Iconix Brand Group Slowly Manifests Its Turnaround

Summary

• Iconix Brand Group is finally showing us signs of a turnaround. The secret lies in international revenue.
• The main question troubling investors is whether there is enough time left for this company to execute its turnaround.
• All is dependent on the 2020 debt refinancing now; we have reason to put hope in our new CEO, Bob Galvin.
• I am extremely disappointed in the absence of Q&A at conference calls, and expect to see insider buying as soon as possible.

The past four years have not been easy for Iconix Brand Group (NASDAQ:ICON) shareholders, who have seen the stock plummet from $43-44 range in June 2014 to a mere $0.14 this week. If you are new to this company, Iconix is a brand management company with a portfolio of 28 brands, all active domestically, and some with international exposure, as well as a few other investments, most notably a hard-to-assess share in Marcy Media. Accounting irregularities, followed by the departure of the company's founder, Neil Cole, and ousting of a more recent CEO, John Haugh, as well as several lost DTR (Direct-to-Retail) contracts at Walmart (WMT) and Target (TGT) (mainly due to stores shifting to in-house brands) have been the main reasons for this drop.

ICON data by YCharts

In response to brick and mortar retailers shifting away from DTRs, Iconix has been moving to wholesale licenses. The wholesale contracts cause short-term weakness, as they often take much longer to return to DTR revenues. DTR licenses have often come with minimum guaranteed royalties for Iconix in the past, ensuring consistent licensing revenues regardless of performance.

Iconix Brand Group reported its third-quarter earnings on Nov. 10th, announcing and guiding numbers below market expectation, primarily due to Sears' (OTC:SHLDQ) bankruptcy. Following its competitors' lead, Iconix discounted Sears' revenue entirely from its numbers, resulting in a $20-30 mil drop in guaranteed licensing revenue in 2018 and going forward. Share price suffered little considering the significant sudden loss in revenue. As I have mentioned in previous articles, Iconix's share price has hit rock bottom. Sears' bankruptcy was priced in, and Iconix is very much trading as if bankrupt; I see little downside from these levels.

Why do I believe Iconix is trading as a bankrupt company? Current market cap stands at a little over $11 million. This is while Iconix has $427.6 million in licensing revenue secured for future years, about 8 times its market cap in cash ($87 mil), and the company is producing 4 times its market cap in cash flow, with $40-50mil in cash flow projected for 2018. Furthermore, the company has projected that it will be in compliance with its debt covenants.

Many see Sears' bankruptcy as the last expected blow to Iconix. We have all been predicting this bankruptcy, and I have no doubt that Iconix has been planning for it (the renegotiation of Bongo and Cannon licenses last year is proof). I am very glad to see that Iconix is not in violation of its debt covenants as a result of losing Sears' revenue. This alone should bring about a positive sentiment.

At first glance, Iconix's Q3 earnings may look like a dead pile of gray ash; revenues have dropped significantly due to lost DTRs and Sears' bankruptcy. But there is a shining spark buried deep in there. Iconix is starting to show signs of a successful turnaround, and we now know for certain where that turnaround might take place: international.

But with over $400 mil in debt being renegotiated in 2020, investors are wondering if it is too late for Iconix to complete this turnaround. Most importantly, we need to know whether or not the company can get favorable terms on its 2020 refinance (its interest is currently at 4.35%) and if its international revenue will continue to grow at the same rate going forward.

Debt Refinance

As I showed in my previous article, Iconix is easily generating enough cash to afford the interest payments on its debt going forward. Sears' bankruptcy and the loss of 8-9% of licensing revenue should not prevent it from doing so.

However, in the near future, Iconix will likely have to refinance part of its debt, or restructure its debt completely in order to avoid higher interest rates on its Senior Secured Notes. Senior Secured Notes of $376.2 mil are due 2043, however, the interest on this debt is going to rise significantly in 2020 (from 4.35% to more than 10%), effectively making it due 2020, as Iconix is barely generating enough cash to afford such high interest rate. As such, management has expressed its interest in restructuring the company's debt completely by 2020.

With rising rates, Iconix may struggle to find great refinancing options for its Senior Secured Notes; however, there is no reason to think good options will not be available. Iconix struggled to refinance its debt under Haugh, and was, at times, subjected to loans exceeding 10% in interest. The situation is different now for the following reasons:

1. Iconix has lowered its debt significantly since 2016. The balance sheet is in much better shape; however, the income is also significantly lower.

