Iconix Brand Group: Breaking Down The Debt Buyback Agreements

| About: Iconix Brand (ICON)


It's impossible to know at this stage exactly how much of a discount Iconix got on its debt buy backs.

What we do know is that they're reducing their debt by 15%, a key step for the company with several benefits.

The effect on EPS will probably be a sizable net gain in EPS after the agreements execute: likely a doubling of EPS.

While the announcement is a net positive, investors overreacted to the initial EPS reduction, which has resulted in a great buying opportunity.

On Monday morning June 13, Iconix Brand Group (NASDAQ: ICON) announced that the company is planning to retire up to $105 million of its debt at a discount. You can read the whole press release here.

What we don't yet know

Investors have initially misjudged the announcement on two fronts: with regards to the EPS impact and with regards to whether Iconix paid a fair price to retire its debt.

Let's start with the latter. A proper analysis of what Iconix is paying can't be done yet because key details are still not known. For example, some investors believe that the deal means that the company is poised to in effect give shares to bondholders for only about $6 to $7 per share. I will show this is extremely unlikely, and that it's impossible to know at this stage how much of a discount the company is getting on the debt. And I will describe what I think is realistic for investors to expect for the discount once the details are disclosed.

In particular, the release states: "the Company may retire up to approximately $105 million in aggregate principal amount of the Notes in exchange for aggregate cash payments of up to approximately $35.2 million, and approximately 6.8 million shares (the "Shares") of the Company's common stock, par value $0.001 per share (the "Common Stock"). The final number of a portion of the Shares may be adjusted based on a number of factors, including, among others, the volume weighted average price of the Common Stock during the term of the agreements and limitations imposed by a minimum share trading price on any trading day."

For starters, it says "the Company may retire" the debt, not "the Company will definitely retire" the debt. This indicates that Iconix might well have the right to opt out of some of the transactions/agreements if they aren't turning out as well as they plan for them to. Note that the financial terms of the agreements can change based on a "number of factors" including two factors that relate to the trading price of the stock over the term of the agreements.

The statement doesn't say what the time period of the agreements are. But given it says the price of the shares to the bondholders "may be adjusted" based on how the factors play out, it sounds like the time period of the agreements has not yet completed. On the flip side, the agreements are referred to in the past tense a couple of times. But it could be they've been made (past tense) and haven't executed yet and are still playing out.

Also, the wording "up to approximately $35.2 million" technically means anywhere between 1 penny and $35.2 million. It's not clear to me whether:

A) Iconix is required by law to announce the broad potential parameters of debt retirement agreements at a certain point in time, and that such parameters have to include the maximum amount of cash it might spend.

B) Or perhaps even if it's not required by law, they felt they "should" give a broad update of parameters of their plans to the public.

In either scenario A or B, it may be the case that their agreements with the bondholders limit them from providing specifics at this stage in the process. For example, when the sale of Complex Media to Verizon was put together, Iconix was only allowed to broadly describe the agreement on their last quarterly conference call, and said they could not disclose specifics because it hadn't closed. Before the call, many investors were hoping for specifics on the call, but I predicted that they would likely not be allowed to give them. I think there's a good chance that's what's occurring now.

C) Iconix is saying that they're pretty much definitely going to spend about $35.2 million in the agreements.

If it's B, I don't see why they would say "up to approximately" rather than simply "approximately." So I think the chances of A or B are higher than C.

Related, I'm guessing that the "up to" doesn't apply to the "approximately 6.8 million shares" because the words "up to" are not immediately in front of the number of shares. But it's entirely possible that the "up to" does apply to the number of shares because "up to" does appear a little earlier in the sentence with an "and" followed by the number of shares.

In addition, the word approximately comes before the number of shares, which indicates it's not a firm number. One could try to parse the meaning of the grammar about the number of shares in many ways, but I don't think any attempt will be conclusive.

Even if we were able to conclude the number of shares was a firm number, the fact the dollar amount could potentially be anywhere between a penny and $35.2 million means it's almost impossible to know how much Iconix would pay in net (total of cash and shares) to retire the debt.

For example, if on one end of the spectrum, Iconix pays close to 0 in cash plus 6.8 million shares and retires $105 million in debt, they'd in effect be getting $15.44 per share for retiring the debt at face value. If they pay all of the $35.2 million plus 6.8 million shares, they'd in effect be getting $10.26 per share for retiring the debt at face value.

