreover, several recent developments have showed that management still has the options to deal with the liquidity problem and the default is not likely. (1) The majority holder of 2016 Convertible Note proposed publicly to refinance the deal with senior secured status, but there has been no response yet from the management team; (2) Two convertible notes due Jun 2016 and Mar 2018 is trading at significant discount to face value which presented buyback opportunity to Iconix; (3) Sports Direct, the original owner of ‘Umbro’ from UK, has bought 14.4% stake in the company in recent months.

Conclusion

After the crash of Iconix’s stock price in 2015 and the ongoing SEC investigation, it is reasonable to be cautious about the business. However, a detailed look at company’s history showed that the crash is more likely to be a failure of financial engineering. With 35 brands generating $400m annual licensing fee and a turnaround expert in control, the Iconix stock is attractive. The eventual solution to the liquidity problem will serve as a catalyst to the stock price.

Apple: It’s Not 2013 Again

Summary: The future of Apple stock is once again becoming a hot topic in the market. The stock’s recent price decline has reminded investors of 2013 when the price tumbled from $700 to $400. Could this be a similar opportunity to buy? In my opinion, this time is different. Although Apple is currently trading at a multiple similar to the 2013 trough, the drivers behind the stock have completely changed. Since 2013, the deal with China Mobile, the introduction of a bigger screen, and the focus on the 64G version have pushed the iPhone to its market limit and helped the stock price to almost double. In 2013, the stock’s investment success mainly depended on Apple executing obvious strategies to capture a clear market and this gave the investors free options on new product categories. However, as Apple has pushed iPhone sales to the extreme for the past three years, the future stock price will be all about new product categories as the company’s risk-return profile has significantly changed.

Push iPhone to Its Limit

Impact from China Mobile deal in one-time: Market has still not fully understood the importance of the deal and why the success of the past two years cannot be repeated. China Mobile is the most important carrier in the country because it controls the market for a large group of people who work for state-owned companies or government entities. These people receive full reimbursement for their monthly mobile bills and so they pick the best phone in the network. This was Samsung prior to Apple’s deal. Then most of the people in this group chose to pick their iPhone freely in the past two years (well, some people may argue about their phone choice if both phones are free). The exciting growth from this source is more like a binary shift than an indicator of potential growth in China. To some extent, the Chinese government became one of the biggest paying customers for Apple and recently this customer has not been in a good financial condition.

Bigger is better but further upside is limited: Besides the China Mobile deal, the introduction of a bigger-screen iPhone and the elimination of the 32G version helped to maximize Apple’s market share and profitability. One big advantage Samsung had three years ago was the bigger screen. But there is nothing preventing Apple from making a bigger phone (except some words from Steve Jobs), so the short-term competitive advantage was completely unsustainable for Samsung in 2013. In the past three years, Apple has used very effective strategies to grab the pieces it left on the table, both dominating the high-end market and squeezing every possible dollar by pushing customers to the 64G version. It is very easy for analysts to project an ever-rising revenue, but it will be very hard for Apple to achieve significant growth from 231 million units of iPhone sales at $670 each in 2013.

Valuation and Buyback

Apple has been increasing cited as a value investment because of its low valuation. Current EV/FCF of ~6x is close to its trough level in 2013, but there was also a clear trend of a declining multiple as iPhone sales grew. With EV/FCF at 5x–6x, the market is again saying that the iPhone’s growth has peaked. While the multiple may not have been justified in 2013 with potential customers from China Mobile and Samsung Galaxy users, Apple completely dominates the high-end global market now.

For buyback, Apple started this program in 2013. The initial signs of a buyback can be traced to March 2013 when Luca Maestri joined Apple from Xerox. If you looked at his experience, you would know that he was famous for his dedication to stock buybacks. But good capital allocation requires more. The program has been successful in the past three years as Apple optimized its iPhone market. Whether it will be a good choice is still a question when the company’s growth depends on its success in the new product categories.

Recommendation

In 2013, seeing Apple’s low multiple, investors could argue that the market was wrong. There existed a clear group of customers that Apple could reach with relatively simple strategies like dealing with China Mobile and a bigger screen. But when the iPhone reached market domination in 2016, the prolonged upgrade cycle and pressure on ASP provided a headwind for the next several years. Although Apple has repeatedly reinvented itself with new product categories, people should keep in mind that Steve Jobs was there every time.

Investors should avoid the stock at the current level as its upside potential is not large enough to justify taking the downside risk. A much larger invention is needed to move the biggest company in the world forward now.