Wednesday, August 31, 2016

Horsehead Holding stock is worthless

Horsehead Holding, a large zinc recycler, filed a petition in bankruptcy court earlier this year.

Horsehead had spent a lot of money--much of it borrowed at high interest rates--building a recycling plant in Moorseboro, North Carolina. The plant suffered from cost overruns during its construction and then, once it commenced operations, a series of technical problems prevented it from producing zinc in commercial quantities.

Horsehead is a publicly-traded company, and before its problems began, its stock was popular among value investors. Two of the stock's most prominent owners were the hedge fund managers Mohnish Pabrai and Guy Spier.

Since the bankruptcy filing, Spier has argued that Horsehead's assets are worth significantly more than its debts, and he convinced the judge overseeing the bankruptcy to let him form an equity committee--that is, a committee to represent the interests of Horsehead's stockholders in court.

I believe the stock is worthless, and I doubt the equity committee will be able to accomplish anything.

Stockholders face long odds in bankruptcy court

In a corporate bankruptcy, stockholders typically lose their entire investment. Less commonly, creditors sometimes make minor concessions--for example, giving stockholders 1-5% of the reorganized company--in order to hasten the bankruptcy process. Very rarely does a company emerge from bankruptcy with its pre-petition stockholders maintaining a meaningful stake in the business. I know of only three instances of that happening:

Texaco: In 1986, the oil producer Texaco lost a $10 billion judgment to Pennzoil and filed for bankruptcy. The filing was a tactical move to prevent Pennzoil from satisfying the judgment by seizing Texaco's assets. The company was profitable before and after it filed, and its assets were valuable enough that its debt wouldn't be impaired even if the $10 billion judgment were upheld.

Amerco: Amerco owns U-Haul, the popular truck-rental service. In 2002, its auditors forced it to consolidate an off-balance-sheet entity controlled by the company's management. The consolidation caused Amerco to violate its debt covenants while credit markets were in the middle of a crisis.

General Growth Properties: General Growth owns shopping malls. It filed for bankruptcy in early 2009 when the Global Financial Crisis prevented it from refinancing its debt. Many of the company's malls are considered high quality, and it was profitable before and after it filed.

You'll note that each of these companies had a healthy business that was earning economic profits. In each case, external events rather than operating problems precipitated the bankruptcy filing. Horsehead's current situation is the opposite: it went bankrupt because of extensive operational problems that are causing it to hemorrhage money.

A month before General Growth went bankrupt, a chemical manufacturer called Chemtura filed for bankruptcy for the same reason, an inability to refinance its debt. Several months after the filing, Chemtura's business was rebounding along with the economy, and the judge overseeing its bankruptcy allowed the stockholders to form an equity committee.

At that time, Chemtura's unsecured bonds were trading above par. Nonetheless, when it exited bankruptcy the following year, its stockholders received only a token stake in the reorganized company. By contrast, Horsehead's most junior debt issue, its convertible bonds, trade at pennies on the dollar. If a company where the creditors enjoy significant recoveries has minimal equity value, then Horsehead's stockholders are in a hopeless situation.

Stated book value isn't necessarily meaningful

Spier's argument hinges on the idea that the historic book value of Horsehead's assets, particularly Moorseboro, approximates their true value. There are both general reasons and specific reasons why he's wrong.

First, the general reason: An asset's book value reflects what that asset cost to build or buy. It says nothing about its ability to earn an economic return now or in the future. Accordingly, research suggests that price-to-book is a less reliable measure of value than price-to-earnings.

Next, the specific reasons:
1. We don't know how much additional investment Mooresboro needs before it can function profitably. The plant's problems may be so complex that no one knows how much additional investment it needs.
2. Every time Horsehead fixes one problem at Moorseboro, it has to shut down the plant temporarily. Each shutdown has the potential to cause other expensive problems.
3. Zinc recycling is a niche, so there's a limited number of potential bidders who have the necessary expertise to manage Horsehead's assets. This gives the bidders negotiating leverage and diminishes Horsehead's chances of getting full value in a sale.

When banks foreclose on construction loans, their losses are generally very high. This is especially true when they have to foreclose on unfinished properties. In 2009, Carl Icahn bought the unfinished Fontainebleau Resort in Las Vegas for little more than its underlying land value even though $2 billion had been invested in the property.

Moorseboro is a lot like the Fontainebleau--it's beset with problems, it's nowhere near finished, and it needs a lot more time and money before it can have a shot at working--and I think Moorseboro will eventually be sold for a token price like the Fontainebleau was.

Edit 9/1/16: Commenters have mentioned American Airlines, Meruelo Maddux, and US Gypusm as three other companies that emerged from bankruptcy with their pre-petition stockholders making a significant recovery. Thanks to Colin Lee, variantperceptions, and IntelligentSpeculator, respectively, for these examples.

Saturday, July 2, 2016

Book review: "Everybody Wins! A Life in Free Enterprise" by Gordon Cain

Despite what its title suggests, Everybody Wins! A Life in Free Enterprise isn't an encomium to capitalism. Instead, it's the autobiography of Gordon Cain, a businessman who led four leveraged buyouts in the chemical industry during the 1980s. All of Cain's LBOs were wildly profitable: the best returned 240x its initial investment, while the worst returned a still-phenomenal 22x.

Cain wasn't a typical buyout sponsor: he was over 70 when he completed his first LBO, having spent most of his adult life until then as a manager in the chemical industry. But he wasn't a typical corporate manager, either. He was a freelance turnaround expert, helping several chemical companies salvage value from money-losing operations.

