CVR - Icahn: The Hunt For The Billion-Dollar Triumph

2023-10-12 13:47:45 ET

Summary

• IEP's past decade's performance has raised questions about its strategy and shaken investor confidence.
• There is an evident need for a significant multi-billion dollar win to regain trust.
• The dividend strategy of IEP is complex. Carl Icahn's commitment to dividends is firm. With the recent dividend cuts, it's now easier to see it through.

Investment Thesis

Carl Icahn has succeeded in amassing a significant following through his shrewd investment strategies and corporate maneuvers.

However, Icahn Enterprises' ( IEP ) performance in the past decade has cast a shadow on its strategy, leading to a notable shake in confidence, the intangible capital upon which every fund manager trades.

What is clear now is a need for a multi-billion dollar win to restore confidence. The following paragraphs sift through IEP's balance sheet in search of potential, but our analysis shows the prospects of such a win are bleak, albeit not entirely elusive.

Concerning dividends, the dynamics are more complex than meets the eye. Icahn's investments fall into two main groups: The widely-discussed equity investments and the wholly-owned subsidiaries. Each group has unique capex and cash flow needs.

For instance, Icahn's equity investment strategy is inherently lumpy, requiring significant capital outlays, activism, and patience until they bear fruit. This translates to significant operating capital outflows that overshadow the performance of its 'backbone,' the wholly-owned subsidiaries. The consolidated financial statements blend these differences, making it harder to get a clear view. If you separate the cash flows of the investment segment from the commercial segment (Energy, auto, fashion, etc), a positive cash flow trend becomes evident.

Moreover, each sub-segment performs uniquely at a different stage of the business lifecycle. For example, the Energy Segment is flourishing, while the automotive is not. Still, as a unit, these operating segments are generating positive cash flows, as shown below.

Icahn's commitment to dividends is clear. He holds himself at the same bar as he does from the companies in his portfolio when it comes to returning capital to shareholders. He has a grounded belief that, over time, the volatile nature of cash flows inherent in his activist strategy will average out to a net positive. This confidence has sometimes led him to borrow funds to sustain dividends, believing in a long-term favorable outcome. While some might argue that he's pushed the envelope, the annual cash distribution to public shareholders currently stands at around $250 million. This seems sustainable, especially considering the various operational levers he can pull. Hence, I remain convinced that IEP will maintain its dividend and give a Buy rating.

Investments

IEP is a big and diverse company. The partnership sells gas, fertilizers, packaged meat, kitchen towels, car parts, garage services, and equity and bond trading. The investment strategy, or the 'Icahn Strategy' as termed in IEP's SEC filings, revolves around investing in undervalued companies that are not doing well before fixing them up to create value.

Each of IEP's commercial subsidiaries started as an equity investment. While they play a critical part in its value proposition, significant interest and speculation lie within IEP's equity investment portfolio in search of the next potential blockbuster investment. Unfortunately, this investment portfolio hasn't been doing great as of late.

As of the latest SEC filings, IEP holds $4.9 billion in a concentrated portfolio (mostly equity) and $3.4 billion in short positions (also mostly equity), bringing the total market exposure to $8.3 billion.

There is little potential for extraordinary returns from the short positions, given that the maximum return is capped at 100%, and in practice, earnings are often much less. For this reason, I won't elaborate much on IEP's short positions except that they are down significantly as a proportion of total investment after peaking in 2022. Another point is that half of the short position is in the Energy Sector. Thus, IEP is hedging its CVR Energy (CVI) exposure.

Moving on to IEP's long equity portfolio, we see that the top five investments constitute most of the portfolio. Below is a table showing how these holdings faired in Q3.

These top holdings declined $182 million in value in the third quarter, representing a 6% decline. Not ideal, but not too bad either, especially given that the S&P 500 ( SP500 ) declined 3.5%.

So, the question is, which one has the potential for extraordinary return?

Crown Holdings: International Aluminum Ambitions

Crown Holdings is a leading supplier in the aluminum beverage can industry. The firm has ambitious growth plans, as evident in its $1 billion capex program.

Wall Street and Seeking Alpha analysts seem bullish on the ticker, but Quant Rating is on the fence due to mediocre growth. This year, sales were down 11.4% in Q2 and 6% in Q1 on a YoY basis.

However, with the August acquisition of Helvetia Packaging, a beverage can manufacturer in Germany, Crown's growth trajectory is set for a rebound.

With a green light from Seeking Alpha and Wall Street analysts and a potential change in Quant Score, IEP's $850 million investment in CCK may be poised for a favorable shift.

Southwest Gas: Icahn Playbook of Spinoffs and Divestments

Southwest Gas is a multi-stated gas utility company serving over 2 million customers across Arizona, Nevada, and California.

