Highlights From Warren Buffett’s 2016 Annual Letter

“Today, I would rather prep for a colonoscopy than issue Berkshire shares.”

— Warren Buffett, 2016 letter to shareholders

The last Saturday in February has become something of a ritual for Berkshire Hathaway shareholders as well as many other interested observers.  Some have likened it to “Christmas morning” for capitalists.  While this has “cult-like” overtones, the release of Warren Buffett’s annual letter to Berkshire Hathaway shareholders is rightly regarded as a major event for anyone interested in business.  This is mainly because Mr. Buffett does not restrict the scope of his commentary to Berkshire’s results but also opines on a wide variety of topics of general interest.  In a format lending itself to greater depth than a television interview, we are offered an opportunity to see Mr. Buffett reveal some of his cards.

This article presents selected excerpts and commentary on a few of the important subjects directly related to Berkshire but is not an all encompassing review of the letter, especially as it relates to commentary on general business conditions in the United States.  Everyone is going to take away something different from reading the letter and it is important to spend some time looking at the actual document before reading the opinions of others, or even reading selected excerpts.  This is particularly true for shareholders who should look at business results with fresh eyes rather than to allow others to direct them to what is important.

Read Warren Buffett’s 2016 letter to Berkshire Hathaway shareholders

Berkshire’s Intrinsic Value

Longtime observers of Berkshire Hathaway know that Mr. Buffett does not comment specifically on the company’s intrinsic value.  This is entirely appropriate for a number of reasons.  If you take two informed individuals and ask them to judge the intrinsic value of any business, it is very unlikely that the estimates will match exactly.  What we should want from a CEO is an assessment of the fundamentals.  As shareholders, we are responsible for determining our own estimates of intrinsic value.  That being said, Mr. Buffett does provide some important commentary regarding intrinsic value as well as clear indications of his view of intrinsic value relative to book value.

At the beginning of the letter, Mr. Buffett comments on how Berkshire’s book value was a reasonably close approximation for intrinsic value during the first half of his 52 year tenure.  This is because Berkshire was dominated by marketable securities that were “marked to market” on Berkshire’s balance sheet.  However, by the early 1990s, Berkshire shifted its focus to outright ownership of businesses.  The economic goodwill of acquired businesses that show poor results are required to be written down based on GAAP accounting.  In contrast, the economic goodwill of successful acquisitions are never “marked up” on the balance sheet.  This causes a growing gap between book value and intrinsic value given that most, but not all, of Berkshire’s acquisitions have turned out well:

We’ve experienced both outcomes: As is the case in marriage, business acquisitions often deliver surprises after the “I do’s.” I’ve made some dumb purchases, paying far too much for the economic goodwill of companies we acquired. That later led to goodwill write-offs and to consequent reductions in Berkshire’s book value. We’ve also had some winners among the businesses we’ve purchased – a few of the winners very big – but have not written those up by a penny.

We have no quarrel with the asymmetrical accounting that applies here. But, over time, it necessarily widens the gap between Berkshire’s intrinsic value and its book value. Today, the large –  and growing – unrecorded gains at our winners produce an intrinsic value for Berkshire’s shares that far exceeds their book value. The overage is truly huge in our property/casualty insurance business and significant also in many other operations.

What we can take away from this brief discussion is that the gap between Berkshire’s book value and intrinsic value has grown over time and, with additional successful acquisitions, should continue to grow in the future.  To be clear, important aspects of Berkshire’s results will show up in book value in the future.  Berkshire’s retained earnings are fully reflected in book value.  Additionally, changes in the value of marketable securities (with few exceptions) are also reflected in book value, net of deferred taxes.  However, to the extent that the economic goodwill of Berkshire’s wholly owned subsidiaries continue to increase, the gap between book value and intrinsic value will continue to grow.

Repurchases and Intrinsic Value

The discussion of intrinsic value, and the growing gap between book value and intrinsic value, brings up an interesting point that we have identified several times in the past.  Berkshire Hathaway has an unusual policy of declaring, in advance, the maximum price that it is willing to pay to repurchase shares.  When the repurchase program was initially created in September 2011, the limit was 110 percent of book value.  In December 2012, the limit was increased to 120 percent of book value in order to facilitate the repurchase of 9,200 Class A shares from the estate of a long-time shareholder.  The repurchase limit has remained constant ever since and Berkshire has not been able to repurchase any material number of shares despite a few occasions where the share price almost fell to 120 percent of book value.

Mr. Buffett continued to defend the repurchase limit while acknowledging that repurchasing shares has been hard to accomplish:

To date, repurchasing our shares has proved hard to do. That may well be because we have been clear in describing our repurchase policy and thereby have signaled our view that Berkshire’s intrinsic value is significantly higher than 120% of book value. If so, that’s fine. Charlie and I prefer to see Berkshire shares sell in a fairly narrow range around intrinsic value, neither wishing them to sell at an unwarranted high price – it’s no fun having owners who are disappointed with their purchases – nor one too low. Furthermore, our buying out “partners” at a discount is not a particularly gratifying way of making money. Still, market circumstances could create a situation in which repurchases would benefit both continuing and exiting shareholders. If so, we will be ready to act.