In this capacity, he acted purely as agent except for one instance: early in his career, he bought a failing perlite kiln and tried to turn it around. After three years of losses, he was broke and had to give up on the business. Unfortunately, the only turnaround in which he risked his own money was his only failed turnaround.

Cain's entry into the world of leveraged buyouts was accidental. In 1982, he joined a small mergers-and-acquisitions advisor called The Sterling Group after a heart attack forced its founder to retire. Sterling had arranged the sale of a building-products company called Balco, but the prospective buyer backed out at the last minute, so Sterling stepped in and acquired Balco itself.

This piqued Cain's interest in doing more LBOs. Undercapitalization and bad luck prevented Sterling from completing its next acquisition for two years, but when it finally happened, it was a far bigger deal than Balco: Sterling bought Conoco's chemical business for $600 million.

The acquisition of a fertilizer business followed later that year. In 1985, Sterling acquired several low-margin businesses from Monsanto. In 1987, it pieced together a collection of plants that produced ethylene and ethylene derivatives. All of these deals were exceptionally successful, earning levered returns of 2,000% or more within a few years.

High returns weren't the only thing that made the deals notable. Each LBO also included generous employee-ownership and profit-sharing plans. In each case, the executives got rich, many middle managers became millionaires, and even ordinary employees earned windfalls.

Reasons for Cain's success

I attribute Cain's success as a buyout sponsor to six things:

Domain expertise. He spent decades in the chemical industry as an operator, so he was better able to judge potential acquisitions than most buyers.

Contrarianism. He bought a styrene plant when demand was growing several percent a year but low prices had deterred the industry from expanding supply. He bought an ethylene plant when it had lost money for seven years and no new plants had been built during the same period. At that point, ethylene prices were near at a multi-year low even though the industry was operating at 94-95% of capacity.

Motivated sellers. Many of the plants he purchased were small, low-margin divisions of large companies. One purchase was a joint venture run by three companies with different interests–one of the three was the plant's biggest supplier of raw materials, while another was its biggest customer. The seller of Cain's fertilizer acquisition wanted to sell so that it could report the loss-making business as a discontinued operation. This seller took subordinated debt as partial consideration, effectively financing the acquisition for him.

Efficiency improvements. Since the acquired plants were previously part of large companies, they had few quality problems, but working-capital management and transportation were usually inefficient. In many cases, Cain was able to save money while taking money out of the business.

Good incentives. He implemented profit-sharing plans and solicited employee suggestions for how to improve efficiency.

Favorable financing. From 1984 to 1986, interest rates plunged and junk bonds became popular investments, enabling Cain to refinance his early acquisitions at favorable rates and pay the stockholders huge special dividends.

A well-written book with useful details

Cain is a good writer–he avoids the cliches and dead metaphors that make most business books painful to read. He also includes many financial details that will be of interest to investors. For each acquisition, he provides a breakdown of how financing was raised and how the money was spent.

Also interesting is his description of the mechanics of making an acquisition. Among other things, he mentions that:

• Prospective lenders often backed out at inopportune times. Bankers Trust almost ruined one of his deals by backing out at the eleventh hour.

• Many banks wouldn't lend to him unless he arranged long-term contracts for some of the acquired plants' output.

• He found big deals easier to do than small ones. Small deals required negotiating with junior managers, who would then need the approval of higher-ups to consummate any transaction. Large deals meant dealing directly with the higher-ups.

• Every acquisition he did had unforeseen delays. Sometimes aggressive lawyers, whom he calls "legal gladiators," delayed acquisitions by haggling over points that weren't important to either side.

• Lenders and ratings agencies were obsessed with numbers and had little understanding of the chemical industry's competitive dynamics.

• To sell junk bonds, he had to do "road shows" in which he met with prospective bond buyers. He found the road shows useless for raising money. Typically, whether or not someone bought his bonds depended on whether "they were satisfied with the last issue they bought from" the underwriter.

• Developing accounting and computer systems for the companies that he acquired was a big challenge. Each of these companies had previously been part of a much larger corporation and had never needed its own systems before.

Compounders don't have a monopoly on high returns

Cain's experience shows that compounding businesses don't have a monopoly on high financial returns. With the benefit of leverage, he earned phenomenal returns in a stereotypically mediocre industry. Even on an unlevered basis, his acquisitions quickly earned back their purchase price.

The key to his success was acting countercyclically–he invested money in the chemical industry when shortages were likely to lift margins far above their long-term average. Later, when margins normalized, he extracted capital rather than reinvesting at low expected returns.

Cain's attitude was far from the norm. As the book describes it, most chemical manufacturers were terrible capital allocators and invested pro-cyclically. Paradoxically, their bad investing was what made his strategy so lucrative–without overinvestment leading to prolonged gluts and disillusioning chemical producers, he never would have been able to make his acquisitions so cheaply.

Friday, July 1, 2016

Book review: "Capital Returns" by Edward Chancellor

Marathon Asset Management is a successful investment manager in London. It manages seven funds with long track records and, remarkably, each fund has beaten its benchmark by a wide margin over the past three, five, and ten years.

Capital Returns is a collection of letters that Marathon wrote to its investors between 2002 and 2015. The letters discuss individual investments that Marathon made, but they also act as showcases for the firm's investment philosophy, which emphasizes the importance of a phenomenon that it calls the capital cycle.