What's a reasonable price to pay to buy out 1/4 of all 2018 bondholders

Let's take a look at how much Iconix realistically might have been able to buy the bonds for below face value. The par value of bonds is the price the bonds (aka debt) is trading at on the open market. Between late April and mid-May when most of these agreements were probably being struck, the 2018 bonds traded mostly between 77 cents and 78 cents on the dollar, with one sizable dip and a few days at about 79, as this chart shows:

CREDIT: Chart by Morningstar

Note that the chart shows numbers such as $65, $70 and $75 (and the line at the top represents $80). That's because in a nutshell they're done in increments of 1,000, so anytime you see $75 it basically means the bond is trading at 75 cents on the dollar.

Generally speaking, for a company to buy out 1/4 of its bonds, the bondholders are going to demand much more than par value to be bought out. Think of it this way: if the bondholders were fine on exiting for just par value, they would have already exited for par value. They didn't exit for par value because they believe the bonds are worth much more than par value. This is due to either yields or expectations of future price appreciation.

It's somewhat similar to what occurs when a company wants to take over another company. Most of the shareholders don't want to sell at the current trading price and typically the buyout price is 25% to 50% higher than the current price. For example, Microsoft just had to pay about 50% higher than the market price to buy LinkedIn as you can see here.

I figure to buy out about 1/4 of its 2018 bonds, Iconix would be fortunate to do so for 85 cents on the dollar, which is only 10% above the 77.5 cents it was trading at. I estimate it might have had to pay more like 15% above 77.5 cents, which would be 89 cents on the dollar, and possibly more than 15% above market value. If I was a bondholder, I probably wouldn't take less than 90 cents on the dollar.

It appears Iconix had to either negotiate private agreements separately with individual bondholders (as it did), or had to try to buy back 1/4 of its bonds piecemeal on the open market. I'm not sure if there are any rules that limit a company buying its own bonds on the open market, or if Iconix's 2018 notes were written in a way that prevents it from doing so. If any bond holders (or others) have details about this, please share the information in the comments. For example, just like stockholders don't want a company like Sports Direct to take over Iconix on the open market and favored forcing SD to negotiate a fair price with the company, are bonds sometimes written in a way that prevent a company from quietly buying them back at low prices on the open market, and requiring them to deal directly with the bondholders?

Likewise, are there are rules that require a company to disclose that they're buying or are going to buy back their own bonds on the open market? For example, disclosure rules revealed that SD had acquired an initial stake in Iconix, and then an additional stake etc. If yes, Iconix likely was better off negotiating private agreements separately rather than revealing to the world that they were in the process of buying their own bonds.

Even if they could buy back bonds completely quietly, buying 25% of all bonds normally drives the price up 10% or more, especially in a market that's not very liquid. If you look at the volume at the bottom of the bond chart above, you'll see low volume in the last two months, so not many bondholders were selling.

So realistically, I don't think investors can expect better than about a 10% to 14% discount below face value in the current market for Iconix bonds.

Discounts will become increasingly smaller with time

In addition, as the company continues to show it has stabilized and is maintaining its very high levels of free cash flow, the bond prices are probably going to go higher, and in 3 to 6 months, a 10% to 14% discount will be less likely. Bonds trade at a discount primarily because bondholders are worried about a default. As fears of a default continue to go down, bondholders will be less likely to sell at a discount because they know they can get the full amount back. So I don't think it made sense for the company to wait to do these agreements.

If the next earnings report is good enough to propel the stock from say $8 to $8.80, you can bet that bond prices are going to go up at least 10% as well, and bondholders would be even more likely to demand a sizable amount above the current price to be bought out.

It would have been ideal if they had a large amount of US based cash 5 months ago when the bonds were trading at crazy low prices. But the majority of their cash is overseas, and they needed a sizable amount of cash to refinance the 2016 bonds and some cash to expand their marketing and digital online efforts. And any company needs to keep a certain amount of cash on hand for operations. It would have been crazy to use equity back then because the stock price was crazy low.

I personally would have leaned towards the company using more cash and less shares to do the current agreements. But as other investors have noted, we don't know what other opportunities the company has for use of its cash, such as acquisitions or expansion of operations.

