Iconix Brand Group (NASDAQ: ICON) is a New York-based company that owns and manages more than 30 brands in categories ranging from clothing to footwear to home goods. Its brands include Peanuts, Danskin, Candie's, London Fog, Royal Velvet and Umbro. It licenses the brands to domestic and international manufacturers and retailers such as Target, Sears, Macy's and Kohl's.
By nearly all major valuation metrics, ICON is undervalued right now. Because the ICON valuation metrics have been covered extensively here, here and other places, I'm not going to repeat them and will simply summarize that Seeking Alpha analysts and people I trust think the stock should be valued between $11 and $18. Also, the consensus price target of Wall St. analysts covering the firm is $19.72. I think the Wall St. consensus is somewhat high. I think $15 in one year is more accurate and it will take longer to go over $19. Still, that's more than double the current share price so there is very large upside.
When seeking alpha, one of the best ways to "find alpha" is to follow Warren Buffett's core advice to "Buy fear, sell greed." Average investors hate uncertainty because it scares them. The fear of what "might" happen causes some to sell and others to avoid buying, which drives prices down far more than the fundamentals call for. The initial decline causes investors pain and makes them feel even more uncertain, which leads to more selling and more fear/uncertainty. A classic vicious circle, and one that Buffet and other great investors say is the best place to look for a great buying opportunity.
When assessing if uncertainties are a great buying opportunity, it's essential to uncover as much information about them as possible. This allows you to reduce the levels of uncertainty, determine what is most likely going to happen and the degree to which the fears related to the uncertainties are irrational or irrational. The bigger the irrationality, the bigger the buying opportunity.
As the information and analysis I'm going to present in this four-part series shows, Iconix is a great buying opportunity because there are four uncertainties, and the fears about them are largely irrational and overblown. One sizable irrational fear makes for a good buying opportunity. Four sizable irrational fears make for a great buying opportunity. Developments in the upcoming weeks and months will result in significant moves higher that I think will total about 100% this year.
In the last nine months, Iconix investors had a perfect storm of negative news, all of which created uncertainties and fears that resulted in several steep declines and its very low valuation. Much of the news was such that the stock should have declined significantly. I don't know anyone who will argue that the stock should have retained its $40 price from 2014. I think the stock should have fallen over 50% based on real things such as a decrease in revenues and earnings. In fact, I bought it in the $13 range in September and sold it in October at $15.71 (though Iconix is now in a better position than it was when I sold it).
However, it fell much further than it should have due to the fears the news created. Let's start with research and analysis of the most recent bad news that created uncertainty and a major price drop.
FUTURE SEC NEWS
On December 28, 2015, Iconix announced that the SEC was investigating its accounting treatment of certain joint ventures. This caused a 21% drop in the stock due to the fear of a severe financial impact from the probe.
Six things make me fairly sure there will be only minor financial impact, if any, on the company:
1) Based on an informal probe by the SEC earlier in the year, the company already spent several million dollars to do a lengthy full-blown examination of its accounting by "a Special Committee … with the assistance of independent forensic auditors and legal advisors," Cuneo said on the last earnings call. This was done while in ongoing communication with the SEC, and included investigation of its accounting treatment of its joint ventures. Several million spent on examining the accounting of a company with only 250 employees and under $500 million in revenues is a large amount and indicates it was very thorough. After the auditing, the company re-stated its financials with corrections of errors that had only minimal impact on its earnings and cash flow.
Forensic auditors have both the Certified Public Accountant designation and Certified Fraud Examiner credential, as well as additional education in criminal justice and law enforcement. More info on them is here and here. Their careers depend on doing a great job with these things, so even if the SEC were to check all of the auditors' work, the chance of it or anyone else finding something materially incorrect is small.
2. The SEC normally doesn't do audits themselves, but instead requires companies to hire an auditor to do the auditing. Typically they require a regular audit, and sometimes they require a forensic audit, which is more in-depth, investigative, comprehensive and stringent. Iconix has already had comprehensive forensic auditing done while in regular contact with the SEC, so I'm fairly sure the SEC will accept it, and won't be re-doing an examination. Instead, the probe is probably focused on whether the discrepancies were the result of simple bookkeeping mistakes or fraud on the part of management.
As the Law Dictionary explains, if forensic auditors "find discrepancies, it may be the auditor's job to investigate and determine the reason for it, or it may be the job of a separate financial investigator." It's likely the SEC is assessing whether the discrepancies found by the auditors were only errors by bookkeepers or whether there is proof that executives pressured staff into making them. People who have overseen a large number of bookkeepers know that small errors are commonplace and come in several types, and the existence of errors does not have a high co-relation with fraud. So there is a reasonable chance the SEC will not find fraud.
3. If the SEC does, I'm somewhat sure the financial impact on the company will be small. A central reason is that I think it will fine the individuals who committed fraud, and not the company. In 2003, Candie's (the company CEO Neil Cole later turned into Iconix) was investigated by the SEC on charges of misstating a portion of its revenues between 1997 and 1999. In a settlement, the SEC fined Cole $75,000 and did not fine the company at all. And separately filed civil suit against other individuals.