According to Marathon, the capital cycle has four stages:

• The prospect of high returns attracts new entrants to an industry
• Rising competition pushes returns below the cost of capital
• Business investment declines, the industry consolidates, and some firms exit
• Improving industry dynamics push returns above the cost of capital

Besides the cycle itself, Marathon cares about "how management responds to the forces of the capital cycle and how they are incentivised," i.e., how disciplined they are with regard to capital allocation. It also likes to invest in industries that are insulated from the cycle because they have strong barries to entry. Conversely, it avoids industries in which regulations and political meddling lead to chronic overinvestment.

Despite Marathon's prodigious investing success, I found Capital Returns underwhelming. Three things turned me off the book:

One, it's a greatest hits collection. All of the letters describe profitable investments Marathon made or unprofitable investments it avoided. Presumably there are times when the capital cycle is overwhelmed by other forces, and presumably it's possible to misjudge the cycle, but the book gives no such examples. Failure is often more instructive than success, so that was disappointing.

Two, the ideas are basic. Marathon may be the first firm to make the capital cycle the focus of its investing strategy, but sophisticated investors generally understand the concept. For instance, over the past few years many financial commentators have predicted that overinvestment in the mining industry would reduce its profits.

Three, while the letters are well-written, they're essentially all variations on the same theme. I think the letters are best seen as a form of marketing to Marathon's investors. By writing about the same topic every quarter, Marathon creates an image of thoughtful consistency. But the repetition that makes the letters successful as propaganda makes them tedious as a collection of essays.

Edward Chancellor's comments

Edward Chancellor compiled and edited the essays in Capital Returns. He also wrote its introduction, in which he summarizes Marathon's ideas and offers some of his own opinions. I think this is the best part of the book: it's more succinct than the essays, and his opinions by themselves are worthwhile.

Chancellor posits several reasons why the capital cycle happens. It's human nature to extrapolate the recent past forward. Many industries have low barriers to entry, so they're periodically flooded with new investment. Corporate managers garner higher salaries and greater prestige from managing larger companies, so they have an incentive to reinvest and make acquisitions regardless of likely returns. Investment bankers earn fees when their clients expand, so they likewise favor investment regardless of returns.

He writes that investment drives mean reversion for individual companies, industries, and entire countries:

Firms with the lowest asset growth have outperformed those with the highest asset growth.

Corporate investment in most developed economies... is a significant negative predictor of aggregate profitability.

Provocatively, he argues that value investors owe much of their success to timing the capital cycle:

[E]xcess returns historically observed from value stocks and the low returns from growth stocks are not independent of asset growth...

[M]ean reversion is driven by changes on the supply side which value investors who consider only quantitative measures of valuation are inclined to overlook.

Conversely, when value investors buy statistically cheap stocks but ignore the cycle, they're likely to lose money, as they did with housing stocks in 2006-08.

Drawing on Marathon's ideas, Chancellor makes two recommendations. One is to focus on supply rather than demand:

Supply prospects are far less uncertain than demand, and thus easier to forecast.

Another is to be an investing generalist. "Analysts with highly specialized knowledge of an industry are prone to" looking at their industry in isolation, whereas generalists consider historical comparisons:

[I]ndustry specialists end up not seeing the wood for the trees. They may, for instance, spend too much time comparing the performance and prospects of companies within their sector and fail to recognize, as a result, the risks that the industry as a whole is running.

I would qualify this criticism, however: I think that specialization is actually the key to Marathon's success. But rather than an industry, it specializes in an economic dynamic that affects numerous industries. This gives it focus that generalist lack while avoiding the tunnel vision that afflicts many industry specialists.

Wednesday, June 1, 2016

Articles of interest

Russell Clark of Horseman Capital warns about risks in the aircraft-leasing market.

Nate Tobik from Oddball Stocks describes what makes a bank successful and how he's playing an expected wave of consolidation in the American banking industry.

Alice Schroder talks to The Motley Fool about Warren Buffett's personality and his career.

Bull, Bear & Value has an impressive write-up of British Columbia Power, a special situation that Buffett and Charlie Munger owned in the early 1960s.

Vienna Capitalist argues that "corporations have been the marginal buyer of US equities" through stock buybacks. The article is from a year ago but still very relevant.

At Base Hit Investing, guest author Connor Leonard writes about companies with "reinvestment moats," i.e. the combination of a defensive business and the ability to grow while earning high incremental returns.

Credit cards
Jana Vembunarayanan offers a detailed history of credit cards.

Declining businesses
Matt Brice describes why declining businesses are bad investments, using Outerwall as an example.

Government debt
Credit Bubble Stocks offers a downbeat assessment of government bonds, particularly long bonds.

Fritz argues that Indonesian banks are economically vulnerable and richly valued.

Industrial gases
Dislocated Value provides a detailed overview of the industrial-gas sector.

Jerry Neumann argues that "innovation comes in waves: great surges of technological development followed by quieter periods of adaptation."

Interviews interviews Robert Wilson, a phenomenally successful private investor. Speaking in 2000, Wilson predicts that the stock market will do poorly and that short-selling will become more competitive. He also comments on Warren Buffett, Julian Robertson, and George Soros. Part one and part two of the interview (h/t Brattle St. Capital).

SATT Global Research writes about South Korea's alarmingly high level of household debt.

A BusinessWeek article describes how Al Dunlap ran Sunbeam into the ground while misrepresenting the company's financial condition (h/t Dorsia Capital).

Morgan Creek Capital Management has a nice overview of George Soros's career that discusses his concept of reflexivity and its importance to investing.

SmartBusiness profiles Charles Stack, who developed the first online bookstore before losing out to Jeff Bezos and

Tom Jacobs talks about Maurece Schiller, who's largely forgotten today but was a pioneering theorist of special-situations investing during the 1950s and 1960s.