The company has embarked on significant restructuring efforts under the influence of Carl Icahn's maneuvers. Earlier this year, SWX sold MountainWest, one year after it bought it from Dominion, in the wake of a bitter battle with IEP.

SWX is also putting the final touches on its plans to spin off its infrastructure business, Centuri, into a new publicly traded company. With a 15% interest in SWX, IEP is poised to hold many shares in Centuri after the spinoff.

This spinoff will make SWX smaller. It is yet to be seen if the two companies will be worth more separately than together. Wall Street seems optimistic, with Citi ( C ) upgrading SWX today, citing a clear path to become a pure utility play as it spins off in its construction business.

FirstEnergy: Emission Regulations, Bribery Probes, and Icahn's Involvements

FirstEnergy is a multi-state electric utility company. It relies heavily on coal for its power production. With the federal government tightening regulation on carbon emissions, FirstEnergy is facing increased costs and capex. Is this a problem? Well, it does impact discounted cash flow and, by extension, valuation. However, the impact is limited because FirstEnergy is a regulated utility, meaning all capex and cost are passed to customers, with guaranteed ROE set in coordination with state regulators, except for Ohio, which is one, if not the only state where utility companies have to compete for customers.

Still, FirstEnergy is facing a myriad of challenges. It is still grappling with an investigation by the Ohio Organized Crime Commission for a bribery case uncovered in July 2020. Subsequently, all rating agencies downgraded the company credit rating to 'Junk' status, magnifying borrowing costs. This comes as the company faces economic challenges related to mismanaged pension schemes.

With a 2% stake, Carl Icahn succeeded in adding two employees to the Board as independent directors. However, I'm not sure how much influence he exerts. This is a serious matter, given that there is a lawsuit asking a judge to rule that Carl Icahn is an affiliate of FirstEnergy. From my understanding, such a designation could have serious legal and economic implications for IEP. If you find this level of complexity daunting, IEP may not be the right fit for you.

During the latest earnings call, the new CEO, who took the helm last June, stated he's been in contact with all stakeholders to present his turnaround plan.

Xerox: Drawing the Curtains on Icahn's Era with a Strategic Share Repurchase.

Xerox derives a significant portion of its revenue from paper printing products. It is not a secret that this sector is in secular decline. Amid this backdrop, the drama stirred by Icahn's Xerox activism is drawing to a close. Xerox management recently unveiled plans to buy back $542 million worth of shares from Icahn, IEP, and other associates. This move comes as Xerox shares remained subdued post-pandemic, as work-from-home and digitalization trends accelerated. The buyback price is $15.84 per share.

Despite acquiring a portion of Xerox shares recently, including 1.34 million shares in 2022 at an average price of $16.9 per share, IEP has been amassing its stake since 2015 at prices significantly higher than today's. Thus, IEP will most likely realize capital losses on its Xerox investment, albeit to a lesser extent, thanks to the mitigating effect of the dividend. Below is a chart showing Xerox's share performance and total returns since IEP's initial investment.

After IEP exits Xerox, the question is: where will the approximately half a billion in cash be reinvested? Icahn will either amplify his stakes in the current portfolio, enhance his influence over management, or potentially introduce a new investment to the mix. Certainly, these are exciting times for IEP and its shareholders.

Illumina: From Gene Sequencing Dominance to Icahn's Contentious Interventions.

Illumina is a market leader in the gene sequencing device market. Recent technological and scientific advancements are expanding the Total Addressable Market. However, the firm faces increasing competitive challenges as peers close the technological gap.

Sales and earnings have been declining, but with lower capex, management improved FCF per share metrics, as mirrored in Seeking Alpha Quant rating.

Desperate to reignite growth, management made a major misstep when it spent billions on an unauthorized merger, which regulators later rejected due to anti-trust concerns. Now, Illumina is compelled to divest Grail, the recently acquired entity, most likely at a loss. To make things worse, EU regulators fined Illumina €432 million for the merger. These dynamics, coupled with an overvalued stock, foster a seller's market. Shares are down 30% this year.

Seeking Alpha's John Vincent estimates Icahn bought Illumina at prices between $194 -$233, significantly above the current price of $140.

With 1% ownership, I'm not sure how much IEP or Icahn had to do with recent management changes. Still, he is creating waves and is in the middle of a dispute with the new management related to the election of three of IEP employees to the Board, and demanding the immediate sale of Grail, contrary to management's plan to invest in the company before selling it, a strategy aimed at increasing Grail's value instead of selling it at a loss. Illumina described Icahn's nominees as 'unfit' and Icahn as 'lacking understanding of both Illumina and the genomics industry' in a press release dated May 2023.

