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Incentives matter: Pro-Dex (PDEX)

October 10, 2013 | About:
whopper investments

whopper investments

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One of the things I harp on more than almost any author/blogger I know of is discussing where / management’s incentives lie. The reasoning is simple: I believe that people are always going to do what’s in their best interest. If it’s in a CEO’s best interest for a company to grow, than that company is going to do everything it can to grow whether it’s in shareholders’ best interests or not. If a CEO can justify giving himself a bonus, then he’s probably going to take a bonus, even if the reason the company is doing well is outside of his control or temporary (think top of a cycle in a boom/bust industry). And if the bottom line doesn’t matter to the CEO because he only owns a token amount of shares, then he’s probably going to spring for that lavish Christmas party with an open bar and iPads for everyone.

But all of those are very hypothetical examples. I want to point out a very real example of incentives making a huge difference. It’s in a stock I’ve discussed several times recently, Pro-Dex (PDEX).

In 2011, the company gave their CEO a $300k bonus to go along with his $300k+ base salary. The company gave him the bonus because EBITDA had risen from under $2m to almost $4m that year. Well deserved, right?

Probably not. The increase in EBITDA had been driven by their largest customer dramatically ramping up orders temporarily in order to prepare for a switch away from Pro-Dex. Not only did the company respond to that temporary increase by giving their CEO a huge bonus, they also responded by raising their board fees quite dramatically.

In other words, while the earnings increase was temporary, management and the board felt like it was a permanent increase that justified spending like drunken sailors. Why would they do that? Probably because they controlled in total ~450k, or less than $900k in stock. And of that 450k, over 1/3 of the ownership was through stock options, so total $ value stock ownership after accounting for option exercise price was well under $900k.

Now, any businessman facing a temporary increase in earnings like that would use the cash to invest in the business and try to replace the lost earnings, or maybe just cut costs and take the cash out of the business to be put towards more productive uses. But Pro-Dex’s management’s incentives encouraged them to think of the earnings increase as permanent and reward themselves, and that’s exactly what they did. In fact, it wasn’t until someone whose economic interests were aligned with an increasing stock price (namely, two hedge funds with huge ownership stakes) came along and started pressing for changes that management announced they were cutting costs, considering returning cash to shareholders, and looking for new growth areas. By then, it was (of course) too late, as the hedge funds wanted to put in a fresh management team to turn the business around and started a proxy fight.

Now, proxy fights are funny beasts. Management team gets to spend shareholder money fighting to keep their jobs against an activist team. If you believe (as I do) that stock owners truly own the business, management effectively gets to spend shareholder’s money to fight themselves. It’s a bit twisted. But most management teams would recognize that a group of shareholders representing 30%+ of shares outstanding is pretty easily going to have their way with any proxy fight. Still, instead of negotiating with the shareholders and trying to save the expense of a proxy fight, management felt content to spend another $100k trying to keep their jobs.

Contrast with what happened once the hedge funds took over. Annual pay for the board went from $24k per year plus 10k stock options to a flat $200 per meeting w/ a max of $2k per year. Salaries were cut to align with the new lower sales base. In other words, now that the bottom line mattered (people with a significant equity stake were in control), the moves any prudent business man facing a lower level of sales would make were… made.

So what does this all mean for you? It’s just something to keep in mind next time you research a company. Where are management’s incentives? Are they aligned towards getting a higher salary or a higher stock price? If it’s the former, you need to have a much bigger margin of safety to invest, because you can be sure that some of that margin is going to go to management, not shareholders.

Disclosure- Long PDEX

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