Wednesday, February 25, 2009

WU - Update and what now?

The advantages of Western Union (Ticker: WU) business model is fairly well known. It is scalable and generates lot of cash. We are now in a new reality and it is worth checking back if it is worth continuing to be invested. Here are some thoughts...

1. General ongoing environment: It looks like we are in for a period of prolonged downturn and possibly a reset to new level of economic activity rather than return to pre-bubble economic activity. Lets say, two years of painful revenue drops (15% drop) and followed by growth based on inflationary levels from that point. No one knows for sure but evaluating companies with this in mind is always a good start. If it survives this scenario, other scenarios (except great depression II) will be good outcomes.

2. Debt: In this environment, any debt is a bad debt. Western Union had around $2 Billion of debt. First the good news. Much of this debt is due to paying a dividend to First Data and not due to business needs. Western Union generates more than $1 Billion dollar of free cash flow per year. Still that assumes future will be like the past. Plus operating leverage works both ways. Since the network of money transfer is already established, incremental revenue falls to bottom line. The reverse (current situation) is also true. That is, drop in revenue could cause much steeper loss of earnings. I think management must act conservatively first and pay back debt as soon as possible.

3. The general lack of growth in economy means less activity in construction and employment levels. So in general, Western Union customers have less money to transfer. So revenue can drop off. This is negative like it is for many other companies.

4. Western Union's competitor (Money Gram) is weaker because of issues in their check cashing business. Since money transfer is not capital intensive business, Money gram can still find ways to grow. But not with as much strength to compete against Western Union. If it comes down to it, Western Union can sustain lower prices for longer than Money Gram. So weaker competitor does not hurt but does not help as much as it would in a capital intensive business. Plus perception of strong player is always a plus in anything to do with money.

5. While growth due to economic activity will be reduced, we can expect some acquisitions of smaller players. Plus smaller players may find it hard to withstand prolonged recession. This is positive.

6. Since multinational Banks are weaker, they may now start to focus on their core areas and not focus on money transfer. This is positive.

7. Western Union does not carry credit risk and can withstand prolonged recession if it manages it's expenses and debt carefully.

8. The current political climate in Washington may result in meaningful immigration reform which will be positive for Western Union.

In summary, if economy falls into few years of weakness, Western Union will take few hits to it's earnings but will survive. The pain until then is definite. But will remain as one of the last standing players. When economy eventually returns to more normal level, their rise will be remarkable! Or so I hope!

Monday, February 2, 2009

Why stock options misalign incentives

It is a common cliche that stock options align management and shareholder interests. The story goes something like this. If stock price goes up, both option holder and share holder benefit. If it goes down, stock option holder does not reap any benefit. I think this is a very superficial analysis and needs a little digging. The following discussion will provide reasons why this is not necessarily the case. In a nutshell, I think shareholders are usually better off without stock options and providing high cash bonus.

Warren Buffet has dealt with stock options in 1985, 1992, 1998, 1999,2002, 2004, 2005, 2007 annual reports. Needless to say, it is a must read for those interested in options and seems to be pet subject for the investment guru. We will look at some of those reasoning below along with suggestions to deal with companies using options.

Basics of stock options offered to management as compensation: Managements are usually offered fixed price 10 year stock options. Essentially, the management has the right to buy the company stock at the strike price (usually market price) any time over the next 10 years after the vesting period is over. So if the company stock was $50 at the time of offer and was $100 after 5 years, management can buy the stock for $50 and hence can make a profit of $50. Similarly, if the stock price were to be $25, it has no value to the stock option holder.

So what's to worry about!
Let's look at some reasons why stock options do not necessarily put stock option holder and share owner in the same boat.

Where's the downside risk? If the share price were to go to $25 in the above example, share holder lost 50% of his capital. There is no such capital risk for management. It is true that management has invested his/her time and skill with the hope of benefiting on the upside. But they do get base pay and other compensation for their efforts. Stock options are an added bonus for success. So for Stock holder, it is "Heads I win, Tails I lose" and for stock option holder, it is "Heads I win, Tails I did not lose or gain anything". So to summarize, both option holder and stock owner's downside are way different. In fact lack of downside for option holder, may set the stage for taking big risks because upside is great without associated huge downside. For stock owner, success on upside needs to be weighed against downside on failure. Why provide incentives to your management to bet big with your money?

