THE ILLUSION OF DEFAULT EXPECTATIONS
At present, Iconix Brand Group (NASDAQ: ICON) is trading as if many people think the company has a significant likelihood it will default on its debt and go bankrupt.
For example, on the options market, it costs a person $2 to buy a put at the $5 strike level for January 2017. That means that short sellers would only make money if the stock is trading below $3 a year from now.
A short seller who buys $100,000 of the puts would lose $100,000 of it if the stock is trading at $5 in a year, $50,000 if it's at $4 and would only break-even if it's at $3. If the stock goes to $2, they'd make $50,000 and if it goes to $1 they'd make $100,000.
Other options show similar. The $7.5 strike January 2017 puts are $3.5, so shorts have to pay $3.5 per option for the chance to only make money if the price is lower than $4 in a year.
This significant chance of default also shows up sometimes in media stories and discussion board comments.
It is also reflected in the level of short interest in ICON, which as of January 29th was 46.42%, meaning 46.42% of ICON shares are held by short sellers. That is about 10 times the market norm.
POPPING THE ILLUSION: 10 REASONS ICON WON'T DEFAULT
The chances of Iconix defaulting and declaring bankruptcy are miniscule for the following reasons:
1) S & P Credit Research has not changed Iconix' credit rating in five months. The credit agencies on average don't update their credit ratings frequently, but they do update them when significant changes occur such as when a company has a high probability of default. On August 7, 2015, it placed Iconix on "Credit Watch with negative implications" due to concerns of a lack of corporate governance after former CEO Neil Cole stepped down. On September 15, 2015 after Peter Cuneo took over as CEO and Board Chairman, S & P removed Iconix from "Credit Watch" and declared in its summery: "The outlook is stable, reflecting our belief that the company can support profit stability, healthy levels of cash flow, and debt leverage between 5x-6x."
On November 6, after Iconix said it was restating its historical financial statement from 2013 to 2015, S & P released a report saying its rating were "unaffected" and "The restatements don't affect the company's previously reported free cash flow or credit measures and relate to the reclassification of revenue and selling, general, and administrative expenses for certain licensing agreements. We have already excluded the gains from its joint-ventures in our calculation of EBITDA, as they are non-cash."
Since then, S & P has not issued any updates to Iconix's rating nor added it back to "Credit Watch" or mentioned any concerns with it.
2) Iconix hired Guggenheim Securities in November to assist with refinancing, so they have high quality and experienced assistance in the process.
3) Iconix's main creditor, Advent Capital, on January 11 proactively proposed doing a refinancing that would move all 2016 debt to be due in 2021. You can read the letter here.
It is dated January 11, 2016, which is two weeks after Iconix's announcement of the SEC probe related to accounting treatment of certain joint ventures it entered into. Advent had plenty of time to digest the news, and has still pro-actively proposed refinancing and said the path is clear, which means the probe won't affect it.
In the letter, Advent says "our view is that your licensing business model is stable and can continue to generate appropriate levels of cash flow and that your unencumbered assets are valuable as are residual interests in your encumbered assets." In plain English, they're saying Iconix is stable and making money and that its assets (its brands and contracts with licensees) are valuable. The letter goes on to conclude "We believe that these among other factors create a clear path towards completing the refinancing ... "
4) CRT Capital, another Iconix creditor, said in a November report, that if the company is willing to secure the refinanced debt with some of its unencumbered assets as collateral including 65% of equity of foreign subsidiaries, it is "likely to put the Company over the top on getting a deal done."
5) Iconix management has expressed confidence it can pay the debt. For example, CFO David Jones said: "Addressing this convert is the top priority for the company, and we are confident that between our existing cash, our free cash flow generation over the next eight months, and our ability to access financial markets, we will have the ability to satisfy this debt obligation." As a piece of context, Jones on the same conference call said that the company's guidance was now conservative due to the change in "culture" at the company.
6) Iconix doesn't need to refinance if it doesn't want to. It has the option to sell one or two of its brands, and use the proceeds combined with existing cash and free cash flow to pay off the 2016 debt in full. While I favor refinancing, Iconix can avoid default even if it doesn't refinance.
7) The price of Iconix's 2018 bonds/debt has gone up more than 40% in the last month from about $37 to about $53 as you can see here. Creditors are willing to pay 40% more for Iconix's debt today, which shows they increasingly think the company is not going to default.
8) Advent and the other creditors have incentives to refinance. If a company defaults and files for bankruptcy, creditors can lose significantly. Bankruptcy courts almost never order a company that is making decent profits to be liquidated. Instead, a core function of the court is to help the company to restructure its debt on improved terms with its creditors. Early on in the process, the company and its creditors attempt to agree on improved terms.
But to simplify bankruptcy court in a nutshell, if creditors refuse reasonable offers, the court can require them to accept a restructuring of debt on improved terms for the company. In essence, it's kind of a forced refinancing, but it's often worse for the creditors than doing a regular refinancing because:
a) the court can force their hand into accepting worse restructuring terms than they could have negotiated directly with the company
b) because the legal fees of bankruptcy for all sides are costly (meaning money that could be used to pay off loans is used for legal fees)
c) it can hurt the business somewhat, for example, making existing and potential new clients and partners less likely to enter into contracts with the company, which in turn reduces its ability to pay off the loans.
So it's in the creditors interest to avoid a default via refinancing and to be reasonable. They normally refinance with companies who have good free cash flow and are still making a decent profit, and Iconix's free cash flow and earnings are better than decent for a company its size. This is why Advent Capital pro-actively proposed refinancing to Iconix. It's also why Iconix has some negotiating power and leverage in the refinancing talks. Not huge amounts, but some.