Illumina presents the least promising among IEP's major holdings, at least from my perspective. At 165x Forward PE, it also diverts from the 'Icahn Strategy,' which, according to IEP's annual report, is based on finding ' undervalued companies in the Graham & Dodd tradition.'

Dividend Safety

For many investors, the question isn't just about high returns but also the sustainability of dividends. The recent dividend cut by IEP may offer an insight into the issue.

Dividend safety traditionally hinges on two elements:

1. Management's Dedication: A committed management ensures regular dividends even in tough times. While some CEOs hastily reduce dividends at the hint of adversity, others persevere to deliver value to shareholders.
2. Financial Ability: The financial prowess of a company to consistently pay out dividends is equally vital.

Carl Icahn has shown a firm commitment to delivering dividends. He's consistently pressured the companies he invests in to return capital to shareholders. He is holding himself to the same bar, a commitment only tested recently when IEP cut its dividend payout in August.

The pressing question is: Can IEP maintain the quarterly dividend (which now stands at $1 per share)? If Carl Icahn continues to accept his dividends in shares rather than cash, the firm would only need to distribute cash for about 15% of shares. This translates to roughly $236 million annually in dividends. With assets worth $22 billion, this seems feasible.

Financial Ability to Pay Dividend

The ideal metric to assess the capacity for sustaining dividends is positive GAAP net income, often accompanied by positive operating cash flow and, with good management, a long-run positive net operating cash flow.

Over the past decade:

• IEP reported a GAAP net loss of $600 million, which is not ideal but also not detrimental considering its size.
• Operating cash flow was a $1.4 billion gain.
• Free Cash Flow, however, was a negative $3.7 billion, impacted by high capital expenditure, especially in the early days of the CVR acquisition.

The energy segment, particularly CVR, requires closer examination. It is the engine of IEP's commercial segment, contributing the largest share of earnings.

Earnings in this segment are intrinsically linked to the fluctuations in oil prices, making them inherently volatile. Nevertheless, this segment has mostly met expectations after Icahn's initial capex inflow, exhibiting intermittent but cumulatively positive FCF. If the current trajectory persists, IEP is on course to recoup its substantial investments made between 2013 and 2015. The graph below illustrates the FCF of IEP's Energy segment, with positive cash flows highlighted in green.

My main concern is the businesses' viability under Icahn's leadership. CVR requires consistent care, given the wear and tear inherent in the petroleum refining and fertilizer business. Icahn's aggressive value extraction strategy is evident in the low capex figures compared to depreciation. Evidence of this can be seen in the recurring safety issues, most recently this year being:

1. Injuries sustained by two employees in a fire at CVR energy's refinery in Wynnewood, Oklahoma, on May 2023.
2. The death of an employee at Coffeyville Resources in March 2023 during maintenance, subsequent to a boiler explosion.

One subsidiary is now flagged as a repeated safety violator by state regulators. These fatalities and injuries mirror a lack of a robust ESG framework, significantly limiting IEP's appeal as an investment.

Valuation

The valuation of IEP has been a topic of debate due to its trading at a premium above its Net Asset Value 'NAV,' a standard valuation metric for investment funds. The latest filings reveal IEP's NAV at around $5 billion, 30% below the current market cap of $7.2 billion.

However, the suitability of the NAV as a proxy to share price is blurred, considering the complex dividend dynamics of IEP.

Whether IEP can pay Icahn's dividend in cash is irrelevant, given his tried and tested commitment to return capital to the 'minority partners' holding the remaining units/shares he doesn't own. With a 21% cash dividend yield to public shareholders, IEP's publicly-traded shares appear undervalued.

Summary

Carl Icahn and his firm, IEP, have historically navigated Wall Street with impressive success. However, the ride has not always been smooth lately, sparking some impatience among investors, even those accustomed to the inherently long-term and unpredictable nature of the Icahn Strategy, characterized by lumpy returns. A multi-billion dollar win seems vital now to restore dwindling confidence.

Sifting through IEP's five major equity investments, it is evident that several are tactically pivoting in ways that could potentially cultivate growth. Still, whether they'll turn into the multi-baggers the company is yet to be seen.

Regarding dividends, I believe that IEP has many levers to sustain dividends. Carl Icahn has demonstrated commitment to sustaining dividend, and with the recent distribution cut, it has become much easier to do so.

No one knows the future, but what is certain is a lot happening right now on the IEP front, especially with the exit of Xerox, the dividend cuts, and price declines. I believe we have reached peak pessimism, with share price trading at an attractive risk/reward profile.

With a 21.5% forward dividend yield, investors can recoup their initial capital in just five years solely from dividends while still holding only their shares.

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