Numbers at different discount levels

Using a discount of 10% on buying out the bondholders, $105 million would be $94.5 million. If on one extreme, Iconix pays close to 0 in cash plus 6.8 million shares, they'd in effect be getting $13.90 per share for retiring the debt at 10% off. I don't think there's any chance they got a deal this good. Again, it's one end of the "up to" spectrum.

If they pay all of the $35.2 million plus 6.8 million shares, they'd in effect be getting $8.72 per share if they're retiring the debt at 10% off ($94.5m minus $35.2m = $59.3m, divided by 6.8m shares = $8.72 per share).

Now let's run the same numbers for a 12% discount, which would be $92.4 million. If Iconix pays close to 0 in cash plus 6.8 million shares, they'd in effect be getting $13.59 per share. If they pay all of the $35.2 million plus 6.8 million shares, they'd in effect be getting $8.41 per share if they're retiring the debt at 12% off.

If they get a 14% discount down to $90.3 million, and they pay all of the $35.2 million plus 6.8 million shares, they'd in effect be getting $8.1 per share.

Add to the question marks that Iconix's more detailed SEC filing says they could potentially issue a bit over 8 million shares. In fact, some of the investor reaction came from concerns that the company was ready to do agreements that in essence would give shares to bondholders for $6 per share. That would be if all of the least favorable range of numbers to Iconix took place, and the company didn't have any clauses in place to make sure it didn't part ways with shares for low prices. Note that the press release says "The final number of a portion of the Shares may be adjusted based on a number of factors, including, among others, the volume weighted average price of the Common Stock during the term of the agreements and limitations imposed by a minimum share trading price on any trading day."

We don't know exactly how those factors affect the agreements, and we also don't know what all of the factors are. My assumption is that Iconix put the factors in there to ensure it gets a minimum amount per share. So we really don't know yet whether Iconix got a bad deal or a great deal in terms of the discount. My bet is that they probably got about $8 a share, which means they probably got a 14% discount on the debt, which I think is a good deal, and probably as good as we could reasonably expect.

What we do know: benefits of a significant decrease in debt

We do know that if the agreements all execute, the company's debt has been reduced by about 15%, and the dilution of shares in tandem with the savings on interest payments has initially reduced the EPS by about 7.3% from a mid-way point of $1.225 to a mid-way point of $1.135. To me, I'm very fine with that trade-off.

Overall, I also think the agreements are good in that it's taken a sizable amount of risk off the table. The albatross around Iconix's neck has been its high debt levels and a fear of default. The debt level has dropped 15% and the 2018 debt has dropped 25%, so the chances of default have greatly decreased. That over time will make new investors more willing to buy the stock.

Also, keep in mind that in about 18 months, Iconix will re-finance whatever 2018 debt it hasn't paid off. I guarantee they're not going to get a rate as low as 1.5% like the 2018 notes are. It won't be as high as the last round, but could well be 6% or 7%. So any debt they retire now has 3 benefits:

1) Buying it at a discount of probably between 10% to 14%. If Iconix only got a 10% discount, it's still saving $10.5 million. If it got a 14% discount, it's saving $14.7 million. Without this deal, the company (and us shareholders) would be paying that $10 million to $15 million in the future.
2) Saving some on interest in the next 18 months
3) Saving a lot on interest after about 18 months

Sizable gain in EPS coming

Also, investors seem to be focusing on the initial reduction of 9 cents in EPS and missing a key line about the EPS in the release: "This revision does not reflect a potential gain or loss on the repurchase of the Notes at a discount."

I believe they're saying that the company will be able to count whatever discount they get on the bonds as a gain in EPS after the agreements execute.

If they save about $12.6 million via a 12% discount, that is a gain of approximately 23 cents in EPS which is much more than double the 9 cent reduction they just announced.

If they manage to get a 15% discount, that's about $15.75 million, which is 28.6% and triple the 9 cent reduction.

Overall impact

Yes there is some dilution. But the company is:

* getting a large sized gain

* saving about 6% to 7% on interest payments for several years starting in 18 months

* removing a sizable risk factor that scared away many potential investors

* preserving more of its cash for possible acquisitions and/or to generate organic growth

Iconix's business and free cash flow have not changed at all in the last two days. The main changes are significantly lower debt, some dilution, lower interest payments and higher EPS. Ultimately it's a net positive for the company.

