Current Price: $25.82
Target Price: $200 (speculative)
Upside: 670% (speculative)
Expiration date: TBD
This idea was shared by David.
This is timely although very speculative idea with potential catalysts on the 15th or 19th of April.
Sequential Brands is a highly leveraged equity stub with the possibility of multi-bagger returns in an acquisition scenario. The company owns a portfolio of mostly apparel brands (Jessica Simpson, Gaiam, Joe’s Jeans, etc). Multiple aspects suggest a possibility of an imminent sale of the company. Recent acquisitions in the sector and peer multiples indicate a potential valuation (in the most optimistic scenario) up to $200/share at 10x forward EBITDA.
A major caveat, which is responsible for the currently low valuation, is company’s high leverage – debt to market cap stands at 10x. Covid caused SQBG to trip their Debt/EBITDA covenant (7.25:1) last year, but they have been getting waivers from KKR (Wilmington Trust), with the most recent waiver expiring on the 19th of April. If the company doesn’t return in compliance by then, it could potentially be forced into bankruptcy, or another waiver will be granted. Adjusted EBITDA was $8.0m in Q4-19, and $43.7m over the last nine months through Q3-20, for a TTM total of $51.7m. Q4’20 should be close to Q3, which would result in total $62.6m EBITDA for FY20. The 7.25 covenant means net debt would need to be $453.9m or less to get back in compliance. SQBG had $453.4m total debt at the end of Q3, and $21m in cash. The company also has a $40m potential earnout on the Martha Stewart sale – due to FY20 strength in Homegoods I expecting that earnout milestones have been achieved. Due to the above, I would expect the company to be back in compliance after filing for Q4’20, which is scheduled for tomorrow, 15th of April. Peer ICON released earnings that support general industry strength Q3->Q4.
A couple of further aspects signal that bankruptcy is unlikely and that a sale of the company might already be in the works:
- KKR’s debt covenant allowed it to appoint a majority to SQBG board if not in compliance at 4/1. SQBG filed an NT-10K instead of releasing earnings on time. Despite having the ability to do so, KKR has made no board appointments in two weeks. Either one of the largest PE’s in the world is asleep at the wheel, or they aren’t going to bother because a sale is about to close. And if SQBG wanted to avoid this, they could have filed earnings in time to get back in compliance yet didn’t.
- Additionally, SQBG announced Strategic Alternatives in December and paid to buy out of an expensive HQ lease in Q4 (not something you do if worried about getting back in compliance on debt) for more than they would have owed in BK.
- The CEO resigned and was not replaced
- The CFO resigned and was replaced with a contract CFO whose prior jobs were selling a company to PE.
- The two major shareholders – Chairman Bill Sweedler and Martha Stewart (10%+ each) – have nothing to gain from a bankruptcy filing/KERP plan, neither would be needed to run the company going forward. They are strongly incentivized to monetize their stakes here and move on with their lives.
Obviously, the expectation of the imminent company sale is just an educated guess of what might be happening behind the scenes. I might easily be proven wrong and the same signs that seem to support my thesis, might also be interpreted in a completely different way – i.e. lenders are preparing to take over the company with limited recovery for equity holders. Thus, do your own due diligence before deciding one way or another.
As mentioned above, the adjusted TTM EBITDA stands at $51.7m. When you look at Q2/Q3, with the lack of CEO costs and removal of the lease, run rate annual EBITDA could easily reach $75m-$80m. The company signed a lot of deals late FY19 and these have yet to impact the financial performance. Jessica (the face of one of the key brands) just hit the road on her new book tour, so expecting the trend to be solid for FY21. I view the run-rate EBITDA of $75m as safe base case estimate.
Peer valuation and recent acquisitions:
- XELB (QVC brands) trades 10x EV/Adjusted annualized Q3/4 EBITDA, however, the company has very low leverage.
- RCKY just bought HON boots biz for 9.3x EBITDA. Unlike SQBG biz this is actual manufacturing of product as well, lower margins;
- ICON trades about 10x EV/Adjusted annualized Q3/4 EBITDA. Although ICON might not be a good indicator for appropriate valuation multiple as almost the whole of EV consist of debt.
- APEX had a default looming at 3/31 and was sold for 8.6x EV/Adjusted annualized Q3 EBITDA. I get that this wasn’t at a premium to the share price, but the buyer still made the calculation it was better to assume debt here than to wait to bid in bankruptcy. Brand quality in this case was Tony Hawk and Cherokee;
- Martha Sale in FY19 was at 8x FY19 EBITDA, or 10x if the earnout is taken into account. This was SQBG’s lowest margin brand;
- VFC bought Supreme for 15x last year, which was praised as a great price and a strategic win.
- I have not found a single material, recent example of a brand transacting below 6x EBITDA, which is what it would take to wipe out shareholders here.
Hitting SQBG’s $75m EBITDA with a floor 8x multiple would result in a $600m sale price, while ignoring the value of $40m earnout, $20-30m positive working capital, and $300m of NOLs. Currently, EV is just a touch under $500m. $100m of additional EV re-rates shares to $100. If they sell closer to 10x (more likely if they unload individual brands to different buyers) and get the earnout, $200 share price comes into focus. To only be “made-whole”, shareholders would need a 7x multiple on a lower $65m EBITDA, the earnout, and no credit for AR/NOLs.
As an additional point of support, many of SQBG brands were aggressively written down in Q2-20 during Covid. Despite this, shareholders are still looking at equity book value roughly equal to the current market cap. If the brands were worth this last spring they’re likely to be even more valuable now. No further writedowns in Q3 might suggest no further deterioration in brand value. The book value of the brands (i.e. intangible assets) is at least partially supported by the prices paid for these brands:
- In 2015, SQBG paid $120m for 62.5% of Jessica Simpson’s brand. Looking at the impairments recorded since, the company has written off about half the book value. She had started a marketing blitz in March last year before Covid hit, in coordination with the launch of her book. Given her financial interest in her brand, I’m sure she’ll try to drive maximum value before selling this again. Case and point, she has been all over the news this past week marketing the paperback launch of her book. Hard to believe she’s out trying to drive results if she’s about to get wiped out in a bankruptcy proceeding. Interview on NBC (4/14) they mentioned she has a $1B line.
- In 2016, SQBG paid $150m for Gaiam, which the company wrote down about $30m at the beginning of Covid. It’s worth noting the brand was acquired while doing about $25m of revenue and 90% EBITDA margins. Given this is one of the brands that should be booming during Covid, selling this for 10x brand EBITDA should result in $200m+ proceeds.
- In 2015, SQBG paid $70m for Joe’s Jeans, which the company wrote down about $15m. This seems to be a very stable brand that should easily get its investment back or more should the sale be contemplated.
- Heelys was acquired for $63m, together with nearly $60m of cash and investments on the balance sheet. In other words, this has barely any intangible book value. How much value did their Reebok collab add this year? Who knows. But selling this one would be all upside against book.
- Similarly, SQBG paid only $3m for William Rast, and just signed a new deal for the brand. There’s no material book value there, again it’s all upside.
- Avia and AND1 were part of their Galaxy Brands acquisition, which cost $100m and 13.75M shares (pre-split). Both should be doing well during Covid. Avia is a bit interesting, as were getting $12.3m for the Avia China brand (terms in flux), but also will assign the Avia brand to a licensee after $100m of cumulative royalties are paid (approximately 5 years from now). AND1 hasn’t had any impairments and remains one of their core brands, which should easily fetch over $100m on sale. Their new deal with Foot Locker Canada did probably sound a bit better before Norm got traded to Portland, though.
- Investing in leveraged equity stubs is very risky. Small changes in EV and valuation multiples result in drastic moves in equity value both up and down. Buying leveraged equity stub is not dissimilar to buying out the money option and might result in the full loss of capital.
- KKR could force the company to file for bankruptcy if they stop granting extensions. However, KKR has been able to do that for a year and hasn’t. Now that KKR is under the tent for strategic alternatives I think other risks like debt for equity swap are off the table. Their choice to not nominate a majority is consistent with an imminent deal closure, and that they’re comfortable being repaid. Of course, this is only my interpretation of the situation and the real reason behind KKR actions could be completely different.
- There’s a potential judgment from the SEC on two counts to fail to impair goodwill. The maximum combined penalty is $2m, I’m not worried about this part. No criminal charges.
- A few ambulance chaser lawsuits regarding share price decline FY16-20. Continued expansion of the class they are pursuing indicates they aren’t getting any traction. Peer ICON spent $10-20m each of the last two years dealing with charges regarding falsifying financial statements and executive fraud, much more serious than failure to impair goodwill.
- The company received a substantial amount of attention from the SA community in March and the stock is already +50% since then. Nonetheless, EV change was minimal as net debt comprises the majority of the company’s value.