2. Sears bankruptcy is no longer looming. It has materialized, and Iconix has stayed afloat.

3. We are very likely to see solid organic growth going forward, once the damage from the lost DTRs is behind us. Read below why I think both domestic and international revenues are set to rise in 2019.

4. Iconix has been keeping some of its largest brands unsecuritized, including Umbro and Buffalo, possibly because it was considering divesting these brands to pay off some of its debt. This is no longer necessary, and management has repeatedly mentioned that it is not going to sell any brands at fire sale prices. As such, Iconix has the option of using a substantial portion of its assets as securitization:

The Securitization Notes were issued in securitization transactions pursuant to which the Securitized Assets, were transferred to and are currently held by the Co-Issuers. The Securitized Assets do not include revenue generating assets of (X) the Iconix subsidiaries that own the Ecko Unltd trademarks, the Mark Ecko trademarks, the Artful Dodger trademarks, the Umbro trademarks, and the Lee Cooper trademarks, (Y) the Iconix subsidiaries that own Iconix's other brands outside of the United States and Canada or (Z) the joint ventures in which Iconix and certain of its subsidiaries have investments and which own the Modern Amusement trademarks, the Buffalo trademarks, the Pony trademarks, and the Hydraulic trademarks.

It is interesting to note that the Iconix subsidiaries that own Iconix's brands outside of the US and Canada are completely left unsecuritized. With international revenue growing at more than 20% a year, this may be an important asset for Iconix in negotiating its debt refinancing.

5. Bob Galvin, Iconix's new CEO, was the chairman at Cherokee (CHKE), a company similar in business to Iconix, which was just able to refinance its debt on favorable terms back in August 2018. It is no coincidence that Iconix chose Galvin as its new CEO. His experience in managing debt will be Iconix's great asset in the near-term.

Future Minimum Licensing Revenue

Starting in 2018, Iconix has been reporting minimum licensing revenues secured going forward. I have been waiting to see these numbers to determine, for one, how much licensing revenue the company has managed to secure between Q2 and Q3, and also to see the impact of Sears' bankruptcy on future licensing revenues. So let's look at the numbers, taken from the Form 10-Q. All numbers are in millions of dollars:

FY	2018	2019	2020	2021	2022	thereafter	Total
Q1	101	104.9	76	42.2	35.8	111.2	471.1
Q2	66.1	109.2	82.2	47.5	40	111.8	456.8
Q3	29.6	98.1	71.5	48.9	42.1	137.4	427.6

Click to enlarge

It is impossible to find an answer to the former question, given that we have lost the Sears' revenue. It seems though that Sears' bankruptcy has mostly impacted revenue for 2018, 2019, and 2020. Sears' contracts were likely due to expire in 2020. As for 2021, 2022, and thereafter, Iconix Brand Group has been able to secure $29.1 mil in new licensing revenue going forward. It is safe to assume that none of that revenue is related to Sears.

As for lost revenue from Sears, we have lost more than $11.1 mil in 2019, and more than $10.7 mil for 2020. I believe those numbers are the minimum possibly lost revenue, because it is quite likely that Iconix has signed new licenses for 2019-2020, offsetting part of the lost revenue from Sears. We have more likely lost close to $15-20 mil a year in revenue for 2019-2020, and about half of that for 2018. That seems to be in line with the lowered guidance for 2018. It is also in line with previous quarterly reports placing Sears' DTR revenue at around 8-9% of Iconix's total revenue. Considering this, Iconix has most likely removed Sears' revenue from its income statements entirely. In other words, it is not expecting any payments from Sears, at least not through the bankruptcy process.

Iconix has been able to sign more than $30 mil in new guaranteed licensing revenue going forward. I say "more than," because we can only see $29.1 mil of this new revenue in numbers. The increase for 2019-2020 is not apparent numbers, as it is offset by Sears' loss.

Disregarding an approximate $40-50 mil lost revenue from Sears, Iconix has actually been able to grow its future minimum licensing revenue significantly (that is, considering that some of the revenue shown in Q2 was already received in Q3). This is particularly impressive given that Iconix has been transitioning away from DTR licenses with minimum guaranteed royalties to wholesale licenses.