Why does Management benefit from additional capital you add to business every year?
Lets say a company's Return on equity is 15% and no debt. Lets also say that it retains all it's earnings. If the equity per share is $100, company's earnings will be $15. This earnings belong to share holder. Management will deploy the retained earnings (that belongs to share holder) to create earnings growth. For example, management may add additional stores if it is fast growing retailer that contributes to earnings growth. So total capital now deployed next year is $115 per share and lets assume that the new store is as productive as the old store for simplicity. Then 15% return on equity would mean earnings this year will be $17.25 per share (Equity * ROE -->115 * 15/100). As you see, earnings growth between two years is exactly 15% (17.25-15/15). Now share price will appropriately move upwards. Share holder and option holder benefits from share price increase. But note that the management could not have caused earnings increase but for the addition of new store. The new store in turn needed capital which came from retained earnings (that belong to share holder). If share holder had withdrawn the earnings as dividends, where will the growth have come from? If so, the option holder must not benefit from this additional capital retained every year. It is true that management skill in opening and running new store (deploying new capital) is key. But that does not mean all earnings growth is due to management skill. It is ideally a combination of management skill and retained earnings. So one solution is to adjust the strike price for the new capital. I am not aware of many (if any) comapnies that do that. As a side note, it causes management to retain capital in businesses even when it is not wise to expand business operations!

Stock options are granted at market price and not at it's intrinsic value
. Market price at the time of grant may or may not be near intrinsic value of a company. Most value investors understand that company's market price may be different from it's intrinsic value. If Mr. Market is in bad mood and prices the company much lower than it's intrinsic value at the time of option grant, then the person receiving option may benefit from market repricing at a future date. This may or may not be the direct result of anything management did. Similarly, the market gets into one of those heady bull markets, the option holder may benefit from general market levels moving higher. Neither of these scenarios are in control of either the management or the Board (who sets compensation). But in either case, the option holder (usually management) benefits for no fault (or work!) of his. Why reward someone for result that they did not produce. If you dont believe market price will be different from intrinsic value, here is one from the master. Mr. Buffet points out in 1985 annual report that when a CEO plans to sell the company or merge with other entity, CEO is unfailing to point out that market price understates the company's worth. Why give piece of your company at anything other than it's fair value ?

Capital allocation misalignment-Dividends Vs Stock buyback decision: Stock option based compensation hinder earnings to be allocated in the best interest of owner. Here is how. The earnings of a company that is left after routine maintenance and "growth projects" can be either distributed as dividends or be used to buy back company shares. For the options holder, anything that increases earnings per share is positive (which share repurchase does). Dividends do not increase earnings per share. Thus, stock option based compensation encourages stock repurchases over dividend without regard to market price of the share.
For a true owner, equation is way different. For the regular share holder, buying back shares makes sense only if the price of stock is less than the intrinsic value calculated conservatively. In other cases, dividends is much better option. In fact buying back high priced shares cause value destruction for the owner. It is like buying dollar bills for dollar and 30 cents.
Thus stock option based compensation encourages repurchase over dividends irrespective of what the share price is. This does not mean managements will always do it that way but why set an incentive that works against you (the owner!).

Why hire employee's whose salary is unknown: A company benefits if the financial benefit arising from services of an employee exceed the compensation paid. Otherwise it is a loss. This statement is true, whether you use cash or any other form of payment. Stock options uses company shares as currency to pay for employee services. It is a currency whose precise (or even approximate) cost is not known at the time of offer( more on this later). Since the cost of options is unknown, it is not easily possible to figure out whether the employee adds more value than the benefit he/she receives as stock options from the the company. Ironically, this is the same argument (cost of options is unknown) that many managements used to not expense stock options(!). But I would flip this argument and say, this is a good reason to use other forms of compensation when possible. May be a high cash bonus for achieving predetermined goals.

Why 10 year fixed price options without holding period requirement! Managements are usually granted 10 year fixed price options. That is, options can be exercised (any time after vesting period) over next 10 years but not required to hold the shares after exercising the options. First, why provide it for 10 years! As discussed before, the capital added in the form of retained earnings exceed the book value in some companies! The option holder benefits over a 10 year period without having a dime of capital at risk. It is true that many exercise their options before 10 years. To bring some balance, why not require holding period (say 2 to 3 years) for some part of the options exercised? Say 30% of the options need to be held for 3 to 5 years after exercise? It will provide some alignment.

