Iconix Brand Group: Q2 Breakdown

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About: Iconix Brand Group, Inc. (ICON)
by: Upside Research
Summary

The company had an EPS beat of 7 cents (37%) and small revenue beat.

The company announced its moving two of its brands from Wal-Mart to new partners and are expanding the brands, a move that will likely increase sales.

Four positive announcements will occur in the coming weeks and months. Three will be about important brands being placed at new major retail chains.

Iconix Brand Group (NASDAQ: ICON) had a Q2 earnings beat of 37% and a smaller beat on revenue, but traded down after its earnings call due to lowered near-term guidance for the next two quarters and concern over its decision to remove its Starter and Ocean Pacific Brands from Wal-Mart (NYSE:WMT). This article will examine the quarter, the decision to move the two brands out of Wal-Mart, some upcoming news from the company and the company's stock price.

A copy of the transcript from the call is here. All of the quotes below come from the call, unless otherwise noted.

The recent quarter

Iconix had earnings of 26 cents per share versus consensus estimates of 19 cents per share, and revenue of $61.65 million that beat consensus estimates by a little under 1%. The results were also stronger than the company's guidance: it had guided that year-over-year results would be the same as the first quarter, when revenue was down 11% year-over-year. But revenue for Q2 was down 7% year-over-year, a reasonable improvement over Q1.

The strong points of the quarter were:

* A 7% increase in Home revenues
* A 3% increase in International revenues
* A 9% reduction in expenses * Operating margin of 57%

The weak points of the quarter were:

* A 12% decline in Women's
* A 18% decline in Men's

Company CEO John Haugh said that the majority of its brands saw sales increases, and that most of the decline was due to Starter, Danskin and Ocean Pacific sales at Wal-Mart, a phenomenon the company has described on past calls. He said: "Similar to recent quarters, the decline is not reflective of the trends across the entire portfolio, but primarily related to three brands: Danskin, Starter and OP, Ocean Pacific."

The Wal-Mart moves

On first look, it appears that the move away from Wal-Mart is a sizable negative, and I think this perception was a main reason for the drop in the stock's price after the earnings. I think, however, that the move tackles the problem of weakening sales in two of its important brands head on in a way that will benefit the company. I think the move is smart for these reasons:

1) Iconix had the right to sell high-end items via a separate label, Starter Black, but it did not have the right to sell mass-market athletic wear, streetwear or athleisure in other chains. Other brands like Nike (NYSE:NKE) and Under Armour (NYSE:UAA) are available at many different retailers. Now Starter can do the same. One of the reasons that the Home category for Iconix improved so much in Q2 is that Iconix moved to selling one of its Home goods brands in multiple chains. Iconix should only give exclusivity to a retailer if that retailer is doing good quality merchandise and maximizing sales by selling a strong selection of products. Which leads to …

2) Wal-Mart only sold a very narrow range of items for the brands. In Ocean Pacific, it only sold bathing suits, and in Starter it really only sold windbreakers and quick-dry shorts and t-shirts. Starter should be selling athletic wear, streetwear and athleisure. Athleisure is sports clothing that you wear to do errands and in casual settings with friends and family. It's fashionable, but usually fairly mainstream and/or low-key designs. Streetwear is usually trendy t-shirts, hats, shoes and other casual, comfortable clothing is influenced by things like hip-hop, skate culture and 80s/90s retro fashion as explained here.

Athletic wear is clothing you only use to work out in such as sweatpants or compression shorts that are functional for exercise, but not fashionable enough for other settings. Wal-Mart has mostly relegated Starter to the athletic wear category. Sometimes the items have enough style to be considered athleisure, but most of the time they are very plain and basic. Even when they've tried to add some style, it's been inconsistent.

By terminating with Wal-Mart, Iconix can sell mass-market athleisure in one chain, athletic wear in another chain and streetwear in others. Within each category, it can also do a wide product selection. It can go from only a small number of athletic wear items to a larger number of athletic wear items, plus add athleisure and streetwear, plus sell to multiple retailers.

3) Wal-Mart's attention to design and quality for Starter was weak. I live in hot Florida weather and work from home, and I regularly buy athletic wear and athleisure wear. I examined Wal-Mart's items regularly, and I wrote a few times on this website that the Starter items at Wal-Mart had weaker styles and quality than the Russell and Fruit of the Loom products. Being at Wal-Mart was hurting the Starter brand. It can be hard to feel great about buying and wearing a $300 Starter Black jacket when Wal-Mart is pushing out low quality $5 shirts.

4) As Haugh noted, Wal-Mart negotiates very low royalty rates. He said that with new partners, a lower amount of total sales will bring in a higher amount of royalty revenue to Iconix.

