Sequential Brands Is A $200 Stock

Summary

Q1 2021 hedge fund letters, conferences and more

• In my last article, I highlighted that Sequential Brands Group Inc (NASDAQ:SQBG) appears to be heading for a sale, but today I'm going to be more direct regarding valuation.
• Due to size, very few investors have done the work on Sequential to understand the earnings power, or the debt situation.
• I'm officially putting a $200 price target on SQBG.

I spent my time in college years ago being told markets were rational and efficient. I even once participated in a stock picking contest where the professor offered extra credit to the best and worst performers, as he said losing money was just as hard as making it. Well, I levered myself up on oil futures contracts and bought into FreeSeas (OTCPK:FREEF), which one SA poster once pointed out was potentially the best value-destroying stock ever. The result? I took my portfolio negative, getting some extra credit (ended up around -200%).

I don't believe markets are rational or efficient. They generally function pretty well, but sometimes they miss big. I wrote a piece last year on Valhi (VHI) which had canceled their preferred equity, increasing shareholder equity by $667m, and the stock hadn't budged, but has since doubled. The market just missed it, plain and simple. Why? It was a $250m market cap stock which is 92% family controlled. No one cared about it or followed it. There were no analyst estimates. Unless you were reading their SEC filings and following the story, you didn't see it either.

I probably don't have to try too hard to convince you markets aren't rational, since GameStop (GME) has been both $3 and $400 in the past 12 months (hope you bought at $4, and didn't sell at $20 like me). Things happen in the market and securities get mispriced. Or things happen, and the prices don't change. Today we'll examine the latter.

How Did We Get Here?

Sequential Brands (SQBG) has crashed in the last 5 years:

(Source: Seeking Alpha)

After a lot of hype years ago over Martha Stewart and Jessica Simpson collaborations, results didn't materialize quite as expected and the selloff began. The real scare in FY19 came when they divested the Martha Stewart and Emeril brands for less than their book value, taking a large one-off write-down on the sale. The market viewed this as a sign their remaining brands might not be enough to cover the debt, and they traded down to stub status, where they've languished for a couple years.

Despite the spectacular tank, there's a second piece to the puzzle:

(Source: Seeking Alpha, but not how I would calculate an EV)

The EV of Sequential has only been cut in half, so a recovery in shares doesn't change the EV the way it usually would for a business. SQBG is highly levered on its $450m debt with Bank of America (BAC) and KKR (KKR). Looking at them (and peer Iconix Brands (ICON)) on the last 5 years, you see they've both gotten much cheaper on an EV/EBITDA basis:

(Source: Seeking Alpha)

Now, this is where many would stop. The story seems to be "It's a highly levered equity stub, with their best days in the past, with questionable book value and fairly valued against peers. Why bother doing more?"

Then you have other hairs:

1. "Going Concern" warning popped up in 10-Q after Covid (Sequential tripped their leverage covenant due to Covid: 7.25 to 1)
2. The SEC announced charges related to failure to timely impair Goodwill.

Are you still reading? Great.

1. Sequential has received waivers on their debt, currently running through their expected reporting date of March 10th. Essentially, if their lenders wanted to force them to file, they could have by now. At each expiration date they have extended for another month (or a few weeks).
2. There were no criminal charges. The maximum combined civil penalties are about $2m under the two respective charges. This actually makes me more confident they have substantiated the $77m shareholders equity on the latest 10-Q, since they have been disclosing they were being investigated for this since FY19. They knew their write-downs were subject to increased scrutiny and didn't take any after Q3. Translation? They have offers in hand that substantiate the value they carry on their books.

Value Proposition

TTM EBITDA for SQBG looks like $38.5m on a screener. This is misleading for the following reasons:

1. Their Covid quarter was almost breakeven. Annualizing (still slightly depressed) Q2/Q3 gets them up to $53.6m, or annualizing Q3 get them to $61.2m.
2. Sequential was paying around $6m per year for their corporate HQ, which they bought out of in October. This was expensive leftover space from Martha Stewart, and not necessary. This also included some eliminated positions, which I estimate as $1m. +$7m.
3. Recent executive departures that were not backfilled add at least $1m to earnings. They don't need a CEO with Sweedler (Chairman) running the ship (who owns over 10% of the business and is very invested in this outcome).
4. Not even factoring in new deals for Heelys and William Rast, SQBG run-rate EBITDA is $70m. This does not give them any additional assumed pickup from Covid impacts in Q3.
5. From their Q3 conference call:

Adjusted EBITDA from continuing operations for the third quarter of 2020 was $18.9 million compared to $13.2 million in the prior year quarter, reflecting the company's continued efforts to reduce expenses.

Adjusted EBITDA from continuing operations for the nine months ended September 30, 2020 was $43.7 million, compared to $37.7 million in the prior year period reflecting the work that company has done to reduce its expenses."

