Ten investment checklist from the arguments of activist investors
Couple of weeks back, I wrote about how investors could spot a potential merger by reading the settlement agreement entered into between the activist and the company. Today, I am going to list out a few critical arguments of activist investors. This can be incorporated into due diligence process.
Most activist letters and proxy documents contain heavy arguments about the management and the Board. These arguments range from capital allocation to poison pill.
A common list of arguments includes poor capital allocation, increase in operating expenses, declining revenue etc. I have observed that out of that umpteen number of arguments, some arguments are distinct and worthy to note in your “investment checklist”.
#1 Favourable transaction to an insider
40 North Management complained that instead of providing all shareholders the opportunity to participate in the contemplated dilutive share offering, Mattress Firm Holding issued over half a million shares to J.W. Childs at a near two-year low. Moreover, within a few months, J.W. Childs sold shares for 86% above the price per share at which J.W. Childs acquired the stock from the company.
Mattress Firm is a publicly traded company and no longer a portfolio company of J.W. Childs. Notwithstanding the fact that J.W. Childs has been a consistent seller of the Company’s stock leaving them with a now minority 36% ownership, the Board continues to be controlled by J.W. Childs, their affiliates and other directors with whom they share close ties, leaving no true voice for all other public shareholders.
Unfortunately, we are compelled to write now given our recent dialogue with the Board and the Board’s decision to amend the terms of the Sleepy’s acquisition on February 3rd and issue over half a million shares of Company common stock to Company insiders including J.W. Childs affiliates at a near two-year low, a transaction which can only be described as an egregious insider deal. We recognize the current volatility in the credit markets, which pushed the Board to consider various financing alternatives including further equitizing the Company. But rather than provide all shareholders the opportunity to participate in the contemplated dilutive share offering, the Board deplorably issued equity solely to its insiders when the Company’s stock was trading at what a J.W. Childs representative described as a significantly undervalued price. This fact is even more distasteful given J.W. Childs’ recent sales of the stock at opportunistic prices, including a sale in April 2015 at a price of $66.47 (or approximately 86% above the price per share at which J.W. Childs just acquired stock from the Company).
#2 Buying back stock of a business in secular decline
Case study #1
In January 2016, Engaged Capital sent a letter to the Board of Outerwall objecting to the massive share repurchase and argued that buyback does not add value if the business is in secular decline.
While we are often advocates of share repurchases for companies whose stock is trading at a discount, buying back stock of a business in secular decline rarely creates value. As mentioned earlier, repurchases only create value if investors ascribe a higher valuation to the business in the future. If the business’ valuation never increases, then a share repurchase will have no impact other than to transfer cash for fairly valued (or expensive) stock. Because public investors will always be concerned that Redbox could deteriorate faster and/or management will waste Redbox’s cash flows, it is unlikely the market will ever ascribe a higher valuation to this business. In short, without a catalyst to change the valuation of OUTR, the stock will continue to look “cheap” regardless of how many shares are repurchased. If one needs convincing, look no further than OUTR’s stock performance – $1 billion in repurchases has reduced the share count by nearly 50%, yet OUTR’s stock price has fallen to six year lows.
In November 2015, OUTR repurchased 2.2% of the Company’s equity at an average price of $64. Only a few days later, the Company pre-announced poor fourth quarter results which sent the stock down approximately 30% into the low $40s.
Case study #2
In another instance, William J. Pulte, founder and largest shareholder of PulteGroup, wrote, “In a recovering housing market, revenue growth and volume growth are critical to creating more value for shareholders. Share buy backs alone will not be successful without meaningful growth at PulteGroup.”
Case study #3
In a letter to the Board of Outerwall, Engaged Capital argued that by buying back significant stake a few weeks before the announcement of disappointing results, the company lost all the benefits related to share repurchase.
OUTR’s repurchase program has lost all of the qualitative benefits that typically result from a publicly announced share repurchase program. In short, the repurchase strategy is no longer a credible signal to the market that the Board believes the Company’s shares are undervalued. In fact, OUTR’s repurchase activities in the most recent quarter highlight the Board and management team’s absolute failure in managing something as straightforward as a share repurchase program. In November 2015, OUTR repurchased 2.2% of the Company’s equity at an average price of $64. Only a few days later, the Company pre-announced poor fourth quarter results which sent the stock down approximately 30% into the low $40s.
Following the profit warning in December, management continued repurchasing shares, acquiring 1.7% of the Company at an average price of $41. The Company followed this second round of repurchases by providing 2016 guidance that was 28% below consensus for free cash flow and sent the stock down an additional 17% to around $30 where it remains today. By repurchasing ~4% of the Company immediately ahead of a pre-announcement and poor guidance, shareholders have already lost approximately 45% on the Company’s most recent “investment.”
