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As you can imagine, this is an incredibly profitable business model. It results in great margins, tremendous cash flows, and diversified revenue streams from retailers running the gamut from Walmart (WMT) to Bloomingdales with very little to no actual capital investment required by Iconix.
Those of you familiar with the magic formula probably just had a bell go off. Strong cash flows… huge margins…. little capital invested… great growth…. Sounds like a perfect magic formula stock. In fact, those are exactly the sort of characteristics we look for in Gurufocus’s own Microcap Magic Formula Newsletter.
And yes, Iconix is currently a magic formula stock. And given how much cash it generates, how stable its cash flows are, and how diversified their revenue stream is, Iconix is likely significantly undervalued.
However, unlike most of the magic formula stocks we’ve discussed, Iconix is significantly levered. That means the risks to owning Iconix are significantly greater than most of the stocks we’ve discussed – but it also means the rewards could be greater.
Returns on capital
So just how good are Iconix’s returns on capital?
On first blush, not great. The company’s balance sheet lists over $2.13 billion in assets, and Iconix used that $2.13 billion to generate $229 million in operating income. That comes out to a return on assets of under 11% – hardly what we’re looking for. That screams “average business with no moat,” not “magic formula stock with a competitive advantage.”
However, a quick look at the balance reveals what the magic formula sees in Iconix: $1.71 billion of Iconix’s assets (80%) come from intangibles like trademarks and goodwill. These are assets that exist only in accounting land and are ignored by the magic formula because they require no continued capital investment to upkeep (compared to say PPE, which needs constant maintenance to stay operational).
Taking these intangibles out leaves just $428 million of tangible assets on the balance sheet. With $229 million in operating income in the past twelve months, Iconix is generating returns on tangible assets over 53%. That level of return is out of this world – it puts it in the top 2% or 3% of businesses in the S&P 500.
Valuation
So what are you paying for a company with a proven history of growth generating returns on capital better than all but a handful of businesses in America?
Honestly, not much.
As mentioned earlier, Iconix has $229 million in operating income in the past twelve months. Their current EV comes in at $1.72 billion. So they trade for just over 7.5x EV / EBIT.
Is that the cheapest multiple we’ve ever seen? No. But it is cheap. And when you consider this is a company with tremendous growth and outstanding returns on capital, not an average business, that multiple is way too cheap.
Here’s another way to look at it. Iconix has forecasted full-year earnings (adjusted for non-cash write-offs) of $1.63-$1.68 per share. At today’s share price of about $17.5, Iconix is trading for approximately 11x earnings… a slightly below-market multiple.
Again, this is a business that requires little capital investment and has significant competitive advantages. This is not a business that should trade for below market multiples. This is a business that should sell for at least a modest premium to the market… perhaps more.
What price would make more sense? Over the long term, the average market multiple seems to approach 15x earnings. Iconix deserves to trade for at least that much. Applying a 15x multiple to the low end of projected earnings yields a price target of $24.45, or almost 40%!!!!
Risks
Unfortunately, there are some risks to an investment in Iconix.
The first and most obvious is their leverage. Iconix is very, very leveraged, and they have a good deal of debt coming due this year. Fortunately, Iconix also has a good deal of cash on their balance sheet, and given their strong cash flows, shouldn’t have any trouble paying down their debts unless they run into some real turbulence.
The second risk is Iconix has grown and continues to grow through acquisitions, and they generally fund these acquisitions by issuing stock. While this has resulted in massive growth, it’s also led to a good deal of shareholder dilution over the years. However, it’s pretty tough to imagine shareholders complaining about the dilution, as shares have increased in value more than 10x over the past ten years and significantly outperformed the S&P 500 over both the past one year and five years. As long as management can keep building value through their deal making, it’s tough to fault them for diluting shareholders.
Ultimately, investors have to decide if the potential upside from Iconix outweighs the risks. Given their steady cash flows, great returns on capital, and considerable upside, Iconix certainly looks like a good bet, but value investors couldn’t be faulted for looking for a bit more margin of safety before taking a position.
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