| Insights

Three red flags to add to your investment checklist – Insight from activist filings

by | Sep 19, 2019


Most of the activist letters and proxy documents contain heavy arguments about the management and the board. These arguments range from capital allocation to corporate governance.

Some arguments are distinct and worthy to note. In fact, if added to the “investment checklist”, it could improve the investment research process.

#1 Transactions that are favorable to an insider

#2 Arguments against a buyback

#3 Issuing stock options at a significantly lower exercise price than a recent buyback program

#1 Favorable 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 price near a two-year low. Moreover, within a few months, J.W. Childs sold these shares for 86% above the price 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 in 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 the buyback did 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 a significant stake a few weeks before the announcement of disappointing results, the company lost all the benefits related to the 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 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.


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