Jeff Matthews had a great blog post a few weeks ago (here) in regards to Target’s (TGT) latest earnings report; here’s a reprint of the portion that is relevant to this conversation:
“Here’s how they started their script:
Target's second-quarter financial results reflect strong US profit performance in spite of soft traffic and sales…. As a result, we delivered second-quarter adjusted EPS of $1.19, at the high end of our expectation going into the quarter. Our GAAP EPS of $0.95 was in the middle of our expected range, reflecting higher than expected dilution of $0.21 from our Canadian segment. As we monitor the economy and consumer sentiment, we continue to see a mix of signals in which emerging optimism is balanced with continuing challenges.
And here’s how they concluded before taking questions:
For the full year, we've become incrementally more cautious in our US sales outlook, given our own recent results and those of our competitors. … Even with our more tempered sales expectation we believe full-year adjusted EPS will remain in the $4.70 to $4.90 range we provided previously, although our expectation has moved to the low end of that range. We expect full-year GAAP EPS will be approximately $0.95 lower than adjusted EPS reflecting $0.82 of dilution from the Canadian segment combined with a net $0.13 of dilution from the credit card portfolio sale and associated debt repurchase.
By way of background, Target recently entered the Canadian market after buying a bunch of store leases from Hudson’s Bay two years ago. The newly opened Canadian Target stores are losing money at the moment. Quite a bit of money — something like half a billion dollars in their first year. Target management, not wanting to spook the easily-spookable analyst community on Wall Street, simply subtracts those losses, along with some other stuff, from its GAAP EPS (readers may recall that “GAAP” accounting means, to be clear, earnings in accordance with Generally Accepted Accounting Principles) to create something it calls “Adjusted EPS.” And Wall Street’s Finest dutifully report what Target gives them.
In fact, in my inbox following the call were half a dozen Wall Street analyst reports using the “Adjusted EPS” figures in their earnings — and P/E — tables. Not the GAAP EPS figures.
Readers will recall that it was the bastardization of GAAP earnings into non-GAAP, made-up, adjusted earnings that fooled Hewlett-Packard’s investors into thinking the company was doing better than it was doing for so many years.
In its defense, of course, Target will argue that investors want to see the “underlying” earnings from the company’s core business, and that certainly has an appealing sense of logic to it.
However, the company’s investment in Canada is not a one-off. It is not a science experiment. It is not, yet, a “discontinued operation.”
It is, in fact, part of the company’s core business.
Indeed, hundreds of public companies across America right now are investing in things that may or may not pay off, yet they do not exclude the expense of those things in “Adjusted earnings.”
Worse, Target includes expected earnings from Canada in the out-years of their financial forecasts, as they bragged on their call:
We’re still very confident in our Canadian strategy, stores and team and continue to believe the segment will generate $0.80 or more of EPS in 2017.
So, as with Hewlett-Packard—which routinely excluded the bad stuff from acquisitions (goodwill amortization and restructuring costs) in its “Adjusted” earnings while including the good stuff (sales, gross profit and operating income, such as it was) from acquisitions— we have a retailer that wants Wall Street to exclude the bad stuff (upfront costs of entering Canada) and include the good stuff (future earnings from Canada).”
As Mr. Matthews noted, management is concerned with pleasing the Street, and there’s no doubt this explains why they bother parading out “non-GAAP” earnings. However, I think there’s another reason why they focus on these metrics, and it has to do with management’s own incentives; we can see why that’s the case as we dig deeper into the company’s proxy statement.
Looking at the company’s pay mix for fiscal 2012, we see that just under 20% of the total (for both the CEO and other named executive officers) is paid in performance share units; one of the measures that determine the number of PSU’s to be paid is the compounded annual growth rate in EPS (relative to the company’s retail peer group) over the trailing three year period.
After discussing the company’s relative performance in the fiscal year on the EPS metric, the proxy offers this important disclosure: “These results exclude the impact of our Canadian Segment...” (In the company’s defense, at least the investment in the Canadian operations is considered in other portions of the comp calculation in fiscal 2012; in the prior year, the board had removed the results of Canadian operations from the majority of variable pay considerations. The region reported a pre-tax loss of $167 million in fiscal 2011, a 4% hit to reported earnings.)
There’s a simple question: Why? This brings us to the board of directors; as the chair of the compensation committee, James A. Johnson is the man worth looking at. Mr. Johnson founded a private consulting company in 2000 (Johnson Capital Partners), and recently retired as the vice chairman of a merchant banking private equity firm (Perseus LLC). He currently holds directorships at Goldman Sachs (GS) and Forestar Group (FOR); previously, Mr. Johnson was on the boards of UnitedHealth Group (UNH) and KB Home (KBH). UnitedHealth may jump out to people who are familiar with the scandal surrounding the former CEO, William McGuire (worth reading about, here and here); as it turns out, Mr. Johnson was also a member - and eventually chairman – of the comp committee at UNH from 2004 to 2007. To be clear, I am not intimately familiar with the situation at UnitedHealth, nor with Mr. Johnson's time on the company's board; for what it’s worth, CalPERS felt strongly enough about his impact (or lack thereof) at UNH to withhold reelection votes for Mr. Johnson (link).
The misaligned incentives for the management team at Target extend to the directors. Mr. Johnson has been on TGT's board since 1996; despite having been on the board for more than 15 years, Mr. Johnson doesn’t own - directly or indirectly - a single share of Target common stock as of the most recent proxy filing (he has received approximately $450,000 in cumulative stock awards in the last three years alone). In the most recent year, Mr. Johnson was paid just under $310,000 to be a board member – or more than $50,000 per meeting. The total figure is nearly 10x what Berkshire Hathaway (BRK.A, BRK.B)'s non-management members of the board – ten people in total – CUMULATIVELY received in the most recent fiscal year as director fees.
For those who consider the comparison to Berkshire too difficult, consider Target's retail peer, Wal-Mart (WMT): Mike Duke, the company’s CEO and the chair of the comp committee, has more than $90 million in Wal-Mart stock to his name; every single director on Wal-Mart’s board owns common stock (two of whom have been on the board for just over 12 months).
I don’t want to paint a one-sided picture of Target's corporate governance; my focus is the overwhelming power of incentives as a whole. In this case, the chair of the compensation committee has no reason to incentivize the type of action that an owner would push for. I think that’s the culprit for the acceptance of this distorted idea that investments should be disregarded, but the benefits (assuming they materialize at some point) should be counted in full. I think the answer to the question asked above – why? – is quite clear: why not? Making a stink about the comp structure offers no benefits, and potentially risks a pretty nice paycheck for a few days of work a year; in the same position, 95% of people would do the same thing as Target's comp committee, if not more.
I’ll close with a relevant quote from Charlie Munger:
“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with a handful of positions accounting for the majority of the total. From the perspective of a businessman, I believe this is sufficient diversification.