Part 81.

Go to TL;DR here now.

Key Lessons:

• Understand lenders’ motivations.

• Be no stranger to rejection.

• Eliminate redundancies.

• Accumulate capital.

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The US economy was in bad shape, which was perfect for opportunistic investors like Sam Zell. Weak economies breed weak companies. There were significant opportunities, as distress forced over leveraged companies to restructure. The hardest hit industries were manufacturing, construction, and automotive.

The economic situation under President Jimmy Carter (1977-1981) was rough. The average inflation rate during Carter's term was about 8%. Inflation peaked at 15% annual growth in 1980. The economy suffered from “stagflation”. This term combined stagnation and inflation. It began before Carter’s presidency but continued throughout his term. Remember, the US dollar became a fiat currency in 1971. Declining value of the dollar and rising import costs exacerbated the situation.

By 1981, Congress passed the Economic Recovery Tax Act, also known as the Kemp-Roth Tax Cut. It was a landmark piece of legislation signed into law by President Ronald Reagan. Among other things, it extended the life of Net Operating Loss (NOL) carry-forwards from 7 to 15 years. This allowed companies to offset their taxable income with past losses. The idea was to help struggling companies recover. Shareholders would benefit from prior losses.

Sam Zell looked for public companies with large NOLs, finding something surprising. NOLs had no effect on resulting share prices. He recognized the arbitrage opportunity that the market missed. Which presented an opportunity to gain control of those NOLs, creating holding companies. He could convert profits shielded by NOLs valued at $0 to around 25¢ on the dollar. His strategy became to find NOLs, add profitable subsidiaries, and maximize the value. The risk was low. The reward was high. The goal was to build companies. It was a new twist on grave dancing.

What was the first NOL he found to serve as a holding company for his manufacturing acquisitions? Great American Mortgage and Investment (GAMI). It was once the sixth-largest REIT enterprise in the United States. By 1973, GAMI had grown to become the sixth-largest REIT in the country. They provided construction loans secured by mortgages. About 80% of its lending concentrated in construction lending. GAMI’s status as a major REIT was short-lived.

The oil crisis that erupted in late 1973 had a devastating effect on GAMI. Arab oil exporters withheld crude oil shipments to the United States. That caused interest rates to rise, drying up investment capital. Tremendous debt obligations and a rising number of defaults exposed GAMI. The company became the target of numerous lawsuits. GAMI was unable to regain stable financial footing after the crisis. They filed for Chapter 11 bankruptcy protection in March 1977.

Zell and his partner Robert Lurie purchased a 3.5 percent stake in the company in 1980. They acquired control of GAMI in December 1982. GAMI's $110 million tax loss carry forwards were attractive. NOLs sheltered profits from taxes for several years. Zell and another creditor, Morgens, Waterfall & Company, negotiated with GAMI’s chairman. They reduced the company’s substantial bank debt. Zell and Lurie provided capital liquidity. In exchange, they received three board seats, including one for Sam Zell.

Zell’s full control of GAMI came in December 1982. That’s when he bought out Morgens-Waterfall’s 27-percent share of GAMI for $24 million. Sam Zell gained control of 51 percent of GAMI. After gaining control, Zell moved GAMI’s headquarters to Chicago. There he began transforming the company. GAMI went from a bankrupt real estate company to a diversified holding conglomerate. Zell’s focus was on acquiring and improving underperforming companies.

At the time, banks required high reserves. Equity on the holding company’s balance sheet only went so far. Zell learned that banks would accept loan receivables as collateral. That way, they could increase the size of the loans. This is a capital-intensive business. Zell made it a mission to understand how to align interests with lenders to get more capital.

The next acquisition was a conglomerate, Itel Corporation. Itel was a diversified transportation and logistics company. In 1981, Itel was one of the largest bankruptcies in the USA. It emerged from Chapter 11 in 1983. It had $450 million in NOLs and a break even cash flow. That’s when Zell became interested. He started buying stock at $3 per share. When he accumulated a 5% stake in the company, he went to meet with the board. They declined to grant him a seat at the table. Zell was no stranger to rejection. He continued to buy the stock, increasing ownership to 22%. In 1985, the board elected Zell as chairman and CEO.

Under Zell’s leadership, Itel underwent a significant transformation. Zell purchased other companies for Itel to operate, allowing them to share in its tax credits. He increased revenue through strategic moves. Selling off a cargo container unit for a $250 million profit was one of his moves. Since they needed capital, the first goal was to liquidate miscellaneous things. The freight container leasing industry was in the control of only 7 providers. Itel was number 4. Zell acquired number 3, and then number 7. That made them number 1.

Eliminate redundancies. That became part of Sam Zell’s strategy. For example, each subsidiary used separate systems. These were extensive operating and logistics systems which were redundant. Separate computer systems. Separate facilities in each city. By eliminating expensive redundancies, he increased margins by 20%. Eliminating redundancies reduces the amount of capital required to run the business. Cutting expenses is more realistic than adding value.

In the 1980s, new supply of rail cars decreased. Demand was flat, but stable. If you followed those lines, you could see that anyone owning rail cars was going to make a lot of money. Once again, Sam Zell noticed the opportunity and bought up all the used rail cars in America. They were on sale. He bought them for half the cost to create them (replacement cost). Supply and demand lines crossed. Owning a fleet gave Zell a competitive advantage.

Itel’s stock tripled in value as a result of these changes. Zell transformed Itel from a bankrupt equipment lessor into a large transportation company. Itel evolved into Anixter International, a wire and cable distribution company. Today, Anixter is one of the largest companies in its sector globally. Revenues exceed $6 billion.

In the early 1990s, Itel’s strategy was to reduce its debt burden. Itel agreed to lease its entire fleet. GE Capital Railcar Services leased approximately 70,000 railcars from Itel Rail Corp. This deal doubled GE Capital's rail-car fleet. The lease agreement was for a period of 12 years. GE Capital agreed to pay Itel $150 million per year for the lease. GE Capital obtained an option to purchase the fleet for $500 million after the lease period. It resulted in a $2.3 billion transaction. The deal was extraordinary.

By the 1990s, Sam Zell and Bob Lurie had been partners for over 20 years. That was soon about to end.

To be continued…

I like you,

– Sean Allen Fenn

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