"You know my methods, Watson. There was not one of them which I did not apply to the inquiry." — Sherlock Holmes
One of the most under-utilized pieces of shareholder information is Form Def 14a, the proxy statement. Two of the most important features of the proxy statement are the detailed profiles of management and directors and a complete explanation of their compensation.
The compensation of officers frequently contains bonuses, stock option grants and other incentives; it is essential for shareholders to understand exactly how the officers are paid if one wishes to fully understand the business and its risks.
Another source of valuable information exists in the footnotes which tend to be buried at the bottom of the 10K (annual report).
Today's article will detail a case where careful analysis of management compensation and 10K footnotes raises some serious questions which shareholders should consider before purchasing or continuing to hold Duckwall-Alco (DUCK, Financial).
Duckwall-Alco Executive Compensation and Net Earnings.
As we can tell by reading his profile in the proxy statement, Richard Wilson took over as CEO of Duckwall-Alco on February 19, 2010. The following describes his bonus plan:
For Mr. Zigerelli and Ms. Gilmartin, the first performance period began on August 4, 2008, and ended on August 2, 2009 and the second performance period began on August 3, 2009, and ended on August 1, 2010. For Mr. Wilson, the first performance period began on February 15, 2010 and ended on January 30, 2011 and all subsequent bonus periods begin at the start of each fiscal year subsequent to the first performance period and end at the end of such fiscal year. Mr. Zigerelli, Ms. Gilmartin and Mr. Wilson’s employment agreements each provide that they will receive a bonus based on the Company’s ROE (as defined below) for the applicable performance period as follows:
As set forth in Mr. Zigerelli and Ms. Gilmartin’s employment agreements, “ROE” means, for any 12-month period, earnings from continuing operations before discontinued operations for such period, excluding cumulative changes in accounting and one-time termination benefits recognized in accordance with FASB ASC Topic 718, divided by the stockholders’ equity at the end of the immediately preceding 12-month period. Under Mr. Wilson’s employment agreement, ROE is defined as, for any 12 month period, earnings from continuing operations before discontinued operations for such period, excluding cumulative changes in accounting and one-time termination benefits recognized in accordance with FAS 146, divided by the stockholders’ equity at the end of the immediately preceding 12-month period. The Compensation Committee selected the performance measures of ROE to focus the named executive officers on creating long-term stockholder value, aligning the named executive officers’ financial interests with the interests of the Company’s stockholders.
The idea of bonuses is to align compensation with the interests of the shareholders, paying large bonuses based upon return on equity is hardly my idea of a shareholder-friendly alignment for the following reasons:
1) ROE encourages the management to lever up since unlike ROC, debt plays no role in the calculation.
2) ROE is calculated by using accrual earnings rather than cash flow; by basing bonuses upon net earnings the management is encouraged to employ aggressive accounting techniques to reach their bonus levels.
Interestingly and perhaps not coincidentally DUCK management chose to change their accounting for inventory late in 2010. From their most recent 10K:
In the fourth quarter of fiscal year 2011, the Company elected to change its method of accounting for inventory to the first-in first-out (FIFO) method from the last-in first-out (LIFO) method. The Company believes the FIFO method is preferable to the LIFO method as it better reflects the current value of inventory on the Company’s balance sheet and provides better matching of revenues and expenses. The impact of this change in accounting principle on the financial statements for each of the periods is further explained in Note 2.
Here is part of Note 2 from the 10K:
Had the Company not changed its policy for accounting for inventory, pre-tax income the year ended January 30, 2011 would have been $1.3 million lower ($0.34 effect on both earnings per basic and diluted share). As a result of the accounting change, retained earnings as of February 1, 2009, increased from $63.4 million using the LIFO method to $66.1 million using the FIFO method. There was no impact to net cash provided by operating activities as a result of this change in accounting policy.
In some cases the pen is mightier than the sword. It seems the CFO at Duckwall added 34 cents in additional earnings for the fourth quarter of fiscal 2011 by merely changing inventory from LIFO to FIFO. He was also able to create an extra 2.7 million in retained earnings by making the change retroactive to Feb. 1, of 2009. If DUCK was a baseball team, the CFO's pen might be elected the teams' most valuable player.
