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By TMFKitKat
July 5, 2006

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Two years ago I tried to evaluate a company that deals only in licensing brand names to manufacturers & retail outlets. The little brand name licenser was Cherokee. Their biggest account was Target. At the time they were selling for around $25 per share. They are now at $37. I had the temerity to call them the Seinfeld of stocks. They appeared to be a company all about nothing--no inventory, no retail outlets, no manufacturing capabilities, no reason for being IMO. So now they are up 50% in two years which isn't bad for a company all about nothing.

Forward two years to June 2006 and Iconix. This time around I have an appreciation for a business model that turns nothing into revenue and finding Iconix written up in the WSJ piqued my curiosity. Interesting company and IMO (again-- my opinion in 2004 was worthless) Iconix may surpass Cherokee in growth and margins--at least they are on track to do that in 2005-2006. They have rapidly built a solid base of customers and brands and are using a blend of equity and debt to do it and generating free cash flow. The business is too new to make any firm predictions, but the start is looking promising

Cherokee has made a success of this particular business model, generating solid if unspectacular high single digit growth and maintaining excellent margins. The price per share has appreciated, they pay a dividend and there has been little share dilution.

The chart for Cherokee:

My worthless opinion

So what is Iconix?--Overview and recent results--Predictions

Some SNIPS from the WSJ:

Teri Agins

Iconix is trying to become something new in the fashion industry: a pure licensing play.Licensing deals are the mechanics of much of the fashion industry -- the way designers become billion-dollar companies at lightning speed. Typically, a designer or brand contracts with a third-party manufacturer to produce some of its branded products, such as fragrances, handbags, coats and sportswear, and sell them to stores; the designer collects a small royalty on sales.

Iconix's twist, with some of the trademarks it has acquired, is to make licensing deals directly with retailers, and to give them far more creative and strategic control over the products than is ordinarily the case.

What makes the deals especially tempting for those retailers is that they are exclusive: Teens can find Candie's fashions, for example, only at Kohl's Corp.'s stores. Joe Boxer sportswear is exclusive to Sears Holdings Corp.'s Kmart chain. And men's and women's apparel under the Mossimo trademark, which Iconix is set to formally acquire in July, will continue to be sold solely at Target Corp.

Iconix's strategy comes as Federated Department Stores Inc. and other big retailers increasingly demand styles from their vendors that are exclusive or in limited distribution. The demands shut out many fledgling apparel makers. But tiny Iconix has turned their demands to its advantage.....

Iconix began its transition in 2003 from an active designer and buyer of inventory, a seller of merchandise and marketer of shoes and jeans to a licensing company that owns, licenses and manages 6(soon to be 7 as it adds Mossimo) consumer brands. In mid-2004, Iconix finally jettisoned all retail and manufacturing.There is now no inventory and no retail outlets.

The company was a disaster as a manufacturer/wholesaler/retailer.

Losses in EPS

1999 ==> -4�
2000 ==> -$1.41
2001 ==> -43�
2002 ==> -12�
2003 ==> -7�
2004 ==> -33� ending 1/31/04
2004 ==> +2� (11 mos starting Feb 04-Dec 04)
2005 ==> +48�

As a retailer/wholesaler they were a dismal failure unable to generate profits. They just couldn't seem to get the hang of increasing revenue and keeping expenses down. Iconix was unable to handle high merchandise returns and SG&A leading to a loss in 1999; in 2000 revenues decreased and they instituted markdowns cutting into gross; revenue declined again in 2001; revenue increased slightly in 2002, but one time charges contributed to operating losses; in 2003 revenue increased but costs also increased and they took charges to close stores

2003 is where Iconix finally realizes they are not really cut out for retail/wholesale and begin to direct their efforts at licensing their brands.They started by licensing Bongo to Kenneth Cole and Candies to Steve Madden(since transferred to Kohl's). The licenses effectively put Iconix out of the manufacturing and distributing footwear business. They continued to manufacture and distribute Bongo apparel--mainly jeans.In 2003, Iconix had 11 concept stores and 3 outlet stores--all scheduled for closure. The concept stores were all losing money. Until the redirection in 2003-2004, Iconix AKA Candie's was not an attractive investment. And the previous 18 years do not have much bearing on the business results today except for the viability of the tradenames "Candies" and "Bongo".