These large stakes show that serious players are very confident that Iconix has a bright future, and certainly is not at a real risk of default. Oppenheimer has many institutional clients including university endowments and pension plans, so they do serious research and analysis before buying. They don't make investments they think are at significant risk of default. Info on them is here.
10) It's possible that Iconix could secure new financing from new creditors and use the money to pay off it's 2016 creditors and even buy back some of its 2018 debt at a deep discount. The fact that companies like Sports Direct and Oppenheimer Funds bought large stakes of their own initiative shows that Iconix and its earnings and free cash flow are appealing. So Iconix may well be reaching out to new creditors to compete with Advent. I think it's more likely that a refinancing will be done with Advent. But Iconix is not tied to it.
11) Cuneo has turned around 7 companies, and refinancing is often part of that, so he's skilled at it. He is known as a master turnaround expert. I'm sure he's aware of his options and is taking his time to explore them and assess what is best.
Ok, so it's 11 reasons. You get one extra.
Based on all of the above, I estimate the probability that Iconix does not default at higher than 99.9%.
BENEFITS OF REFINANCING
If Iconix refinances, it will be a significant positive catalyst. As the Advent letter explains, "With no public solution announced to date, we believe that the level of uncertainty in the market place has negatively impacted your stocks and bonds and will continue to do so until the refinancing is complete." Even if the terms are only so-so for Iconix, announcement of refinancing in and of itself will cause a significant rise in the stock price by removing the perceived risk about a default.
Some managers at institutional investors are scared of looking bad, and avoid companies that might make them look bad through a default. They don't want to have to explain to upper management and/or their clients why they chose a company that defaulted. So many of them play it safe when there is chatter about a default. When refinancing is announced, they become free to buy shares.
Related, the upper management of some investment companies use quantitative software to restrict their investment managers from investing in companies that the software predicts has a higher than normal likelihood of default. For example, quantitative software might look for common traits among companies that defaulted in the past, and then assign probabilities of default to current companies based on whether they have similar traits.
For investment companies that are choosing between a few thousand potential stocks, it can be a useful tool to narrow down the field, especially for companies who don't allot much time for their managers to do in-depth research and analysis.
A weakness of quantitative software is that it doesn't take into account numerous factors about specific companies that matter, such as all of the information above. For example, many quantitative formulas use the size of a decline in a stock's price in determining the probability of default. If investors overreact to bad news (as investor did with Iconix), but the health of a company's business model and cash flow is actually good (as Advent and many others say is the case with Iconix), the quantitative software will be much more likely to draw the wrong conclusion about that particular company.
Anyway, when refinancing is announced, investment managers blocked from acquiring ICON due to their quantitative software will be able to buy shares. Institutional investors can move the needle on a stock price a lot.
Refinancing also has potential to allow Iconix to use some of its existing cash to buy back 2018 debt at very low prices, rather than use the cash to pay off the 2016 principal. 2018 bonds are trading for about 53 cents on the dollar. Even if they rise to 65 cents on the dollar after an announcement, every $65 million Iconix put towards this will reduce its debt by $100 million, a net benefit of $35 million. It's rare to be able to get that kind of giant return on use of cash.
A refinancing announcement by Iconix also has reasonable likelihood to create a short squeeze because it matches up exactly with the three ingredients for a short squeeze:
A) a high short interest level. Short sellers have to become buyers sooner or later because they have to buy the stock in order to exit their positions, including if they want to take their gains. As of January 29, 46.4% of Iconix shares are held by short sellers, which is a very large amount of buying that is going to be unleashed at some point in the future. The average short interest for the S & P is usually around 4.5%, so ICON's level is about 10 times the norm.
B) As Investopedia.com notes: "Short squeezes tend to occur more often in smaller cap stocks...." because they don't have as much liquidity or as many shares trading hands as mid-caps and large caps. ICON is very much a small cap.
C) A positive development or a shift in sentiment. As this page says, "If you want to find potential short-squeeze candidates, keep your eye on the short-interest levels of stocks that have been losing value. If the short-interest levels are high, watch for little turnarounds and signs of life."
For example, in 2012, Groupon's stock benefited from a short squeeze simply by beating earnings estimates by a penny. While little developments can trigger a squeeze, the bigger the catalyst, the higher the chances for a major squeeze.
The stock naturally rises a bunch due to the news causing more longs to buy. The price increase triggers margin calls on some of the shorts which forces them to buy shares of the stock to exit and raise cash. At the same time, some other shorts without margin calls are already trying to buy to "get out of dodge" before the squeeze gains momentum. Their buying also causes the price to rise.
A vicious circle takes place as higher prices trigger more margin calls with shorts being squeezed into selling, which leads to even higher prices. There is a dearth of sellers because the good news indicates the stock is worth more, and as soon as longs notice the squeeze, they often hold off on selling until the price gets quite high.
In fact, some investors and websites specialize in finding good short squeeze candidates, which adds to the pool of longs. Investors with enough money can sometimes trigger a short squeeze on their own on small pieces of news by buying shares until the price starts to trigger margin calls.
If refinancing is announced and the price rises and you're thinking of selling, I recommend holding for at least a day to see if a short squeeze unfolds. Sometimes short squeezes happen in the last 15 minutes of the trading day because many brokerages issue their margin calls and/or initiate forced liquidations in the final 15 minutes.
Iconix announcing a refinancing would be a sizable catalyst, and could easily result in a short squeeze. Even if it doesn't, the announcement will increase the share price significantly the day it's announced and increase it somewhat more in the following weeks. As always, I strongly encourage investors to assign probabilities and then make moves pro-actively to take advantage of them. Most of the change in price comes within minutes of news of a catalyst, so investors need to act before them.
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.