Back of the Envelope has a detailed analysis of Catella, a Swedish financial conglomerate.

Venture capital
"georgesmith" from the EEVBlog forum argues that uBeam's technology is fundamentally flawed and laments that "Unfortunately, in the world we live in, receiving VC funding doesn't show a company's science is sound."

Tuesday, May 24, 2016

Book review: "The Very, Very Rich and How They Got That Way" by Max Gunther

Before Forbes began publishing its list of the 400 richest Americans, Fortune magazine compiled its own annual rich list. Max Gunther's The Very, Very Rich and How They Got That Way profiles fifteen self-made millionaires who were featured on Fortune's lists during the late 1960s and early 1970s.

The Very, Very Rich is haphazardly written: Gunther wrote some of the fifteen profiles, but others are reprints of older magazine articles. Interspersed among the profiles are digressions about financial history, the psychology of the rich, and the role of luck in making money. The book is worth reading because it describes people and events that, despite their importance to financial history, are largely forgotten today. But don't expect it to have any logical organization or narrative flow.

Demographics of the ultra-rich

The ultra-rich from 40-50 years ago were a very different group from today's billionaires. Gunther mentions that more than half of the people on Fortune's 1968 list inherited their money.

Many of today's most prominent billionaires, like Bill Gates, Larry Page, and Mark Zuckerberg, went to elite colleges and became rich while they were still in their twenties. Academic success and early wealth weren't the norm for Gunther's subjects. Most of them started businesses during their twenties but didn't really make it until their thirties or even later. At the extreme end was Ray Kroc, who spent most of his adult life as an unsuccessful salesman before he came up with the idea for McDonald's at age 52.

Only one of Gunther's subjects, William Benton, attended an Ivy League college. Appropriately, he got rich by publishing Encyclopedia Britannica. Most of his subjects lost parents to death or divorce while they were young; they were also themselves far more likely than the general public to divorce.

Notable profiles

Joe Hirshhorn: Hirshhorn became rich in the 1920s by speculating in the stock market and got out before the market crashed in 1929. (The book isn't clear about whether his getting out was luck or foresight.) Later, he became an investor in the Canadian mining industry. Most of the mining companies he bought into were small and speculative, but he generally made money.

In the 1950s, he staked a geologist who discovered an enormous uranium deposit in Northern Ontario. They assembled a large mining claim in the area and then sold it to Rio Tinto for a windfall profit.

Most commercial geologists never find a deposit that's capable of supporting a profitable mine, so the discovery that made Hirshhorn's fortune was a total fluke. But I think one can say that his skill—specifically, his knowledge of mining and the investing savvy that made him rich enough to stake new ventures—put him in unique position to capitalize on that kind of fluke.

Daniel Ludwig: Ludwig was small, unsuccessful shipowner until his late thirties, when he acquired surplus ships from the US government at a bargain price. He then pioneered a new way to finance the acquisition oil tankers and grew rich after World War II. In 1982, when Forbes published its inaugural list of the richest Americans, Ludwig was in first place.

You can read his chapter here.

Jeno Paulucci: Paulucci created a brand of fake Chinese food called Chun King, grew it using innovative television advertisements, and sold it to R.J. Reynolds for nearly $63 million in 1966. When he died in 2011, however, his estate was worth only $150 million. While the story of how he made his fortune is interesting, I think the story of how he subsequently failed to grow it at even the rate of inflation would be more interesting.

Clement Stone: Stone began selling insurance as a teenager, and by his late twenties he was the founder and head of a successful insurance agency. He managed to grow the agency during the Great Depression, and in the late 1930s he received his big break: a financial conglomerate wanted to sell a small insurance company it owned, and it was willing to let it go at a bargain price. Stone didn't have enough money to buy it, but he convinced the seller to lend him the entire purchase price. Over the next few decades, he transformed the acquisition into a major insurance underwriter.

That acquisition, as advantageous as it was for Stone, isn't historically unique. Conglomerates are often dumb, motivated sellers, and buying from them is an underappreciated way to get rich. A few similar examples:

• In 2003, BHP Billiton wanted to sell the minority interest it owned in an Argentine gold/copper mine. It sold it to Northern Orion at a price below net asset value and offered financing for part of the purchase. The sale took place a month before the commodities bull market took off.

• In 1977, a conglomerate called National Kinney sold a collection of Manhattan office buildings to the Reichmann family for $325 million. The buildings were sold at a low enough valuation that the Reichmanns were able to borrow nearly the entire purchase price. Eight years later, the buildings were worth more than $3 billion.

• In 1982, Wesray acquired Gibson Greetings from RCA for $80 million. As with the Reichmanns' acquisition, Wesray bought Gibson cheaply enough that they could borrow nearly the entire purchase. Gibson went public at a $290 million valuation sixteen months later.

Monday, May 23, 2016

Predicting long-term winners is difficult

In the past few years, compounders—companies that can steadily compound their earnings and equity value over long periods of time—have captured investors' attention.

The allure of compounders is easy to see: Day traders have to find new trades all the time. Event-driven investing is less hectic than day-trading, but event-driven investors still have to search regularly for new ideas. By contrast, buying compounders necessitates no endless search for new investments. Instead the compounders naturally grow, doing the investor's work for him.

As elegant as that is in theory, it's not always easy in practice. Some companies that look like long-term winners turn out to be dogs. Valeant and Ocwen Financial are two faux-compounders that have imploded recently. The opposite can also happen: some apparent dogs turn into long-term winners, with their success being largely unforeseeable. Here are three examples.