Royalty payments are typically 2.5%-5%. And if a retailer doesn't reach a guaranteed minimum, they pay the minimum--never less. These are guaranteed and after corporate expenses go straight to the bottom line. Analysts estimate revenue will be $82 million in 2006 with net of $37 million(net was around $16 million in 2005) The increase is mainly acquisition driven from Mossimo and Mudd. The new business model has not been adequately tested for sustained organic growth yet. The strategy has been to acquire rapidly to build the brand base. To finance its acquisitions, Iconix has borrowed about $215 million against future minimum royalty guarantees(asset backed bonds mainly).
Current outstanding debt is around $97 million.

I estimate 2006 revenue is likely to be around $67 million

$12 million for half a year of Mossimo
$19 million Kmart(not reaching excess beyond minimum)
$5 million Kohls with 14% growth
$16 million Rampage & Bongo(50% of revenue after Kohls and Kmart are backed out at 12% growth)
$15 million 3/4 of the year Mudd

That represents 120% growth in revenue over 2005 mainly on the strength of the Mossimo and Mudd acquisitions
If net margins stay at 55% net will be $36.85 million and EPS around $1.05 with a forward PE of 15


Total outstanding long term debt is $97 million(most recent quarter):

**an $88.8 million asset-backed securitization
**a loan to Kmart for $7.4 million
**a $2.9 million note to management of Unzipped(reduced by minimum guarantees under litigation)

**$17.5 million refinanced previous notes
**$40 million to buy Joe Boxer
**$25.8 million to buy Rampage
**$1.7 million in a reserve
**$1.8 million to pay expenses associated with issuing debt
**$4.0 million kept for working capital

Majority of debt at 8.5%
30% of notes at 8.1%
Kmart note at 5.12%

The interest coverage ratio on this debt is 4 which gives them a synthetic rating of BBB--slightly risky. Depending on what the ratio of debt to equity used in the Mossimo deal is, this could degrade

However the after tax cost of debt is only 5% compared to 11% cost of equity. Using at least some debt makes sense.The WACC is 10% and returns are 12%

Iconix is easily able to cover its interest payments with EBIT and there are relatively few other demands on cash with the lean licensing business model.The level of debt to capital is now 38.5% and seems reasonable for a "new" business looking to build. They do manage to generate positive free cash flow of 27� per share. That includes acquisitions as capital expenditures. They are helped by negative working capital

A look at some results from Iconix

No results for the Mudd acquisition in these figures
Joe Boxer closed July 2005
Rampage closed September 2005

                     3/06    12/05     9/05      6/05

Growth, revenue       7.3%    34.8%    114.0%    0.0%
Growth, gross income  7.3%    34.8%    114.0%    0.0%
Growth, EBIT          8.9%    47.4%    442.9%  -12.5%
Growth, net income   -1.3%    44.2%    108.0%  212.5%
Growth, Basic EPS    -0.5%    31.5%     73.7%  131.7%
Gross margin        100.0%   100.0%    100.0%  100.0%
Operating margin     59.4%    59.7%     54.3%   25.6%
Net margin           55.6%    60.5%     56.5%   58.1%

Its obvious the big impact Joe Boxer had in the third quarter of 2005. Growth slowed significantly in the first quarter 2006. However,7% per quarter would be acceptable for organic growth--12%-14% per annum is what I figured might be reasonable for the growth phase of the business(excludes acquisitions). The negative growth in net and EPS 3/06 compared to 12/05 are due to a smaller tax credit. They have NOLs of more than $66 million

Some margins from 2002-2005 to show the effect of the change in business

                  2005   2004   2003   2003     
Gross margin     100.0%  30.1%  21.9%  25.8%
operating margin  49.0%   3.9%  -6.2%  -0.6%
Net margin        52.6%   0.3%  -8.6%  -2.5%

These results are interesting for two reasons

*The switch to the licensing model for the business increased margins and allowed Iconix to post positive EPS for the first time in several years. Even though revenue declined significantly in 2004 and 2005 as retail/wholesale was dropped, the new business was immediately more profitable. By comparing the annual margins to the recent quarterly data, you can get a sense of where they are going.