#3 Issuing stock options at a significantly lower exercise price than the recent buyback program price
In a letter to the Board, Iroquois Capital Management criticized the company for issuing options to the CEO and CFO at a price less than its recent stock buyback program.
We find it outrageous that the Company repurchased only a fraction of the shares authorized under its previous buyback program at an average price above $2.00, and then issued 250,000 options to the CEO and 100,000 options to the CFO in December 2015 at $1.86 per share.
What’s more, the prices at which these insiders are selling the shares are often higher than the prices at which the Company has offered to repurchase its own shares from LRAD shareholders. Ms. McDermott on the Q1 2015 earnings call essentially admitted that the stock price has been too high for the Company to engage in share repurchases in the first quarter, stating:
“We didn’t have any repurchases in the first quarter. Based on where our stock price has been, it’s been up pretty high at this point so its still – the program is still active through the end of the calendar year. So, depending on the price, if the prices are at a reasonable level, we will do future repurchases, but there weren’t any in the first quarter.”
It appears that LRAD management and the Board will not engage in share repurchases unless it can acquire the shares at a discount, however, when it comes to their own shares, the CEO and CFO are happy to exercise options and sell their shares regardless of the price.
At a time when the Company has excess cash reserves and is conducting its own share buyback program, why are these executives selling their stock in such high numbers? These actions are in contrast to what the Company is attempting to accomplish through the share buyback program.
#4 Negative Glassdoor review
Glassdoor (www.glassdoor.com) is a database of employee reviews and CEO approval ratings. Recently, activists cite reviews found in Glassdoor, in their arguments.
In a letter to the Board of Directors of Green Dot, Harvest Capital Strategies wrote, “Admittedly, employee reviews can be one sided. However, the insightful reviews and comments universally point to Mr. Streit as a poor leader. Across all reviews, Mr. Streit’s 32% approval rating is in stark contrast to the 76% and 84% approval ratings of the CEOs at NetSpend and PayPal, respectively”.
In another instance, dissidents of Farmer Bros wrote, “One only needs to look to recent Glassdoor employee reviews to see the low morale and how little respect employees appear to have for senior management”.
#5 CEO : FAR FAR AWAY
In a few situations, activist investors have argued against the policy which let the CEO live far away from the company’s core operational location. Also, there are instances where the activist argued that the company’s headquarter should be closer to its operations.
Case study #1
In a letter to the shareholders of Barnwell Industries, Ned Sherwood wrote, “the board permits the company to continue owning a valuable residential apartment in New York City (more than 1,500 miles from the Company’s closest operation) and permits the CEO live there rent free with no convincing explanation or rationale”
Case study #2
In a letter to PICO Holdings, River Road Asset Management wrote, “The corporate office in LA Jolla should be shut. It is an extraneous expense. The corporate headquarters should be relocated to Reno, NV, where a majority of PICO’s assets reside and where Vidler is already based.”
Case study #3
In a letter to the Board of Perceptron, Moab Partners wrote,” Rick Marz (CEO) lives in Northern California. Perceptron is based in Plymouth, Michigan”.
#6 Conflict of interest
When a significant shareholder sits on the Board of “target” and “acquirer” and the Board approves an acquisition, it is a red flag that there is a significant problem in the way the business is run.
In March 2012, Green Dot spent $43 million to acquire Loopt…….At the time of the acquisition, Sequoia Capital, which was Green Dot’s largest shareholder, owned 25% of Loopt, and sat on the boards of directors of both companies. This conflict alone should have presented Green Dot’s management and Board with high hurdles before consummating the deal…..Loopt was dilutive in 2013 and has never been financially accretive. Further, Green Dot shut down Loopt almost immediately after closing the acquisition and has not used Loopt’s code in any of its product offerings.
#7 Management’s conflicting actions:
Some Boards and managements have continually failed to live up to their own promises.
Case study #1
After announcing that the company would sell a property, it came back to investors stating that the demand was poor and the property could not be sold. Subsequently, the company bought out its joint venture partner at a near record price.
In early 2015, Stratus announced that its Block 21 property would be sold, which would have been consistent with the May 2015 presentation. But within months, Stratus reported that there were no “acceptable” offers in spite of an extremely robust market for commercial property in downtown Austin. Instead, Stratus borrowed significant funds and bought out its partner at a near-record per-room price for an Austin hotel property.
Case study #2
The company released a plan saying that it would return cash to shareholders. Within a few months, it raised a loan which had restrictive covenants which included restriction on dividend or buyback.