Atlantic Tele-Network

Atlantic Tele-Network (ATNI) acquired Guyana's telephone monopoly in 1990. During the 1990s, it acquired other telecom assets in the Caribbean before splitting them off into a separate public company in 1998. Since then, ATNI's stock has appreciated 2150%—a 19% annual return over 17 1/2 years. Dividends increase the annualized rate of return to 24%.

Two acquisitions are responsible for most of this prodigious appreciation. In 2005, ATNI acquired Commnet, which operates "wireless base stations" in sparsely populated areas. It paid $59 million for Commnet, which will produce $75 million of EBITDA this year.

In 2009, ATNI acquired 900,000 wireless subscribers from Alltel when it merged with Verizon. ATNI paid $200 million for the subscribers, invested another $100 million in the acquisition, and sold it to AT&T for $800 million in 2013.

But before 2005, there was nothing in ATNI's history that suggested it was capable of making successful acquisitions. From 1990-98, ATNI's stock lost 60% of its value. The Caribbean telecom company that was split off in 1998 later went bankrupt. In 1998 and 2000, ATNI bought two Haitian telecom companies that it had to write off in 2001. In 2001, it invested in a bandwidth-trading company that filed for Chapter 7 bankruptcy less than a year later. Other money pits included a Guyana-based call center and a collect-call business. The entrepreneurial acquisition strategy that eventually made ATNI a home run incinerated money for years.

Tractor Supply

Tractor Supply (TSCO) operates "rural lifestyle retail stores," i.e. stores that cater to hobby farmers. Since its all-time low in late 2000, TSCO stock has appreciated a phenomenal 18,700%, or 40% annualized over 15 1/2 years. The company has achieved these returns by retaining most of its earnings and reinvesting them at high incremental returns.

But before 2001, TSCO's results suggested it was a below-average business. From 1995-2000, TSCO grew earnings per share only 6% per year despite retaining all earnings. It earned $70 million from 1995 through 1999, yet earnings were only $4.25 million higher in 2000 than in 1995. From 1994 to 2000, TSCO stock fell 60%.

In early 2001, soon after the stock began its upward rampage, "Charlie479" from Value Investors Club wondered if TSCO's business model doomed it to poor returns:

It seems to me that it's competitive strategy is precisely the one that anchors it to mediocre returns on capital. If the stores' attraction (indeed, the key to their 5-10 year survival against the big boxes) is the hard-to-find, slow-turning item that the Home Depots or Lowes won't stock, then a large inventory is a permanent part of this company's operating model. This large working capital requirement translates into high capital requirements for the business... I think the economics of the business will produce only average market returns over the long term.

Ball Corporation

Ball Corporation (BLL) makes aluminum cans. Since March 2000, BLL stock has risen more than 2000%, or 22% annually. Over time, the can-making industry has gradually consolidated into an oligopoly, increasing the pricing power that BLL and its competitors enjoy. Notably, BLL has been active in acquiring its rivals, so it's been both an instigator and a beneficiary of this trend.

Consolidation's benefits didn't materialize immediately, however. BLL and its competitor Crown, Cork & Seal made numerous acquisitions during the 1990s, yet in early 2000 BLL's stock traded at a price it had first reached in 1985. Even including dividends, the stock barely kept pace with inflation over that fifteen-year period.

Another thing these three companies have in common, along with the improbability of their stock-market performance, is that they've all benefited from multiple expansion. At their 2000 lows, BLL and TSCO traded at 5.5x trailing free cash flow and 4.5x trailing earnings, respectively. Today they trade at 20x and 27x this year's estimated earnings.

ATNI traded at less than 3x earnings in 1998. Today it's difficult to value because it owns a mix of businesses that produce steady earnings and asset-rich projects with minimal reported earnings, but one investing pitch suggests that the market is valuing ATNI's operating businesses at double-digit earnings multiples.

Sunday, May 22, 2016

Book summary: "King Icahn" by Mark Stevens

Below is a summary of Mark Stevens's King Icahn, a biography of Carl Icahn. It's an interesting book about an interesting guy, and I've tried to capture the highlights.

Early life and career

Carl Icahn was born in 1936 to a family of modest means and grew up in Queens, New York. He was the first student from his high school to be accepted to Princeton University. After finishing college, he enrolled in New York University Medical School at his mother's behest, but he hated clinical work and dropped out after a patient with tuberculosis coughed on him.

After quitting med school, he joined the army reserves and completed four months of basic training at a military base in Texas. During training, he won $4,000 playing poker. Upon returning to New York, he began trading stocks, and in less than two years he parlayed his poker winnings into more than $50,000 before losing everything in the June 1962 market crash.

Icahn had rented an apartment before going broke. With no money left to pay the rent, he sold his car and subleased the apartment to an older man who used it as a love nest. His benefactor also used it to host poker games:

Sometimes the guy would use the place for these marathon poker games as well,” Icahn recalls. “When I returned after these sessions, the place reeked so badly of cigarette smoke that I had to keep the windows open for three days at a time to get the stench out. It was a hell of a way to live, but my ‘partner’ paid half the rent...

He recovered from this by becoming a successful options broker for Gruntal & Company. At the time, options were traded over the counter rather than on an exchange. Pricing was opaque, and brokers often ripped off their customers. To establish his reputation, Icahn published a newsletter listing suggested prices for different options based on recent transactions. He also negotiated aggressively with other brokers on behalf of his clients.