*Of some concern is the reliance on acquisitions to boost revenue. Badgley Mischka/Bongo is not broken out separately for 2004/2005.We only know Kohls/Kmart was 42% and that the addition of Rampage and Joe Boxer contributed $11.7 million to revenue of $30.2 million in 2005. Roughly speaking almost 30% of growth 2004-2005 was acquisitions. It's difficult to estimate organic growth in the new business model beyond the track record of Kohls with the Candies brand. Bongo's is too widely distributed to rely on one store or retail chain to proxy for growth and results are lumped with BM. Target should provide additional basis for estimates for 2006-2007. Kmart may be relied upon for at least the minimum

Kohls has been growing revenue at 12-14% the past three years and over 50% of their sales are men's/women's clothing and accessories. It might be reasonable to expect Candies to grow at around that rate.

When Iconix finalizes Mossimo we can perhaps use Target's growth as a proxy for the Mossimo license growth. Target is growing at approximately 12%. Mossimo earned $31 million in revenue in 2005, $22 million from Target up 46% from 2004. Using 12% may be conservative.

In 2005

27.9%= $8.37 million from Kmart(less than half a year)
14.6%= $4.38 million from Kohl's
57.5%= $17.4 million from Bongo's, Rampage & BM


Addition of Mudd and Mossimo for partial year(see above)

In 2007 Iconix will have all 7 brands for the full fiscal year. Some wild speculation regarding potential revenue

Mudd              12% growth     $22 million

Badgley Mischka   12% growth     $18 million

Joe Boxer          no growth     $19 million

Mossimo           12% growth     $26 million

Candies           14% growth      $6 million

Total $89 million(closer to analysts estimate for 2006)
If Iconix finds further acquisitions this could be higher
If retail takes a swan dive, revenue may be considerably less. Iconix depends on volume of product sold to make money beyond the minimum royalty payment.

Its probably dangerous to keep granting Iconix 55% net margins. Eventually, NOLs will run down and the tax rate will cut into net margins. Its difficult to predict when to take this into account. In 2005 they had $5.1 million in tax benefits.

The bad news is options

There are 9 million outstanding options on total common shares of 35 million representing nearly 26% dilution if exercised. The options as they stand over a three year period (from the reorganization 2003) are 10% cost of revenue going forward. The 2005 grant was very large at 5 million shares on only $30 million in revenue. Long-term trends are difficult to evaluate with the recent change in the business. Conservatively, 10% could be deducted from estimates of future free cash flow growth leaving growth at 2-4%. This seems unlikely. Because of the lumpy nature of the options and revenue in 2003-2005, it might be better to deduct 10% from the current year's free cash flow and value the company from that.

The second component of the options calculations was the current expense. That was high at $1.80 and could be deducted from calculated values per share.

I have tried a couple of different ways to put a price on this company. Neither was convincingly successful. A DCF at 12% high growth and dinging them for all options gave a value around $19. I also tried to value them per EVA and ended up with next to no value.

I like the company. The management is pretty good now that they realize their limitations re: retailing. Good strategy to build a stable of revenue generating labels (a label stable). Good use of debt so far. They are not obscenely stretched. If retail does not crumple the revenue/earnings going forward two years should be good enough to catch the interest of the market. They already have to a certain extent with a big increase in price per share in the last year

Any ideas on how to arrive at a fair value appreciated

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