The signaling effect of Berkshire setting the repurchase limit at 120 percent of book value has clearly limited the opportunity to actually repurchase shares and has made many shareholders, including some very prominent hedge fund managers, view this level as a floor which is something we have consistently disagreed with. Mr. Buffett once again reiterates that shareholders should not misinterpret the purpose of the repurchase limit:

The authorization given me does not mean that we will “prop” our stock’s price at the 120% ratio. If that level is reached, we will instead attempt to blend a desire to make meaningful purchases at a value-creating price with a related goal of not over-influencing the market.

It is clear that Mr. Buffett regards Berkshire’s intrinsic value as far exceeding the 120 percent of book value limit and he has said so numerous times.  Interestingly, he has also given us a clue regarding what he thinks is above Berkshire’s intrinsic value:  200 percent of book value.  The following excerpt is taken from Mr. Buffett’s 2014 letter to shareholders:

If an investor’s entry point into Berkshire stock is unusually high – at a price, say, approaching double book value, which Berkshire shares have occasionally reached – it may well be many years before the investor can realize a profit. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth. Purchases of Berkshire that investors make at a price modestly above the level at which the company would repurchase its shares, however, should produce gains within a reasonable period of time. Berkshire’s directors will only authorize repurchases at a price they believe to be well below intrinsic value. (In our view, that is an essential criterion for repurchases that is often ignored by other managements.)

So, there we have it:  Mr. Buffett considers 120 percent of book value, and levels modestly above it, to be likely to produce gains for buyers within a reasonable period of time (but still several years) whereas buying at a high level like 200 percent of book value could result in a very extended period of time before a profit can be realized.

As of December 31, 2016, Berkshire’s book value per Class A share was $172,108.  Class A shares closed at $255,040 on Friday, February 24.  This indicates that shares currently trade at 148 percent of book value.  This seems to be more than “modestly above” Berkshire’s repurchase limit, but well below the clear danger level of 200 percent of book.  Is 148 percent of book value a close approximation of intrinsic value?  A good level to buy shares?  Or a good level to sell?  Shareholders cannot expect to be spoon fed an answer by Mr. Buffett and must decide for themselves.

Berkshire’s 21st Century Transformation

A shareholder considering Berkshire Hathaway as an investment opportunity today faces a radically different company than what existed at the turn of the century.  As Mr. Buffett notes early in the letter, the second half of his tenure has been characterized by the growing importance of controlled operating companies.  The effect of this transformation can be clearly seen in a chart of after-tax earnings since 1999:

Sometimes, long term trends are not readily apparent to those who are observing changes on a year-to-year basis.  What is clear, however, when looking at the table above is that Berkshire is a far different company today compared to 1999.  Furthermore, this trend is likely to accelerate significantly in the future, especially if Berkshire intends to retain all or most of its earnings.  As we discussed last year, Berkshire in 2026 is going to look radically different than it does today.  However, we do not know what shape it will necessarily take, other than to note that a major recession is likely to help Berkshire substantially when it comes to capital allocation:

Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.

What Mr. Buffett believes to be an advantage for individual investors with the right temperament is even more of an advantage for Berkshire given the company’s ability to accomplish very large transactions quickly during times of economic distress:

During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.

Berkshire today has significant excess capital available for deployment but the level of exuberance in capital markets is quite high so we have seen cash continue to build up.  Mr. Buffett is 86 years old and apparently has no plans to retire anytime soon.  With some good fortune, he may still be at the helm during the next major economic downturn. From the perspective of Berkshire Hathaway shareholders, the continued retention of earnings and build up of cash makes sense primarily because we are increasing the options available to Mr. Buffett if opportunities arise during his remaining years running Berkshire.

Non-GAAP Accounting

Journalists seeking a “gotcha” story have sometimes identified Berkshire’s treatment of amortization of intangible assets as fertile ground for charges of hypocrisy.  This is because Mr. Buffett has frequently criticized the use of non-GAAP accounting measures at other companies.  In Berkshire’s presentation of the results of certain operating subsidiaries, the amortization of intangible assets is excluded and instead presented as an aggregate figure.  This appears to be done for two primary reasons:  First, the presence of intangible amortization is a function of Mr. Buffett’s capital allocation decisions rather than the underlying ability of subsidiary managers to generate returns on the actual tangible capital they are working with.  Second, much of the intangible amortization is not really an economic cost from Mr. Buffett’s perspective.  Indeed, some of the intangibles are likely to be appreciating in value over time rather than depreciating.