These efforts to make pricing fairer won him customers but alienated the more established options brokers, who made a secret agreement among themselves not to trade with him. The agreement quickly fell apart, however, as the conspirators defected:

Each of the option brokers who were party to the ‘secret’ deal called me on the sly. Real hush-hush they said, ‘Look, Carl, the other guys don’t want to do business with you. But I think you’re a great guy so I’m going to break ranks. You’ll have my business—just don’t tell the others.’ It was comical.

After several years as a broker, Icahn convinced a rich uncle to lend him $400,000 so he could buy a seat on the New York Stock Exchange. He used the seat to start his own brokerage firm in 1968 and became a successful arbitrageur. One form of arbitrage he pursued was buying closed-end funds that traded below their net asset value.

That evolved into a more general strategy of investing in companies trading below asset value. The high inflation of the 1970s raised the liquidation value of companies with hard assets, but it also depressed stock-market valuations, with the result that many small companies were deeply undervalued.

Icahn created a partnership to invest in these companies, writing in the partnership's offering memorandum that:

It is our contention that sizeable profits can be earned by taking large positions in ‘undervalued’ stocks and then attempting to control the destinies of the companies in question by: a) trying to convince management to liquidate or sell the company to a ‘white knight’; b) waging a proxy contest; c) making a tender offer and/or; d) selling back our position to the company.

In 1977 he turned to his first target, a stovemaker named Tappan Company. Tappan had a book value of $20 per share but the stock was trading at just $7.50. It had just reported its first annual loss in four decades, but Icahn expected a turnaround. Over the next two years he steadily increased his stake in the company, pressured it to sell itself, thwarted management's attempt to block takeovers by issuing preferred stock, and gained a seat on the board of directors.

Electrolux acquired Tappan in 1979 for $18 per share, a 50% premium to the market price at the time. Although the company had initially resisted Icahn, its chairman was so impressed with the takeover premium that he invested $100,000 in Icahn's partnership.

Icahn's second target was an externally-managed REIT named Baird & Warner. In 1978 Baird traded at $8.50 per share, but its book value was $14 and Icahn thought that its liquidation value was even higher. He bought 20% of Baird's stock and demanded that it give him a seat on its board of directions.

Baird refused, and Icahn prepared to launch a proxy battle. His odds of success improved when management reacted to disappointing financial results by omitting the REIT's dividend, thereby angering shareholders. Icahn added fuel to the fire by drawing attention to several related-party transactions that the management company had executed at Baird's expense.

Under pressure, Baird agreed to liquidate, but this didn't satisfy Icahn because the REIT's board of directors owned relatively little stock and thus "had no vested interest in ensuring that the liquidation proceeded in the shareholders’ best interests." He boosted his stake in Baird to 34%, which was enough to block any plan of liquidation the company proposed. He then took control of the company through a proxy contest and began selling its assets, using the resulting cash as ammunition for his later takeover battles.

His third act as a corporate raider nearly ended his career. In late 1979 he bought 5% of Saxon Industries, a paper and copier company, and pressured the company to sell itself. Instead, Saxon's management offered to repurchase Icahn's stock at a premium to the market price—that is, it offered to pay him greenmail. After a round of negotiations, he accepted.

Unbeknownst to him, Saxon's management had a very good reason to prefer paying greenmail to selling out: the company was overstating its earnings and assets, something that a potential acquirer would have discovered while performing due diligence. If this fraud has caused Icahn to lose money, his fledgling reputation would have been destroyed:

[I]f Carl had gone through with the Saxon deal, he would have been finished right then and there,” said a former Icahn adviser familiar with the transaction. “Don’t forget, he wasn’t the Carl Icahn yet. He was just another guy with an idea for making money. Into only his third raid, he was on the verge of making a tremendous blunder. Had he done that, he would have looked like the world’s biggest schmuck.”

Icahn followed his Saxon raid by taking greenmail from several other companies: Hammermill Paper, Simplicity Pattern, Owens-Illinois, American Can, and Anchor Hocking. In each case, he flipped the stock for a quick 15-30% gain that he magnified with borrowed money. His willingness to take greenmail showed that "In spite of his proclamations heralding the glories of corporate democracy, in practice Icahn’s real-world persona was that of a shrewd arbitrageur who had found a weak link in the corporate system and was determined to exploit it for personal gain."

Icahn enters the big leagues

In 1982, Icahn acquired 30% of the department store chain Marshall Field. It was far larger than his previous targets, and when it sold itself to a white knight several months later, his profit was also far larger: $30 million versus less than $5 million for most of his earlier raids. Marshall Field was also the first company for which other raiders piggybacked on Icahn's actions.

During the same year he went after Dan River, a textile manufacturer in Virginia. After he acquired 29% of Dan River's stock, the company went private in order to safeguard its independence. The going-private transaction involved its pension fund converting into an employee stock ownership plan and the buying all of its outstanding stock. Employees saw their retirement funds evaporate in the next few years as Dan River suffered from aggressive foreign competition, but the buyout left Icahn and his limited partners $8 million richer.

In 1983 Icahn made $19 million taking greenmail from Gulf & Western, and in 1984 he made $41 million from B.F. Goodrich. In 1984 he also made his first acquisition of a whole company, buying ACF Industries, a manufacturing conglomerate, in a leveraged buyout. The buyout brought him into Drexel Burnham Lambert's orbit: Drexel helped ACF issue junk bonds, the proceeds of which Icahn used for future raids.

