Economic incentives govern how participants behave and interact in a free market economic system. In context of company analysis, spending some time understanding incentives is one of the most rewarding activities in terms of “bang for your bucks“.
We previously looked at incentives in context of capital providers to MYOB and Xero. Here I would like to explore how investors can often obtain useful signals and insights though an assessment of management incentives.
What is notable about management incentive schemes is that they are theoretically negotiated at arms-length between informed insiders (assuming adherence to good corporate governance practices). Thus they can often yield clues as to what the real and reasonable internal expectations are for the company. It is then a revealing exercise to reconcile these internal expectations against external (i.e. market) expectations.
I will demonstrate how this process can yield an additional level of insights using IDP Education as a worked example.
What are the internal expectations?
A myriad of Performance Rights and Options are currently on issue to IDP’s management team as part of IDP’s Long Term Incentive (“LTI”) scheme. Of particular interest to us is the most recent issuance of Performance Rights in October 2015 (less than one month prior to IDP’s Prospectus lodgement).
We see below that the NPAT CAGR vesting threshold was set at between 5%-6% NPAT CAGR, using FY2015 NPAT as a baseline:
…the baseline FY2015 NPAT referenced being $30.3m:
So it appears that from, an internal perspective, achieving NPAT growth of 5%-6% p.a. over FY2015-FY2018 would be considered a decent outcome. In other words, achievement of $36m NPAT in FY2018 ($0.7m above FY2016 NPAT) will be sufficient for full vesting of tranche 2 of IDP’s long term incentive plan.
Then let’s take a look at external expectations for IDP in context of the IPO offering:
We can see here that externally, IDP’s IPO is being sold to investors at 18.8x FY2016 NPAT and IDP’s NPAT trajectory is described as follows:
So is there a misalignment between internal and external expectations?
Interestingly, the 2013 and 2014 LTI Awards granted in February 2014 had a significantly higher EPS CAGR vesting thresholds at 10% p.a. So has there been a shift in internal expectations with respect to IDP’s earnings growth rate?
Let’s then look at IDP’s Total Shareholder Return (“TSR”) threshold, requiring a delivery of TSR CAGR of 8% p.a. for full vesting:
Note here that the baseline market capitalisation had been set at $360m. This compares against an IPO market capitalisation $665m. Accordingly, this was also the valuation that had been set for CEO sign-on options (exercise price of $1.10 compared to IPO issuance price of $2.65).
So was this reflective of an internal valuation for IDP arrived at between informed insiders a month prior to Prospectus lodgement? And how are management and shareholder interests aligned if TSR from Management’s perspective is calculated from a starting point that is $305m below the starting point for IPO investors?
Are internal expectations being met?
Remuneration Reports can also provide clues as to the company’s performance from an internal perspective, as opposed to the external investor relations perspective.
We note below that the measure “Growth in source countries achieving target volumes of finalised multi destination students” was deemed to have been Below target.
…which somewhat contradicts the external facing narrative where the company was supposed to have achieved strong results in this area:
Why is this so? How can management have achieved 72% YoY growth and still be Below Target? From here we can do some further digging and it appears that a portion of the 72% YoY growth in multi-destination revenue were attributable to the acquisition of “a small China based Student Placement agent” during FY2015.
Do options align the interests?
Investors often fail to distinguish between the receipt of free options by management and the investment of management’s own capital alongside investors. They are not the same.
Buffett articulates this distinction in Berkshire Hathaway’s 1985 shareholder letter:
Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift – but I’ll never buy one.)
So are management’s interests truly aligned with yours and are you expecting a set of results that are in alignment with internal expectations?
Obviously, this is not the full picture when it comes to company analysis and I caution against making an investment decisions based on this analysis in isolation.
However, at minimum it is an extremely useful heuristic to apply in your investment due diligence.
Note: The above article constitutes the author’s personal views only and is not to be construed as investment advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this article. Disclosure – I hold no positions in IEL at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION).