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.

4 comments:

  1. Nice article. Good summary. I think I won't have to read this one now :)

    ReplyDelete
  2. YM,

    If you were Carl Icahn, do you think you'd seriously consider putting your capital into the S&P500 when you realize you're getting beat by it over time?

    ReplyDelete
    Replies
    1. No, pride would prevent me from ever going the passive route. I'd also feel that if I'd made a lot of money in the past, then I could do it again at some point.

      Delete

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