This $30+ mil increase compares to only 20 mil increase in guaranteed licensing revenue between Q1 and Q2. In other words, the growth in guaranteed minimum licensing revenue going forward has accelerated by more than 50% between Q2 and Q3. Don't get too excited! This may simply have to do with the timing of contracts, but there are definitely signs of hope and vitality in these numbers. Iconix is rapidly signing new contracts. So I will be curious to revisit those numbers again in Q4.

2019 Licensing Revenue and Operating Income: Calculation of the Worst-Case Scenario

With Sears' bankruptcy, this quarter revealed to us the maximum blow we can expect to Iconix's revenue in 2019. It is important to forecast this to determine whether Iconix has the ability to stay afloat in 2019, having lost all of Sears' revenue.

Compared to Q3 2017, we lost approximately 13% of our licensing revenue. This includes losses from DTRs with Walmart, Target, and Sears. Let's calculate what our 2019 numbers might look like, if we lose 13% of our licensing revenue for other quarters as well. David Jones indicated on investor's day that we may see a $20 mil drop in licensing revenue in 2019. As such, I have deducted an additional $5 mil per quarter from the licensing revenue. I calculate the operating income to be 35% of licensing revenue. The numbers below assume that the company experiences zero organic growth, domestically or internationally, in 2019. As I show in this article, I believe that will not be the case, and we should see organic growth in single digits in 2019.

Upcoming Quarters	Q4	Q1	Q2	Q3	Q4
Licensing Revenue 2017-18	52	49	50	46	45
Projected Licensing Revenue 2018-19	45	37.5	38.5	41	40
Projected Operating Income 2018-19	15.7	13.1	13.4	14.3	14

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I think the above portrays the worst-case scenario, in which we can expect total licensing revenue in 2019 at $157 mil. With 20% international growth, and the possibility of single-digit domestic growth, I think it is safe to put our worst-case-scenario estimate in the range of $165-170 mil.

As shown above, Iconix has already secured $98.1 mil of that revenue. The actual revenue is likely to be much higher than $98.1 mil. As an example, for the remainder of 2018, Iconix is announcing $29.6 mil in minimum guaranteed revenue. However, given its revenue forecast of $185-195 mil, we can expect Q4 revenue to actually be in the range of $40-50 mil, at least 35-65% above the announced minimum guaranteed revenue. So assuming that Iconix does not manage to grow its revenue in 2019, or secure any new short-term licenses in Q4, $165-170 mil in revenue seems like a safe minimum bet for 2019.

With an interest expense of approximately $15 mil per quarter, and $87 mil cash on hand, Iconix should not have a problem paying its interest expense in 2019. But in order to receive favorable financing terms, Iconix needs to start showing organic growth very quickly.

Is Sears' Revenue Entirely Lost?

While Sears' bankruptcy has wiped out its revenue from our income statement, I am not entirely convinced that we will lose all Sears revenue. Sears has filed for Chapter 11, not Chapter 7. During the bankruptcy process, Sears' stores will continue to operate, and Cannon, Bongo, and Joe Boxer products will continue to be sold at its stores. While several vendors have reported missing payments from Sears, Sears has declared it a priority to continue paying its vendors in order for the vendors to continue supplying it. Sears has started talks with banks to secure a "debtor-in-possession" financing to ensure that its vendors will receive payment through the bankruptcy process, and has received commitment for $300 mil financing for such purpose.

I believe Sears will continue to make full or partial payments to its vendors (such as Iconix) in order to stay afloat through the bankruptcy process. Iconix has completely cleared Sears' revenue from its statement; market has already reacted to a complete loss in Sears' revenue. Should Sears manage to continue making payments to its vendors as it plans to, Iconix's earnings may see a nice unexpected boost in Q4.

Read more about Sears' plans in paying its vendors here. To quote some important parts:

We are open for business and the restructuring will have little impact on our day-to-day operations. Our Sears and Kmart stores, and online and mobile platforms, are open as usual and continue to offer a full range of products and services to members. Our services and brand businesses continue operating as normal as well. We are committed to working with our vendors and other partners to help maintain inventory levels and ensure timely product delivery.