As this article details, the SEC also filed civil suits against COO Lawrence O'Shaughnessy, who agreed to pay $100,000 to settle, and former Principal Accounting Officer Gary Klein, who was fighting the case. The SEC also brought an administrative cease-and-desist proceeding against the company's former CFO, David Golden, who also settled.
So the SEC fined or attempted to fine four executives directly, and did not fine the company itself a penny. Fining the individuals who committed the fraud is even more likely in the current probe since all of the executives in charge during the accounting discrepancies have left including the CEO, COO and CFO. Related, a sizable portion of the SEC's web page on investigations focuses on actions it takes against individuals who commit fraud.
4. The SEC usually does not levy significant fines against companies at risk of default since it would punish the firm's creditors and shareholders who had nothing to do with the wrong behavior. The SEC's goal is to prevent future bad behavior, not to cause companies to default and inflict damage on debtors and stockholders.
5. A 2013 study by the Wall Street Journal found median fines on individuals more than doubled from $60,000 in 2005 to $122,500, while the median fine paid by firms dropped from $600,000 in the 2005 to under $200,000. Since Iconix is a small-cap stock, if it were fined, I think it would likely be well below the median.
As context, the company has over $170 million in cash and over $60 million in earnings. So even if it were fined at the median level, $200,000, it would be miniscule. And even a fine of triple the median level would be a small impact relative to the company's earnings and free cash flow.
Average investors are probably used to hearing only about high-profile SEC cases that have huge fines and settlements. However, those cases usually involve: a) huge companies and b) situations where the companies' actions had significant direct negative effects on others and/or put the entire financial system at risk, as was the case with big banks during the 2007-8 financial crisis.
Thus, investors tend to overreact to news of investigations. They very much overreacted to the Iconix situation, even though it isn't a huge company and its accounting treatment of the joint ventures didn't have a significant direct adverse effect on others or put any section of the financial system or sectors at risk.
6. The fact that Iconix's main creditor, Advent Capital, proposed refinancing and said the path to refinancing was "clear" two weeks after announcement of the probe indicates they are not concerned about a significant financial impact from it. Advent did not even bring it up in the letter. I'm pretty certain Advent did a thorough assessment of the probability of a significant financial impact.
WHAT THIS MEANS
Based on the information in the six areas above, I put the probability of a significant financial impact at less than 1%, the chances of a small but basically meaningless fine at 49% and no fine at 50%.
I was trained in international business risk analysis, and one thing we were trained to do was assign specific probabilities to uncertainties rather than talk in vague phrasings. I encourage investors to do the same as it will sharpen their thinking, and help them step past their emotions. Emotions prey on vague thinking. A vague notion of future risk can easily lead people to sell when they should buy. A vague notion of future gains can easily lead people to buy when they should sell.
Next let's take a look at the upside that will probably happen with this.
A study in the Journal of Forensic & Investigative Accounting examined market reactions to the announcements of informal and formal stages of an SEC investigation. It found that on average companies experienced a 29% decline in their stock price in the 3 trading days surrounding the announcement of an informal investigation. Iconix's announcement in August of the informal probe by the SEC and ensuing forensic auditing of its accounting mirrored this, as it resulted in a 26% drop in its stock.
The study found that the market reaction to a subsequent announcement of a formal investigation was much milder, with only a 7.6% drop on average. Interestingly, Iconix after its announcement dropped 21.61% from $7.45 to $5.84, or about triple the average. This indicates that investors are expecting a dramatically negative financial impact from the probe, so anything less than that should be a positive catalyst.
SEC probes of small companies tend to last between 2 and 12 months, and are longer for complex probes of large companies. The Iconix probe is focusing only on the company's accounting treatment of some of its joint ventures, and that treatment has already been investigated and audited by forensic accountants, so the scope of this probe is small and a lot of the groundwork is already done. Thus, I predict an announcement sooner than later.
The stock price is currently pricing in a severe impact on the company from the probe, so if there is a severe impact, it probably won't affect the stock much.
The stock dropped 47.61% in all in the short windows after the SEC announcements. If it's announced there is little to no financial impact from the probe, the stock will likely recover the majority of that and possibly most of it.
Note this important math: if a stock drops 50% from $20 to $10, re-tracing all of the loss results in a 100% gain for anyone who buys at $10. Re-tracing half of the loss to $15 results in a 50% gain for people who buy at $10.
If there is little to no financial impact from the probe, I predict ICON will re-trace about half of its 47.61% loss from the SEC announcements, resulting in an almost 50% increase in the stock price.
With a 99% probability of little or no financial impact from the probe, this means a 99% probability of about a 50% gain. Even if you think the probability of little or no financial impact is only 90%, and you think the company will only make up a third of the declines from the previous two SEC announcements, that's still a 90% probability of a 33% gain. Even if there is severe fine, it will be far less than the over $200 million in market cap ICON lost on the announcements of the probes, so the downside is minimal.
There are very few stocks with that strong of a risk/reward set-up, and on that catalyst alone, I recommend investors be overweight in ICON. While the SEC news catalyst may take many months to occur, the other three catalysts I'm going to cover are likely to occur in the next 1 to 25 days. I recommend investors establish their positions before any of the catalysts occur because after catalysts make headlines, stock prices usually change within a couple of minutes of the news. The major gains come from acting before the catalysts.
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.