5) Wal-Mart's price points on Starter items are so low that it has a negative effect on Iconix revenues. When they sell a t-shirt for $5, it means a 5% licensing cut is only 25 cents to Iconix. One might assume that it could maybe lead to double the amount of sales and therefore have a strong net revenue impact. However, the lead times on manufacturing low-cost clothing in Asia and shipping it half-way around the world is fairly long. Wal-Mart regularly ran out of the colors and products that were good, leaving ugly colors and weaker products on the racks that weren't going to sell even at low price points.

I believe Wal-Mart may have been using Starter as a bit of a loss-leader to help pull people in looking for low price points, and some would buy the good ones when they were in stock, and the rest would buy the higher priced items.

Starter and Ocean Pacific

Created in 1971, Starter pioneered the fusion of fashion with sports clothing. It grew to be an enormously popular brand with sales of over $350 million a year. Its sportswear included compression shirts and shorts, basketball shorts and sneakers and tennis shoes. Its streetwear included a host of products from jackets to shirts to hats. Out of Iconix's brands, Starter is one of the ones with the greatest upside, especially with the retro craze that has recently begun. It had little chance of achieving that upside at Wal-Mart.

Haugh stated that Iconix will be making a major announcement about Starter soon related to that upside: "I can tell you, Starter, we will be talking about in the very near future here, we think a very good new opportunity. We think it's a chance to bring Starter back to the heritage of what it was. Starter really was the first logo strong athletic brand out there. We think there's a chance to upgrade the product, upgrade the price point and appeal to a consumer that still is very, very aware of Starter."

Also, he said the company has already signed a deal for Ocean Pacific with a major retail chain that will start sales in 2018. He said the retail chain will decide when it will announce the partnership, so he couldn't reveal the company.

He noted that Wal-Mart was only selling swimwear and only during the swim season, meaning one product for about 3-4 months a year. In the past, Ocean Pacific was a year-round brand with a variety of products. It can sell shirts, sunglasses, sandals, hats, lip balm and other items. As to the claim by some that Ocean Pacific has no appeal at present, Iconix sold the brand this summer at Urban Outfitters, which is a hip store chain. As Wikipedia explains, Urban Outfitters largely draws "from bohemian, hipster, ironically humorous, kitschy, retro, and vintage styles" targeted at young adults aged 18 to 28.

Haugh said the brand at Urban Outfitters "sold very well, and frankly, a bunch of the industry took note of what the brand really could be, the breadth of it and the brand more as a lifestyle brand versus a pure swim. And so as a result of that, we have it placed for next summer… we're very excited about bringing Ocean Pacific back … as a total lifestyle brand." He said the new partner is a leading department store chain that will be running an "exciting new program" to promote the brand.

Something I believe many people missed during the Question and Answer period is that Haugh said that Starter royalties will reach then surpass the Wal-Mart royalties "pretty quickly" and that Ocean Pacific will "take a little bit longer."

Iconix announced it took a $23 million one-time charge in Q2 for terminating licensees early. A few people speculated that the whole charge may have related to reports that the company is moving Umbro North American sales from a small partner to a yet-to-be-announced major retail chain.

In February, a small wholesale company filed a suit against Iconix related to what it said was Iconix's decision to terminate its license in order to make a deal with a major national retail chain. Iconix had the right to terminate the license so long as it signed a deal with a new partner that guaranteed sales of at least 50% higher than the existing partner. The suit says Iconix did get such a deal, but tried to blame Iconix for its weak sales, claiming Iconix rejected too many of its proposed designs. Iconix said it had the right to reject designs that weren't good enough.

The partner also claimed Iconix didn't give it a required amount of notice of about six months, and sought compensation for inventory it said it would have trouble selling. I highly doubt all or most of the $23 million went towards settling this case because the partner had a weak argument on the rejected designs front.

Even if it had a good case on the notice period, the losses of liquidating its relatively small amount of merchandise would not have been $23 million. Also, Iconix never actually announced the new partner, so the old partner has had plenty of time to sell its inventory. The new partner is not yet carrying competing merchandise, and the public is not yet even aware that a new partner will be carrying the brand.

Thus, I think the majority (or more) of the $23 million more likely relates to the termination of the Starter license. If Iconix is going to "pretty quickly" reach then surpass the Starter royalties Wal-Mart was generating, and then can strongly grow it from there, then it would be worth it to pay a large fee to exit. A portion of the fee might also relate to the Ocean Pacific termination.

On the call, the company also noted that in 2019, its Mossimo brand will be moving from Target to other stores. This news was already widely reported by dozens of news outlets in the past several weeks, so I think most investors were already aware of it. Haugh stated: "Mossimo is one of the strongest brands in our portfolio. It has extremely high favorability across all demographics, and based on a recent study that we conducted, we found that Mossimo is a brand that consumers would expect to find across a broad variety of retailers, including mass department stores, off-price and online."

It seems Iconix's goal is to have Mossimo in a few different retail chains, rather than exclusively at one.