Stratus’s May 2015 investor presentation outlined a five-year plan. The plan is vague and often contradicts itself or is contradicted by Stratus’ subsequent actions. For example, there is a slide in the presentation entitled “Plan to Return Cash to Shareholders,” but other slides outline a multi-hundred-million-dollar development pipeline that Stratus cannot possibly fund on its own — especially if cash is being returned to shareholders. Furthermore, loan covenants entered into after the plan was released preclude or restrict stock buybacks and dividends, the only means of returning cash to shareholders.
#8 Usage of certain words: Honesty
In a letter to the Chairman of the Board of Build-a-Bear, Cannell Capital wrote, “You couched your pitch to us while using the word “honestly” eleven times. It is the experience of Cannell that when a member of a Board of a public company who does not own much stock of the company itself, uses the word “honestly” or the words “to be truthful” with such a high frequency, the verisimilitude of the orator should be questioned.”
#9 Too much investment in investor relations
In a letter to the Board of Perceptron, Inc., Moab Partners criticized the CEO for focusing “too much” time on investor relations instead of spending time on building the business.
#10 Improper option and warrant grants by subsidiaries to insiders
In a letter to the Board of Sorrento Therapeutics, Wildcat Capital Management referred to the improper option and warrant grants by subsidiaries to insiders as “little more than looting of the company assets” and “little more than theft”.
We have recently learned of an egregious series of transactions that reflect blatant conflicts-of-interest and self-dealing by Dr. Ji and other Company executive officers, endorsed and abetted by the Board. In short, the Company has repeatedly transferred assets to newly created subsidiaries and then granted stock options to acquire significant amounts of stock at nominal prices to Dr. Ji, other executives, and non-employee Directors of the Company. Compounding that misconduct, Dr. Ji has also taken for himself warrants to acquire extraordinary numbers of shares that have 10 votes per share — all for nominal consideration. These equity stakes are in addition to the equity stakes in Sorrento already granted to Dr. Ji and the other members of management and the Board, effectively “double dipping” at the direct expense of the Company and its shareholders. In addition, these grants represent uncrossed, virtually free options in each of the subsidiaries, creating a situation where Dr. Ji and the other recipients win even if the Company and its other shareholders do not.1
As disclosed in Item 13 of the Company’s Amendment No. 1 dated April 29, 2016 (“Amendment No. 1”) to its Annual Report on Form 10-K,2 five of Sorrento’s subsidiaries have issued stock options to certain Company executive officers and unidentified non-employee members of the Board. The five Sorrento subsidiaries that issued such stock options are TNK Therapeutics, Inc. (“TNK”), LA Cell, Inc. (“LA Cell”), Sorrento Biologics, Inc. (“Biologics”), Concortis Biosystems, Corp. (“CBC”), and Scintilla Pharmaceuticals, Inc. (“Scintilla”). In addition to Dr. Ji, other Company executive officers that received such stock options are George Ng (Executive Vice President, Chief Administrative Officer, and Chief Legal Officer), and Jeffrey Su (Executive Vice President and Chief Operating Officer).
In a telling sign of self-dealing, Dr. Ji is the President and CEO of four of the five subsidiaries (TNK, LA Cell, CBC, and Scintilla) that issued the stock options to him, Messrs. Ng and Su, and the unidentified non-employee members of the Board. Each of the five subsidiaries
- As a result of these options and warrants being uncrossed, the recipients would benefit from the success of any one subsidiary even if the others failed, a very different outcome than the shareholders would receive through their ownership in the parent Company.
- It should be noted that some of these option and warrant issuances were granted as early as May 2015, but were not reported until the Company’s Form 10-K was filed on March 15, 2016. Further, disclosure of these grants was buried in a footnote to the financial statements until the recent filing of Amendment No.1. Board of Directors of Sorrento Therapeutics, Inc. have also issued warrants to Dr. Ji to purchase class B common stock that have 10-to-1 voting rights, thus giving Dr. Ji “super” voting rights.
Through this scheme, the equity value in the Company’s subsidiaries has literally been ripped away from the Company’s shareholders and given instead to Company insiders, including the individual Directors. By any standard, this scheme constitutes various breaches of the fiduciary duties owed to the Company’s shareholders by the Company’s Board, its Directors, and its officers.
Based on these belated disclosures, this series of transactions appears to be little more than a looting of Company assets by Dr. Ji, other Company executives, and, perhaps most disturbingly, the purportedly independent non-employee members of the Board. This is little more than theft, and demonstrates a fundamental willingness of this Board and this management to put their own personal interests above those of Sorrento and its shareholders, a situation that cannot continue.