Drexel did Icahn an even greater service the next year when it financed his biggest raid yet: a takeover offer for oil behemoth Phillips Petroleum. Another corporate raider, T. Boone Pickens, had taken greenmail from Phillips in late 1984. Icahn tried the same thing just a few months later. Drexel supported Icahn with a "highly confident" letter, stating that it was confident it could finance Icahn's offer but stopping short of making a formal commitment. This was the first time that Drexel issued a highly confident letter, although it became a staple of Wall Street dealmaking during the late 1980s.

Eventually Phillips agreed to a recapitalization plan that boosted its stock price and earned Icahn $50 million. The recapitalization greatly increased Phillips's debt load, exacerbating the company's problems when oil prices crashed at the end of 1985, but by then Icahn had sold his stock. The Phillips raid, like his previous raid on Dan River, enriched him while leaving his target much weaker.

Icahn made his second whole acquisition in 1986 when he bought Trans World Airlines. TWA had few defenses against a buyout because "the beleaguered carrier, whose cumulative profits over the years had been virtually wiped out by an equal volume of losses, never expected to hear a raider knocking at the door, [so] it had failed to install the legal defenses most of corporate America had already put in place."

Nonetheless, management invested considerable energy in trying to repel Icahn. And that wasn't his only obstacle to acquiring TWA: he soon found himself in a bidding war for the company with Frank Lorenzo, the president of Texas Air. Two things allowed Icahn to win: first, Lorenzo failed to lock TWA into an ironclad merger agreement because he assumed that his rival merely wanted to flip TWA's stock for a quick profit. Second, in 1983 Lorenzo had taken his airline through a voluntary bankruptcy in order to renegotiate union contracts at lower wage rates. This made him an object of intense hatred among airline workers and turned Icahn, despite his reputation as a corporate liquidator, into a white knight.

The prospect of a Lorenzo takeover allowed Icahn to extract large concessions from TWA's unions. He also won concessions because he was a uniquely aggressive negotiator:

Icahn scheduled late-night meetings so that he could attack his adversaries when they were bush-tired, mushy-brained and eager to go home.

“I remembered a meeting during the TWA negotiations that was scheduled to start at 9 P.M.,” recalled TWA’s investment banker, Mike Zimmerman, of Salomon Brothers. “As it turned out, Carl didn’t show up until eleven. While everyone else was negotiating, he went home, napped and showered. By the time he made his entrance, the TWA people looked like trash and Carl walked in looking like a million bucks.”

“Carl wears you down,” said former pilots’ representative Tom Ashwood. “He negotiates into the night. Five, six, seven hours. He’ll ramble on about baseball and artificial insemination. Then when you lose your train of thought, he’ll pick up right where he left off, hammering at a point he wants to make.”

Despite the concessions, TWA was far less successful than Icahn's previous investments. He underestimated how much domain-specific knowledge he needed to run the airline, overestimated its ability to generate cash, and overpaid for it because he fell in love with its glamorous history:

“When Carl took over, he was very cocky,” said Edward Gehrlein, TWA’s former vice president of sales. “He loved the idea of running an airline. At one Christmas party the executive staff exchanged gifts. The staff gave Carl a leather jacket, a silk scarf and a World War I aviator’s helmet, and he paraded around the office like a combat ace. He ate it up.

“But he didn’t understand the leverage in the business... he was amazed to see how a penny increase in fuel prices could cut earnings by about $14 million... This kind of leverage really surprised him. He didn’t have the experience in the business to understand it.”

Success at Texaco, failure elsewhere

After the 1987 stock market crash, Icahn made the defining investment of his career.

In 1984, Getty Oil had agreed to merge with Pennzoil, but the oil giant Texaco made a rival bid for Getty and acquired the company. Pennzoil sued Texaco for tortious interference, and in 1985 it won a $10.5 billion judgment. Texaco appealed the verdict and obtained an injunction blocking Pennzoil from seizing its assets to satisfy the judgment, but in April 1987 the Supreme Court lifted the injunction, forcing Texaco to file for bankruptcy to prevent asset seizures.

The bankruptcy was strictly tactical: at the time, Texaco's book valued exceeded $20 billion, so it had the wherewithal to pay the full judgment and remain solvent. And that was a worst-case scenario. Most investors expected the judgment to be reversed on appeal or settled for a smaller amount, and some of them saw Texaco's stock as a bargain.

One such bargain hunter was Robert Holmes a Court, an Australian corporate raider, who spent almost a billion dollars buying 24 million Texaco shares. He borrowed heavily to do so, and after the 1987 stock market crash his lenders pressured him to sell assets. Icahn offered to buy half of his shares, and he accepted.

In December 1987, the judge overseeing Texaco's bankruptcy gave a committee of the company's stockholders the right to negotiate with Pennzoil and propose a settlement to the court. The committee duly negotiated a $3 billion settlement. Notably, Icahn played no role in the settlement—he was excluded from the committee because he wanted to continue buying Texaco stock, which would've been considered insider trading if he'd joined. And before the deal with Pennzoil, Icahn had actually expressed a willingness to settle for $4 billion or more.

After the settlement, Icahn bought the other half of Holmes a Court's Texaco stake. He also bought millions of shares on the open market both pre- and post-settlement, using extreme leverage: ACF and TWA had issued junk bonds, and he used the proceeds to buy Texaco stock on margin. He'd leveraged his investments this way before, but never on such a scale.

Icahn pressured Texaco's executives to conduct a large tender offer for the company's stock and finance it by selling many of its assets. They refused, and Icahn launched a proxy contest for control of Texaco's board of directors. He lost but exerted enough pressure that management agreed to sell two foreign subsidaries, Texaco Canada and Deutsche Texaco, and use the proceeds to pay a large special dividend. Texaco stock rose, and Icahn cashed out with a $500 million profit on a $1.5 billion investment.