Near-term guidance

In the report, Iconix lowered its guidance for 2017 from $235 million to $245 million to a range of $225 million to $235 million. It said $2.6 million of this was related to deconsolidation of its Southeast Asia joint venture - though that has no effect on earnings.

So, really the midpoint of guidance for the year was lowered by $7.4 million, or 3%. Haugh said this was primarily due to the timing of new initiatives, and the transition between licensees. I assume that the transition mostly refers to the Wal-Mart transitions. While those transitions mean the second half of 2017 won't be as strong as anticipated, I think they'll lead to higher sales in the medium and long term.

I'm surmising that the timing of new initiatives mostly refers to:

A) The new Umbro deal being slowed down by the lawsuit. The deal was made in January, and normally that would mean sales starting in Q4. The company might have factored some revenue from that in, with the timing pushed back a few months now.

B) Haugh on the call announced that: "We have finalized an exciting new multiyear program with Target for one of our brands, and we'll have more detail to share in the coming months." They may have been aiming for that program to start in Q4.

Even with the lowered guidance for the year, Iconix said Q3 and Q4 will still be much better year over year than Q1 or Q2.

Four significant positive announcements are coming

Anyway, the impending Target news means there are four major announcements on the horizon now:

* Main new partner for Starter
* Umbro moving from a fairly small wholesaler to a major national retailer
* Main new partner for Ocean Pacific
* New multi-year program with Target for a brand

As of the close of Wednesday, Iconix was trading about 48% below its January high of $10.62 and 21% below its July high of $7.03. I don't think drops of those amounts are warranted. Iconix is still a very profitable company. It's only 2 quarters through its 12 quarter plan to achieve organic growth. The new management has already achieved a sizable amount in its first 15 months, including reducing the debt by over $650 in the last 12 months, a 44% reduction.

Doing that involved a number of large moves, all of which required a sizable amount of time and focus from management. With its debt situation now fully under control and in good shape, the company can focus 100% of its efforts on organic growth.

There is a risk that their numerous efforts won't succeed. That of course is a risk with all companies. The company is already seeing success in its re-launch of the Pony brand, and it is going to expand on that.

It recently also bought back its joint venture partner in Canada. Canada is very under-penetrated by Iconix brands at present and has strong potential for growth. It's a natural for Iconix because marketing to Canadians is similar to Americans, and tastes in the two countries are similar. Iconix has a strong track record of increasing sales in regions of the world where it takes back joint ventures.

In past articles, I've recommended that people increase their positions on major dips and then trim them somewhat after gains of about 10% or so. I'm hoping people heeded my advice and sold some in July in the $6.80 to $7.03 range, so they have more firepower to buy on the new dip. Every time in the past that the stock price has gone below $6.50, it's rebounded to over $7 relatively quickly. At an entry point of $5.8, $7 is a 20% gain, and at an entry of $6, $7 is a 16.6% gain.

Conclusion

When each of the above announcements is made, the stock will likely rise between 5% and 10%. A few times during the call, Haugh indicated that some of the news will be coming within weeks.

Another factor is that the company just significantly beat its guidance for the recent quarter, and it's entirely possible it will beat its lowered guidance. It's also beaten consensus estimates the majority of the recent quarters.

Retailer Michael Kors (KORS) recently reported a very good quarter and its stock rose over 28% in the ensuing days, and is up about 50% in the past two months. We've seen the same (gains of 50%) twice with Iconix in the past 18 months. In both situations, sentiment was highly negative during the dips and few people thought a 50% gain within several months was possible. I'm not predicting a 50% gain in several months. It might happen, but it's not my base case. My base case is a 20% gain within three months.

At the same time, the downside is fairly limited. Each time the stock has dipped, big investors swoop in and buy large numbers of shares. Sports Direct often buys 6,000 to 60,000 shares every day the price is below $6.50, then sells them between $7 and $8 as you can see here and here. It appears retail investors are buying high and selling low, and institutions are buying low and selling high. I strongly recommend being in the former group.

In addition to being a great near-term trade, I think Iconix is also a strong long-term investment for four primary reasons:

1. It's a significantly profitable company that is undervalued.

2. Its growth is to a good degree focused on international growth. While US retail growth will likely have a continued headwind that may result in only mild growth or flat domestic sales, the global middle class is rapidly growing and is relatively untapped. And most foreign countries like American culture, fashion and brands.

3. On the domestic front, Iconix is focusing on moving existing brands into new product categories and into new stores. This has already paid off in the Home goods category. Their focus is on leveraging existing resources rather than spending money to buy new brands.

4. Management is strong quality. They have gotten a lot done in 15 months, and have made a number of good moves such as selling Peanuts at a strong price and buying back their Canada partnership.

Thus, I recommend a two-pronged approach of buying sizable amounts of shares on major dips as a trade, and having a long-term buy and hold position.

Disclosure: I am/we are long ICON. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.