How to play it

For all of the reasons above, I don't think the stock price should have dropped at all on the announcement, so this represents another buying opportunity. If you look at every time I said in articles and the comments of articles that the stock price had dropped low enough to be a buying opportunity, the price gained between 8% and 25% in the ensuing two months. I overall recommend making your main Iconix position be a long-term buy and hold until it reaches $12 or higher.

When the price drops low enough to be a buying opportunity, I recommend considering buying extra shares for trading purposes and selling them at about 5% to 15% higher. If the price drops for example to $7.30, you get a 10% gain when the price goes to $8.03. That's well below $12, which is why I don't recommend trading your core holding in the stock. The long-term slope of the stock over the next 12 months will most likely be up significantly, so if you sell half or most of your core holding on hopes the price will drop, it might not and you'd lose on the long-term gain.

But if you mobilize trading cash when the price dips and sell it for gains, you'll retain the long-term gain of your main holding. Over the last 5 months, while not touching my core holding, I've made gains of over 60% just buying on the dips and selling when it goes up 5% to 15%. My normal "trading money" is $100,000, so I've made over $60,000 simply buying the dips the last 5 months. I think the worst that will happen is the stock will take several months to make a gain of 5% or more and my trading money will be tied up so I can't make short-term trades in other stocks.

That's not a problem, especially given that I rarely find other short-term trades which have so consistently paid off so quickly. And also given that I'm very confident in the stock for the long-term. I never recommend doing short-term trades unless it aligns with where the fundamentals say the stock should be in the long-term. For example, I never buy a stock as a trade that I think will go up in the near term but down in the long-term.

In the near term, Iconix now has a very high probability of two sizable gains that it's not including in current guidance. One is a highly probable gain of about 10 cents per share from the Complex Media sale. The other is the gain from the savings on the debt buy back, which I think will likely be over 20 cents. Those figures amount to a monster beat that I think will cause at least a 20% gain in the stock price. The stock often goes up 10% in a month on almost no news. 30 cents of increase in EPS will lead to a major gain in the stock.

In addition, the beat on the last earnings report indicates that the company is probably being very conservative in its EPS guidance, and possibly sandbagging to lower expectations.

When the price drops below $7.50 or $7.60, I suggest putting trading money to work to take advantage of it. When the price drops low enough such as when it went below $7.30 the day of the press release, I sell part of my positions in a few other stocks and mobilize it short-term to Iconix.

The overall S & P 500 at most is going to go up 4% by year end, and probably will be flat or down a few percent. I'd put the chances of ICON having 5% to 15% gains off those levels at some time in the next several months at 99.9%. Compared to the flat line that most other stocks are probably going to take for the rest of the year, a 99.9% probability of 5% to 15% gains is a great opportunity. And the chances are pretty high you'll be able to mobilize that money somewhere else in 1 to 3 months after taking profits.

Long-term strategy

If you've been on the sidelines, this is a great opportunity to establish a position in the company. As I've described before, institutional investors are ready to scoop up shares of ICON if the price falls below $7, so there's a strong floor under the stock and your downside is very limited. I forecast the stock will be at $11 by the end of the year.

The upside for the next 12 months is about $12 to $14, with the potential for mild to moderate annual gains from there. The rise to $12 to $14 will be easier simply because the company is so undervalued and has such strong free cash flow. Gains after $14 will be slower because they will depend entirely on growth.

The rise to $12 should occur if the company simply continues to stabilize, meets guidance, maintains its cash flow and uses a sizable chunk of its free cash flow to reduce debt. $14 should occur if there is a moderate amount of growth in sales/earnings over the next 12 months, which I think is very doable. After $12 to $14, I think the stock will become less of a great buy because it's likely its gains would be 5% to 12% per year based on growth.

For long-term investors, I recommend being very overweight at prices below $9 or $10, then gradually becoming regular weight as it approaches $12 to $14. At that point, the risk/reward will likely make Iconix closer to an average to good buy - something to possibly have in your portfolio but probably not a top holding. Cuneo, Haugh and Jones may prove me wrong on that, so I'm open to assessing the upside past $12/$14 in the future. But I wanted to provide what I currently think are price levels at which to start reducing your position in the future.

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.

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