Icahn's other investments during the late 1980s failed to match this success. In 1986 he bought a large stake in USX, the parent of U.S. Steel and Marathon Oil. When he sold the stake five years later, his profit was small enough that "he would have fared better by investing his money in T-bills over the same period of time."

Nor was his investment good for USX. The raider pressured USX to sell assets and buy back stock; it complied by selling a 51% stake in the short-line railroads that served its steel plants to Blackstone Group. The railroads earned a better return than USX's core steelmaking business, so the sale was an example of "pulling out the flowers and watering the weeds," and it occurred at a bargain price. As David Carey writes in King of Capital:

Blackstone got everything it bargained for: a sturdy business on the rebound, which it had snared for an extraordinarily low price of four times cash flow. That was one-third to one-half below the stock market valuations of most railroads...

A little more than two years after the deal closed, Blackstone had made back nearly four times the $13.4 million it had invested. By 2003, when Blackstone sold the last of its stake in a successor to Transtar to Canadian National Railroad, the firm and its investors had made twenty-five times their money and earned a superlative 130 percent average annual return over fifteen years.

Icahn became more bearish at the end of the 1980s. The arrests of Dennis Levine and Ivan Boesky unnerved him, as did the subsequent collapse of Drexel Burnham Lambert, which had financed many of his corporate raids.

He read a book called The Great Depression of 1990 and worried that the stock market would collapse, although that didn't stop him from investing in leveraged cyclicals like USX. (There was a similar contradiction between his beliefs and actions last December, when he called the junk-bond market "a keg of dynamite" even though he owned large equity stakes in several junk-bond issuers.)

But by far the biggest reason for Icahn's pessimism was TWA.

In 1988, he took the airline private through a leveraged buyout. By then it had swung from a loss to a modest profit, partly because of improving dynamics in the airline sector and partly because of concessions he'd wrung from TWA's unions. This improved profitability, along with a frothy market for junk bonds, allowed him to replace all of the airline's equity with additional debt. The result was that he cashed out his entire investment in TWA along with a 19% profit while maintaining control of the airline.

Operating results deteriorated soon after the buyout, and the additional leverage didn't help. Icahn offered TWA to several prospective buyers, but they all declined because his asking price was too high. He also tried, and failed, to sell the airline piecemeal:

“Carl kept thinking that if he couldn’t sell TWA as a company, he could do an orderly liquidation of the business,” said Kent Scott. “But in the airline business, there is no such thing as an orderly liquidation. One plane can be worth $7 million but try to sell fifty and they are worth $3.5 million each. Also, Carl doesn’t want to be in the position of having to sell a load of planes to a buyer like American’s Bob Crandall, if Crandall knows Carl has to sell.”

Marty Whitman, the mutual fund manager, described the root of Icahn's problems with TWA:

“Carl is a smart Neanderthal. He’s a Neanderthal because he doesn’t listen. He has fixed ideas. He doesn’t see that you can make money by investing in a business. He only wants to cash out—to get cash flow. He doesn’t understand that most of the great businesses built in this country were cash consumers. They used public markets and consumed cash to build fabulous wealth for their owners. But Carl just wants the cash-out approach.

“The characteristics that made Carl a great arbitrageur made him the worst guy to run TWA. He’s demonstrated that he couldn’t manage an operating business. He can’t play the reorganization game with troubled companies.”

A representative of TWA's pilots union was less charitable:

"Icahn was, and is, a financial engineer. He can’t run a business. He can’t run a corner deli. If he ran the deli and the freezer broke, he wouldn’t fix it. He’d try to sell the spoiled milk rather than have the freezer fixed."

Leverage from the buyout eventually put TWA in bankruptcy. Although the LBO had let Icahn cash out his initial investment, it also made him "control investor" and thus legally responsible for the the airline's sizable pension deficit.

The Pension Benefit Guaranty Corporation, the government agency that takes over the pensions of bankrupt companies, had the power to terminate TWA's pension plan, which would trigger an early-retirement clause in the airline's pension agreement and increase the deficit to $1.2 billion.

Spurred by Missouri Senator John Danforth, Congress passed a law that prevented Icahn from getting off the hook by reducing his stake in TWA.  Faced with the prospect of losing more than a billion dollars—almost his whole fortune—Icahn negotiated skillfully and struck a deal that limited his liability to a $200 million secured loan to TWA and a maximum of $240 million in pension contributions spread out over eight years. The book ends with the parties tentatively agreeing to this deal.

My opinions

Icahn has continued to thrive while many of the other raiders who rose to prominence in the 1980s have fallen by the wayside, so he's clearly smart, but investing acumen isn't the only reason—or even the main reason—for his success.

By taking greenmail in the late 1970s and early 1980s, he became rich when history's greatest bull market was beginning. Icahn Enterprises, his publicly-traded partnership, has underperformed the S&P 500 since 1987 despite using leverage. If he'd put all of his money in S&P index fund after selling his Texaco stock, he'd be richer today.

Most the strategies that made him rich are no longer feasible. Options pricing has been standardized, legal changes have made greenmail much less lucrative, and few companies trade below liquidation value nowadays. Reading about successful investors is fun, but their techniques can't always be copied.

Icahn won his negotiations with corporate executives because he was more flexible. The execs wanted a specific outcome—to keep their jobs—while he was happy with any outcome that made him money.

Icahn often criticized corporate executives for mismanaging their companies, but his experiences with TWA and USX show that he could do no better. Shareholder activism isn't a panacea for foundering businesses.