Market Commentary: Is This The Largest Scandal On Wall Street?

Carl Icahn is as infamous as he is famous. As an activist investor, he sewed fear into the boards of target companies. Famous for his aggressive approach to taking large stakes in companies and pressuring management to make changes that benefit shareholders, Icahn started his career in the ’70s when he took a stake in the Tappan appliance company, forcing a sale to Electrolux, and making a profit of $2.7 million.

In the 1980s, Icahn became known as a “corporate raider” after aggressively acquiring companies such as TWA, Phillips Petroleum, and USX. By the 1990s, Icahn began to focus more on shareholder activism. He pressured companies to spin off divisions, pay dividends, and reduce executive compensation.

Some of his most notable activist investments include:

• Phillips Petroleum (1985): Icahn took a stake and forced it to spin off its chemicals division.
• USX (1986): He established a holding in USX, a steel company, and caused it to spin off its Marathon Oil subsidiary.
• Apple (2012): Carl took a position in Apple and pressured the company to return more cash to shareholders.
• Netflix (2016): Icahn snapped up shares in Netflix and pressured the company to split its stock.

Did  Hindenburg Expose Carl Icahn?

The vehicle Icahn uses for much of his initiatives is Icahn Enterprises, which recently was subject to an expose by Hindenburg Research, which alleged that IEP is  trading well above its net asset value and that its dividend is being financed by stock sales. Hindenburg further spotlighted Jefferies as the only large investment bank to publish research on Icahn Enterprises in aiding IEP.

At its core, Hindenburg alleges that Icahn Enterprises uses stock sales to finance a dividend. The report also notes that Icahn has taken margin loans on Icahn Enterprises, which could force him to sell more stock if the stock price continues to drop.

The Sharks Circle for the Kill

Adding fuel to the fire, Icahn’s arch-rival, Bill Ackman, who famously feuded with Icahn over whether Herbalife was a pyramid scheme, wrote the following (bolded commentary below is ours):

One learns from IEP that a controlling shareholder of a company with a small float that pays a large dividend can cause his company to trade at a large premium to intrinsic value, best approximated in IEP by its NAV per share.

The premium to NAV creates liquidity for the controlling shareholder by enabling him to access margin loans secured by overvalued shares that can be used to fund investments. The IEP premium has been sustained by a large dividend yield, which is not supported by operating cash flows. The yield is generated by returning capital to outside shareholders, which is in turn funded by the company selling stock to investors.

This system has worked for a considerable period of time, but it is highly dependent on the maintenance of the premium and the placidity of Icahn’s margin lender(s). IEP stock held by Icahn is not a liquid asset as it represents approximately 85%+ of IEP shares outstanding.

Here, Ackman highlights the point of weakness in Icahn’s financial structure. If the margin lender stops lending, a financial house of cards may begin to crumble due to poor liquidity.

The shares also purportedly represent 85%+ of his net worth so he apparently does not have much outside resources to draw upon. A sustained premium requires confidence in Icahn and IEP. If Icahn were to sell any shares, the stock would likely drop precipitously as the overhang of additional sales and the further resulting loss in confidence would catalyze other shareholders to exit before the deluge.

Ackman fires a shot across the bow, highlighting the chess game Icahn is in, and how the wrong move will worsen his already dire situation. If Icahn holds his position and the price falls, he loses. If he sells his position, it will open the doors to a floodgates of selling and he loses too.

Transparency is not the friend of IEP having caused a more than 50% decline in the shares, which has caused Icahn to post more shares, now more than 65% of his holdings. Further declines over the last several days will likely require additional postings. Even after the recent share price decline, IEP still trades at a 50%+ premium to its NAV. Its performance history and governance structure do not justify a premium; rather they suggest that a large discount to NAV would be appropriate.

Ackman turns the knife. As bad as the selling has been, the stock is down 63% year to date, it still has more to go to reach fair value. With fear already palpable, Ackman amplifies concerns any shareholders have by inferring the selling to-date has still left IEP shares inflated when viewed through a valuation lens.

There is likely more than one margin lender involved here because of the very large size of the loan and the risk limits that margin lenders have. IEP reminds me somewhat of Archegos where the swap counterparties were comforted by each having relatively smaller exposures to the situation. The problem is that multiple lenders make for a more chaotic situation. All it takes is for one lender to break ranks and liquidate shares or attempt to hedge, before the house comes falling down. Here, the patsy is the last lender to liquidate.

This is the coup de grace. Ackman paints a dire picture for lenders: take any action to protect the existing position and a stampede of selling follows. Fail to take action and others who do will leave you wearing the dunce’s hat, losing the most.  

13D rules is that they require disclosure of sources of financing and even copies of financing agreements, although many investors ignore these requirements. Icahn’s favorite Wall Street saying: “If you want a friend, get a dog.” Over his storied career, Icahn has made many enemies. I don’t know that he has any real friends. He could use one here.