We have received commitments for $300 million in new debtor-in-possession (DIP) financing and are negotiating a $300 million subordinated DIP financing. This financing will help support our operations - and meet our obligations to vendors - during this process.

So if Sears can stay true to its words and plans, Iconix may very well not have lost Sears' revenue after all. If Sears' situation proceeds as planned, we should see Sears making some payments to Iconix going forward, and this can serve as an important catalyst for Iconix.

Expect a Rise in Domestic Revenue from These Levels: Starter x AAF, Starter x Amazon, and Umbro x Target Should See a Boost in 2019

I strongly believe our domestic revenue has now hit rock bottom. Three of Iconix's brands, Bongo, Joe Boxer and Cannon, are projected to have zero revenue for the remainder of 2018 and going forward. Of those three brands, only one (Joe Boxer) is stranded at Sears. The other two are free to pursue potentials with other retailers, or join the other wholesale brands. It will take a while for Iconix to return to Sears revenues, but it should not take long for Iconix to sign smaller new licenses and for revenues to start growing from current levels.

The other important catalyst in 2019 is the Starter collaboration with Alliance of American Football (AAF). Chairman and former interim CEO Peter Cuneo described this as a "very significant opportunity for Starter," on which it intends to capitalize. Furthermore, Starter has not fully released its line of products on Amazon (AMZN). Former CEO John Haugh had announced 300 Starter items were to be available on Amazon. Less than half of that amount is currently listed on Amazon. It has been rolling out the products slowly, replacing items that did not receive favorable reviews with new ones.

Any boost from Starter's collaboration with AAF, which should bring renewed strength in Starter's sales on Amazon as well, has not been forecasted or reflected in numbers. I look forward to seeing the company's guidance in Q4, which should give us an idea as to how it expects Starter to perform in its partnership with AAF. AAF begins in February 2019.

Insider Purchases or A Lack Thereof

At investor's day, attendants clearly expressed their frustration with management, not only for the stock's poor performance, but also for the absence of any insider buys. In fact, the last transaction of record is Peter Cuneo selling the majority of his shares for tax write-off. While this was pre-planned and understandable to some extent, investors cannot fathom why management has not used other opportunities to buy more shares.

Peter Cuneo told us that he has not been able to buy more shares, because there have been too few opportunities for insiders to buy. The company has constantly been working on refinancing its debt; this means that insiders have been privy to information regarding refinancing potentials that the average investor is not aware of. As such, insiders have not had many opportunities to buy. Cuneo clearly conveyed his interest in buying more shares, when the opportunity arises. Investors expect insider buys, both by Cuneo and Galvin, as soon as an opportunity presents itself. I am hopeful we may see insider buys this week.

The Key to This Turnaround Lies in International Revenue Growth

The shining light of Q3 was Iconix's international revenue! I just noticed that for the 3 months ending September, international revenue is the highest source of revenue we have at over $16 mil. Look at company financials going back to Neil Cole's time (where there was nominal international revenue), or simply watch Neil Cole's famous old presentation at Jim Cramer's Mad Money, where Cole tells Cramer he is most excited about international expansion going forward. That international expansion has happened successfully, and international is now the greatest source of our licensing revenue. It is also the fastest growing segment, with a 26% yoy growth in Q3. If it continues to grow at the same rate, the growth in international will more than make up for any loss experienced in men's, women's and home combined going forward.

Furthermore, our international licensing has the highest margin at 55%, meaning that we can only expect for Iconix's margins to improve going forward.

What Should Investors Do Now?

I doubled my position at $0.18, and am currently holding. If you are already long this stock at a higher average, I recommend averaging down here. I believe the stock has hit rock bottom, as witnessed by the fact that after losing 8-9% of our revenue, we saw little drop in share price. Most of the negatives are already priced in, and we are trading at a lower market cap than the bankrupt Sears.

I will continue to hold until refinancing is announced. Following the reverse split, we should hopefully see more institutional buying. At $0.15-0.16, many institutional investors cannot touch Iconix's shares. This should change when shares go above $1, and should change significantly if Iconix can manage to return to above $5. I still believe in the long story and the possibility of a powerful turnaround. At the heart of this turnaround, we need organic growth. Showing solid organic growth will help Iconix in refinancing its debt in 2019. We have seen that growth in international numbers, and I believe we will see it in domestic numbers starting in 2019.

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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.