Doesn't Share buyback cancels out effect of option dilution? This is the height of shareholder unfriendly activity. Share buy back costs money. If options cause additional shares to be issued, then buying back additional shares does not offset the effect of options. The money used for buyback comes from share holder money (retained earnings) and is is not free money. So do not accept that share buyback nullifies stock option dilution. In fact, it can make it worse. It induces management to buyback shares when the prices are not attractive. In effect, it doubles down the harm caused to share holder.

The worst kind: Reprice stock options: This is height of misalignment between share holder and investor. If you buy a share at $100 and it's price goes to $50, you lose $50. However, if an employee is offered stock options at $100 and if price goes to $50, the options are way under water. Unlike share owner who has put in capital, employee has put in his time and skill with the hope of benefiting on the upside. Since options are under water, he like share holder will at least not get any return until company's fortune reverses. But this equation is flipped upside down when the management suddenly decides to reprice the already outstanding stock options at $50. This means that if the stock now goes to $75, employee will benefit by $25 per option while share holder who purchased at $100 will lose $25. To add insult to injury, the lower the share price goes before repricing, more the profit for employee and more the expense for the share holder for those options. It simply means that 'Heads I win and Tails I win even more'. Many companies have moved away from this but not entirely. Recently Google repriced their stock options. Their logic likely is that they will lose talented employee if they do not reprice. I would say if you want to pay employee irrespective of stock price ('Heads I win, Tails I want to win still'), do not use options. Provide cash bonus and do not claim alignment with stock holder. Stock option reprice must be viewed with skepticism by investor and usually should reconsider being share holder.

Tell me how an excellant company will treat me ! Before we end, here is an excerpt from Berkshire owner's manual for some cooling of eyes.

o We will issue common stock only when we receive as much in
business value as we give. This rule applies to all forms of
issuance - not only mergers or public stock offerings, but stock
for-debt swaps, stock options, and convertible securities as
well. We will not sell small portions of your company - and that
is what the issuance of shares amounts to - on a basis
inconsistent with the value of the entire enterprise.

Since many company's use options, what can an investor do? It is not possible to totally avoid companies with options. So here are some thumb rules.

1. Stay away from the one's that use options excessively. Even if it means passing up some nice opportunities, you can sleep soundly. Plus there is likely to be other share holder unfriendly activities at the firm.

2. If a firm that does not offer stock options, consider it a shareholder friendly move. Provide weight in your analysis for share holder friendly firms. They need to trade at slight premium to rest (all other things being equal), since share holder can better benefit from wealth created by business.

3. Options can be used properly but is rare. I will not get into this subject since I do not believe that share holder friendly ways of using options will be devised. For those interested, please refer to Warren Buffet's 1985 annual report for suggestions.

4. Prefer companies with CEO or board members with significant stake in the company. You will need to filter out those where CEO's who already have significant stake but reward themselves with additional stock options.

4. How to value effect of options: At this time, companies are forced to value options and treat them as expense. Most use Black Scholes model with varying assumptions. Wall Street Journal's weekend edition (Jan 31, 2009) had a nice article. It stated that option expense is understated by Black scholes model if price of stock appreciates and overstates when price of stock falls. On the whole expensing options does provide investor some built in protection against overestimating earnings. I use a more conservative estimate. Here is how I do.

I aim to generate 14% return from a stock when I purchase including dividends (doubling in 5 years). That does not mean I do it! Lets say price is $50 at purchase and I sell at $100 after 5 years. To keep it simple, lets remove dividends for a minute.
Find the total stock options (say 1 million options) outstanding and their net weighted average strike price (say $35). This information is available in annual reports.

If all options are sold after 5 years, then cost is $65 per option ($100 - $35) after 5 years. So total is $65 million over 5 years. I divide by 5 years for yearly cost and apply tax benefit. This does not take into account time value of money. This usually turns out to be higher than the model but it makes me comfortable. If this is complex, use the model output and use bigger margin of safety.

Also, it will help to note Warren Buffet's comment on impact of stock options on earnings in his calculation. Note that this was written at a time (1998) when option expensing was optional. So now it does not apply completely now that is required to expense it. But provides a window from the Master!

"The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported per-share figures by 5%, with 10% not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made."

5.The bigger problem is the fact that you do not know how much more stock options company will issue over the next few years of holding period, thereby diluting your holdings! This does create an issue for long term holders of stock.