So going off "real" EBITDA, you can get to $70m as a run-rate estimate. If you take the adjusted number and the measures they've put in place, you get to $75.6m before the rent adjustment, which easily gets you over $80m. I'll pick a midpoint, and say the SQBG is earning $75m of run-rate EBITDA for our purposes.

Valuation

I chose not to make direct comp comparisons in my last article, but not this time:

1. Apex Brands (OTC:APEX) had their backs against the wall with a chapter 11 filing looming at the end of March. They struck a deal to be acquired by Galaxy Universal, valuing the enterprise at about $60m. This is for a business that did $5.9m of TTM EBITDA. On an adjusted EBITDA basis, they were at $1,759k in Q3, or $5,175k through 9 months. $7m is the most aggressive run rate EBITDA number we can make from this by annualizing Q3. So Apex, a forced seller, was able to extract a minimum 8.6x EV/EBITDA multiple for unloading their brands.
2. Iconix Brand Group (ICON) has not been a forced seller, and another stub equity. Unlike the relatively stable Sequential topline, their revenues have fallen about 75% in recent years. They have ~$550m of net debt, a $30m market cap, trailing 9 months adjusted EBITDA of $36.8m, and Q3 adjusted EBITDA of $13.7m. They also just sold off Umbro and Starter in China during the quarter, registering material gains on sale. Using the optimistic $55m (Q3 x 4) for the run rate EBITDA, ICON trades above 10x EV/EBITDA.
3. Rocky Brands (RCKY) just bought a bucket of footwear brands off Honeywell (HON) for $230m, which did $24.5m of adjusted EBITDA in FY20. This is particularly important, since that is off a revenue of $205m, so not even 15% margin. Rocky both owns the brand and manufactures the product, so much lower margins than Sequential, Apex, or Icon. Yet they still paid 9.4x FY20 adjusted EBITDA.
4. If you go back to the Martha Stewart/Emeril brand sale, which was a lower margin brand compared to the rest of Sequential brands, they got ~8x FY18 EBITDA (~$5m non-cash charges are reflected in 10-K FY18 summary) and a $40m potential earnout that gets them to 10x.

What's the takeaway? Distressed, stub equities that have worse growth and none of the recent positive changes that Sequential has, still trade at ~10x EV/EBITDA. Lower margin manufacturers of brands are paying ~10x EV/EBITDA. Sequential's lower margin brand sold for ~10x EV/EBITDA. My takeaway? Sequential Brands should be worth 10x EV/EBITDA.

It makes sense that few have noticed this, since on a screener they appear to trade near this fair valuation. But Sequential as it stands today is a $75m EBITDA business, not $38.5m.

Sequential has about $440m net debt and a $30m market cap. With $75m of EBITDA, that's an EV/EBITDA of 6.3x. If Sequential traded at a $750m EV, their market cap would be ~$310m, which is a ~$185 share price. Factor in the $40m earnout potential from the Martha Stewart sale (which is not part of the $43m receivables on the balance sheet), which I will haircut by 50% for conservatism, and you get another $15/share, for an aggregate value of $200/share. This completely ignores positive working capital and over $300m of NOLs that could have substantial value going forward.

Due to Sequential actively advertising their pursuit of a sale, and their seeming to dress the company up by eliminating C-Suite roles and the HQ, this value could be unlocked imminently. Some other investors have been buying.

Risks

• Sequential could stop receiving waivers on their debt and be forced into default. A sale of the company as a result of this process could still yield good returns to shareholders.
• KKR will take over the board of Sequential on April 1st if they do not regain compliance with their loan covenants. They may do this when they report earnings this month, but it is not certain. If KKR takes over, they may force a sale without as much focus on total shareholder returns.
• Due to the size of the business, the terrible looking chart, and the issues with the SEC, if Sequential only sells off one or two individual brands to pay down debt, the significant undervaluation may persist for a longer period of time as many investors won't touch this stock out of principle.
• Stock is thinly traded and can widely fluctuate on any given day, and trades at very low volume.
• Sequential is highly concentrated with 3 of their brands representing over 50% of their revenues.

Conclusion

Sequential Brands has been missed by the broader market, and I believe it's a $200 stock trading under $20. Opportunities like this don't come up without substantial risks, but I believe the risks present for SQBG do not justify the absurdly cheap valuation compared to peers. The stock was $200 less than 5 years ago, and I believe it should be again. Time will tell how efficient the market has been valuing Sequential Brands below $20.

Article by Kingdom Capital, Seeking Alpha

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About Kingdom Capital

Deep value investor focused primarily on microcap stocks, seeking to avoid being one of the people fooled all of the time. Shareholder activism is underrated.

Rough track record: https://www.tipranks.com/bloggers/kingdom-capital

Occasionally collaborate with Risk Research Inc.