Icahn Enterprises: Don't Chase The 24% Yield

seekingalpha05-31

Icahn Enterprises stock is legendary for its 24% yield.Unfortunately, its dividend has been declining over time, and is on the verge of being cut again.The problem is that the company has been paying ...

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I don't see how this turns around.  A man who, like Carl Icahn, enjoys positive cash flow. Bambu Productions Icahn Enterprises (NASDAQ:IEP) is a legend in the world of high yield stocks. Boasting a massive 24% yield, it gets the yield hunters salivating. Although the stock gets a mere hold rating from both Seeking Alpha authors and Seeking Alpha Quant, it is a star on Wall Street, with a consensus ‘buy’ rating and no sell ratings! On the surface, it’s somewhat hard to figure out what those bullish IEP are thinking. The company would appear to score poorly on quality/profitability metrics, boasting such ignoble numbers as:  A -4.5% net margin. A -3.4% free cash flow margin. A -11.9% return on equity (“ROE”). A -2.2% return on invested capital (“ROIC”). Negative earnings in the last eight out of 10 fiscal years. Negative free cash flow (“FCF”) in the last six out of 10 fiscal years. A declining dividend payout.  That would seem to be an open and shut case for avoiding the stock, or even shorting it. However, there are some ways in which IEP could conceivably be viewed as attractive. For example, its portfolio consists of mainly “value” sectors like energy, real estate, seniors’ living and automotive services. These sectors are generally cheaper than the big tech names that have been riding high in the markets lately. It’s natural to get interested in a portfolio like IEP’s.   IEP's companies (Icahn Enterprises) The problem is that this portfolio is owned by a company with severe financial problems at the corporate level. The company usually loses money, has a Ba3 (“junk”) rating from Moody’s (MCO), and appears to be paying about a 7.6% yield on its debt, as the image below shows. Put simply, this company is under serious financial strain.   IEP's high cost of debt (Icahn Enterprises) Now, I can see why some investors would be bullish on Icahn Enterprises. With a 24% yield, the company’s stock doesn’t even need to go anywhere to provide an attractive return. If a stock has a 24% yield and its price moves 0%, then you double your money after four years plus one quarter (assuming quarterly dividend payments). If on the other hand, the stock goes down in price to $0.01, you break even after four years plus one quarter. That latter point is academic, because it is highly unlikely that a stock would decline to near-zero while maintaining its dividend. I make this hypothetical simply to illustrate that a high enough yield can provide high returns regardless of stock performance. However, when you look at IEP’s dividend history, you see that buying the stock just for the yield hasn’t worked out very well for long-term shareholders. 10 years ago, IEP traded for $101.49. Today, it trades for $16.53. It paid $67 in dividends between June 2014 and today. Therefore, the total return on an IEP share bought 10 years ago and sold today was -17.7%. It’s entirely possible that the investors of today will have a similar experience. IEP’s dividend has been declining over time, its earnings and free cash flow have persistently been negative, and the company has been issuing stock, apparently to pay for the dividends. The possibility of more dividend cuts in the future can’t be ruled out. For these reasons, I consider IEP a hold, as it is a stock that should basically be avoided but is also unsuitable for shorting due to a risk factor I will cover in a subsequent paragraph. High Levels of Debt at an Enormous Cost In the opening paragraphs, I repeatedly mentioned IEP’s high yield, and said that its portfolio has some attractive characteristics. Given that I did touch on two positive qualities of IEP’s, I should explain why there is a risk of the poor performance continuing into the future, as the company does have some things going for it. The main reason why I think IEP’s poor performance could continue is because of its financial condition. The company’s balance sheet has several red flags. Although IEP’s debt is less than its equity and its current ratio is above one, metrics that combine both the balance sheet and the income statement are less flattering. For example:  The cash position is down over a 10-year period. Book value per share is 82% over the same period. EBIT interest coverage is only 24%. As previously mentioned, $554 million in interest to $7.2 billion in debt implies a 7.6% interest expense. Total receivables are rising while revenue declines (indicates large amounts of non-cash revenue).  This is quite a laundry list of red flags. Additionally, investors need to consider all the share issuance that’s been happening. Icahn Enterprises has issued about 281 million new shares over the last 10 years. This is relevant to the balance sheet quality because:  It contributes to the declining book value per share. It offsets the company’s declining debt level, which is one of the few positive balance sheet characteristics IEP has.  One final note: although IEP’s debt level has declined precipitously over the last five years, its interest expense has actually increased since 2018. So, the company’s cost of debt is above average, and apparently trending higher over time. Valuation It would appear that Icahn Enterprises is in poor financial condition. Most of its balance sheet and interest coverage metrics are poor, and it is persistently unprofitable. Its dividend per share is also declining. You would expect such a stock to trade at a rock bottom valuation. Surprisingly, IEP doesn’t. It scores an A+ in Seeking Alpha Quant’s valuation page, probably because the price/cash flow ratio is an unbelievably low 2.3. However, some of the other multiples do not indicate cheapness:  The 107 EV/EBIT ratio is extremely high. The 30.87 estimated forward P/E ratio is about as high as that of the NASDAQ-100, which mostly consists of profitable, growing companies. The price/book ratio of two looks cheap on the surface, but remember that book value is trending downward.  Put simply, Icahn Enterprises is not cheap in a scenario where the historical trends (e.g. declines in earnings and book value) persist. Risks to Those Shorting Although everything I’ve written about IEP so far has been very bearish-sounding, there are some serious risks to shorts here. One, indeed, is potentially fatal: The dividend. If you short a stock using the conventional \"borrow, sell, buy back, pay back\" method, you have to pay the share lender the share's dividends. In the case of IEP, that cost will run you about 24.5% of the stock price if the dividend doesn’t get cut! As I wrote above, I think that IEP’s dividend IS at risk of being cut. It’s not guaranteed that that will happen in the near term, however. A one-year period with a 24.5% dividend payment owed and a 5% interest expense could easily cause a short seller to have to cover their position at a loss. So, IEP is not a good candidate for shorting. The Bottom Line On the whole, Icahn Enterprises is a stock that is best avoided. It has enough financial problems that an investor can’t reasonably expect a good outcome when going long, but the dividend could create problems for those going short. Considering both of these possibilities side by side, a neutral or slightly bearish leaning view on IEP seems correct.  One 'short' play on Icahn Enterprises that looks smart on the surface is using puts rather than share borrowing to make the trade. Puts let you make money betting against a stock, but they don’t require that you pay the dividend directly like conventional short selling does. However, high dividends tend to increase the premiums paid on puts, and indeed IEP puts generally look pricier than the calls. So I can’t endorse the put strategy either. I’d say just avoid IEP. 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