The net income may have increased by employing more aggressive accounting practices, but the cash flow from operations did not reflect the increased profitability. According to the Financials provided by Gurufocus, year-over-year cash flow from operations dropped from about $15 million for the fiscal fourth quarter 2010 to about 10 million for the fiscal fourth quarter of 2011. Nevertheless, this is how the CEO Wilson described the situation:
"As evidenced by the year-over-year earnings improvement from continuing operations in the fourth quarter, we believe this quarter was one of those stepping-off points where we have the sense of accomplishing many things, are starting to see the results of our efforts, and are well positioned for the future.
In reality, results were much weaker for the fourth quarter of 2011 despite Mr. Wilson's glowing spin. If the company had not switched its accounting for inventories during the quarter, the net income from continuing operations for the year would have been 14 cents instead of 48 cents, compared to 46 cents for 2010. That would have likely sent the stock into a complete tailspin.
The weakness in the company' performance can also be witnessed through its steady increase in debt (note the long term debt on the balance sheet, as of 4/30/201). The long-term debt of DUCK has increased to a multi-year high of over $63 million.
Conclusion
By reading the proxy statement and footnotes for Duckwall-Alco, it is apparent that the company has a management bonus system which does not align with the best interests of the shareholders. It is conceivable that management could draw bonuses while reducing the liquidity and the cash flow of the company. The bonus system offers no incentive to reduce company debt. Rather it encourages the use of leverage to enhance the company's accrual earnings and ROE.
Second and more important, the company switched from a LIFO to a FIFO inventory system in the fourth quarter of fiscal 2011 which embellished earnings by 34 cents per share for the Christmas quarter. A retroactive shift in the valuation for inventories inflated the companies retained earnings by $2.7 million. This embellishment was clearly visible by reading the footnotes to the annual reports.
disclosure, no position in DUCK
One of the most under-utilized pieces of shareholder information is Form Def 14a, the proxy statement. Two of the most important features of the proxy statement are the detailed profiles of management and directors and a complete explanation of their compensation.
The compensation of officers frequently contains bonuses, stock option grants and other incentives; it is essential for shareholders to understand exactly how the officers are paid if one wishes to fully understand the business and its risks.
Another source of valuable information exists in the footnotes which tend to be buried at the bottom of the 10K (annual report).
Today's article will detail a case where careful analysis of management compensation and 10K footnotes raises some serious questions which shareholders should consider before purchasing or continuing to hold Duckwall-Alco (DUCK, Financial).
Duckwall-Alco Executive Compensation and Net Earnings.
As we can tell by reading his profile in the proxy statement, Richard Wilson took over as CEO of Duckwall-Alco on February 19, 2010. The following describes his bonus plan:
For Mr. Zigerelli and Ms. Gilmartin, the first performance period began on August 4, 2008, and ended on August 2, 2009 and the second performance period began on August 3, 2009, and ended on August 1, 2010. For Mr. Wilson, the first performance period began on February 15, 2010 and ended on January 30, 2011 and all subsequent bonus periods begin at the start of each fiscal year subsequent to the first performance period and end at the end of such fiscal year. Mr. Zigerelli, Ms. Gilmartin and Mr. Wilson’s employment agreements each provide that they will receive a bonus based on the Company’s ROE (as defined below) for the applicable performance period as follows:
ROE | Amount of Bonus | |
7.49% or less | No Bonus | |
7.5% to 9.99% | 50% of base salary | |
10% to 12.49% | 75% of base salary | |
12.5% to 14.99% | 100% of base salary | |
15% to 17.49% | 125% of base salary | |
17.5% or more | 150% of base salary |
As set forth in Mr. Zigerelli and Ms. Gilmartin’s employment agreements, “ROE” means, for any 12-month period, earnings from continuing operations before discontinued operations for such period, excluding cumulative changes in accounting and one-time termination benefits recognized in accordance with FASB ASC Topic 718, divided by the stockholders’ equity at the end of the immediately preceding 12-month period. Under Mr. Wilson’s employment agreement, ROE is defined as, for any 12 month period, earnings from continuing operations before discontinued operations for such period, excluding cumulative changes in accounting and one-time termination benefits recognized in accordance with FAS 146, divided by the stockholders’ equity at the end of the immediately preceding 12-month period. The Compensation Committee selected the performance measures of ROE to focus the named executive officers on creating long-term stockholder value, aligning the named executive officers’ financial interests with the interests of the Company’s stockholders.
The idea of bonuses is to align compensation with the interests of the shareholders, paying large bonuses based upon return on equity is hardly my idea of a shareholder-friendly alignment for the following reasons:
1) ROE encourages the management to lever up since unlike ROC, debt plays no role in the calculation.
2) ROE is calculated by using accrual earnings rather than cash flow; by basing bonuses upon net earnings the management is encouraged to employ aggressive accounting techniques to reach their bonus levels.
Interestingly and perhaps not coincidentally DUCK management chose to change their accounting for inventory late in 2010. From their most recent 10K:
In the fourth quarter of fiscal year 2011, the Company elected to change its method of accounting for inventory to the first-in first-out (FIFO) method from the last-in first-out (LIFO) method. The Company believes the FIFO method is preferable to the LIFO method as it better reflects the current value of inventory on the Company’s balance sheet and provides better matching of revenues and expenses. The impact of this change in accounting principle on the financial statements for each of the periods is further explained in Note 2.
Here is part of Note 2 from the 10K:
Had the Company not changed its policy for accounting for inventory, pre-tax income the year ended January 30, 2011 would have been $1.3 million lower ($0.34 effect on both earnings per basic and diluted share). As a result of the accounting change, retained earnings as of February 1, 2009, increased from $63.4 million using the LIFO method to $66.1 million using the FIFO method. There was no impact to net cash provided by operating activities as a result of this change in accounting policy.
In some cases the pen is mightier than the sword. It seems the CFO at Duckwall added 34 cents in additional earnings for the fourth quarter of fiscal 2011 by merely changing inventory from LIFO to FIFO. He was also able to create an extra 2.7 million in retained earnings by making the change retroactive to Feb. 1, of 2009. If DUCK was a baseball team, the CFO's pen might be elected the teams' most valuable player.
The net income may have increased by employing more aggressive accounting practices, but the cash flow from operations did not reflect the increased profitability. According to the Financials provided by Gurufocus, year-over-year cash flow from operations dropped from about $15 million for the fiscal fourth quarter 2010 to about 10 million for the fiscal fourth quarter of 2011. Nevertheless, this is how the CEO Wilson described the situation:
"As evidenced by the year-over-year earnings improvement from continuing operations in the fourth quarter, we believe this quarter was one of those stepping-off points where we have the sense of accomplishing many things, are starting to see the results of our efforts, and are well positioned for the future.
In reality, results were much weaker for the fourth quarter of 2011 despite Mr. Wilson's glowing spin. If the company had not switched its accounting for inventories during the quarter, the net income from continuing operations for the year would have been 14 cents instead of 48 cents, compared to 46 cents for 2010. That would have likely sent the stock into a complete tailspin.
The weakness in the company' performance can also be witnessed through its steady increase in debt (note the long term debt on the balance sheet, as of 4/30/201). The long-term debt of DUCK has increased to a multi-year high of over $63 million.
Conclusion
By reading the proxy statement and footnotes for Duckwall-Alco, it is apparent that the company has a management bonus system which does not align with the best interests of the shareholders. It is conceivable that management could draw bonuses while reducing the liquidity and the cash flow of the company. The bonus system offers no incentive to reduce company debt. Rather it encourages the use of leverage to enhance the company's accrual earnings and ROE.
Second and more important, the company switched from a LIFO to a FIFO inventory system in the fourth quarter of fiscal 2011 which embellished earnings by 34 cents per share for the Christmas quarter. A retroactive shift in the valuation for inventories inflated the companies retained earnings by $2.7 million. This embellishment was clearly visible by reading the footnotes to the annual reports.
disclosure, no position in DUCK