For several years I have told you that the income and expense data shown in this section does not
conform to GAAP. I have explained that this divergence occurs primarily because of GAAP-ordered rules regarding purchase-accounting adjustments that require the full amortization of certain intangibles over periods averaging about 19 years. In our opinion, most of those amortization “expenses” are not truly an economic cost. Our goal in diverging from GAAP in this section is to present the figures to you in a manner reflecting the way in which Charlie and I view and analyze them.

On page 54 we itemize $15.4 billion of intangibles that are yet to be amortized by annual charges to earnings. (More intangibles to be amortized will be created as we make new acquisitions.) On that page, we show that the 2016 amortization charge to GAAP earnings was $1.5 billion, up $384 million from 2015. My judgment is that about 20% of the 2016 charge is a “real” cost. Eventually amortization charges fully write off the related asset. When that happens – most often at the 15-year mark – the GAAP earnings we report will increase without any true improvement in the underlying economics of Berkshire’s business. (My gift to my successor.)

Mr. Buffett goes on to point out that, in some cases, GAAP earnings overstate economic results.  For example, depreciation in the railroad industry regularly understates the actual cost of maintenance capital expenditures required to prevent deterioration of the system.

Are the charges of hypocrisy valid?  We should want managers to present results according to GAAP (which Berkshire does within its financial statements) and to also point out important factors that might cause investors to make appropriate adjustments.  This requires both trust in management’s honesty and the ability of investors to bring to bear appropriate analytical abilities to judge the situation for themselves.  We do not have to blindly trust Mr. Buffett’s statement on intangibles.  We can see the results of the business operations over time and attempt to evaluate whether intangible amortization makes any sense in light of results.  Viewed in this manner, Berkshire’s supplemental presentation seems both useful to shareholders and reflective of economic reality.

In contrast, many companies use non-GAAP measures for purely self-serving purposes, as Mr. Buffett goes on to describe in some detail:

Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.

Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants.

Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.

Those of us who read earnings results routinely know that the types of “adjustments” Mr. Buffett refers to are more the norm than the exception.  The idea that items that recur every single quarter should be excluded from earnings is obviously absurd, but this is how managers are evaluated by the investment community.  Stock based compensation is almost always excluded from “adjusted” figures as if dilution is irrelevant (or, worse, doesn’t matter because the company is blindly repurchasing shares at any price to offset the dilution).  Many companies, including some Berkshire investees, announce restructuring activities on a routine basis and either exclude them entirely from non-GAAP numbers or report these costs as a separate corporate line item that is unallocated to business segment results.

Will Mr. Buffett’s admonishments have any effect whatsoever on the behavior of managers or the blind willingness of the analyst community to accept non-GAAP numbers at face value?  The answer is likely to be no.

Investment Portfolio

Although Mr. Buffett does not discuss Berkshire’s equity investment portfolio in much detail, there are a couple of notable items that deserve investor attention:

  • Berkshire’s investment in Kraft Heinz is accounted for by the equity method and is not carried on Berkshire’s balance sheet at market value, unlike most equity investments that are regularly marked-to-market.  As a result, Berkshire’s 325,442,152 shares of Kraft Heinz are carried by Berkshire at $15.3 billion but had a market value of $28.4 billion at the end of 2016.  This $13.1 billion in unrecorded market value is worth an incremental $8.5 billion in book value for Berkshire after accounting for deferred taxes at an approximate 35 percent tax rate.  It is probably a good idea to adjust Berkshire’s reported book value by adding this $8.5 billion.
  • Berkshire owned $7.1 billion of Apple stock at the end of 2016.  There has been much speculation regarding whether this position was purchased by Mr. Buffett or by Berkshire’s two investment managers, Todd Combs and Ted Weschler.  Mr. Buffett provides a clue:  Mr. Combs and Mr. Weschler manage a total of $21 billion for Berkshire which includes $7.6 billion of pension assets not included in the figures reported for Berkshire.  Accordingly, they control about $13.4 billion of Berkshire’s portfolio reported in the letter and annual report.  While it is not impossible that the entire Apple position can be attributed to Mr. Combs and Mr. Weschler, it would have to account for more than half of their combined portfolio.  This seems unlikely.  We would infer that Mr. Buffett is responsible for at least part of Berkshire’s position in Apple.

Are Berkshire’s positions in marketable securities “permanent”?  Many are held with no predefined “exit” date, but Berkshire reserves the right to sell any security at any time:

Sometimes the comments of shareholders or media imply that we will own certain stocks “forever.” It is true that we own some stocks that I have no intention of selling for as far as the eye can see (and we’re talking 20/20 vision). But we have made no commitment that Berkshire will hold any of its marketable securities forever.

Confusion about this point may have resulted from a too-casual reading of Economic Principle 11 on pages 110 – 111, which has been included in our annual reports since 1983. That principle covers controlled businesses, not marketable securities. This year I’ve added a final sentence to #11 to ensure that our owners understand that we regard any marketable security as available for sale, however unlikely such a sale now seems.

While it is best to not read too much into this statement, we should keep it in mind the next time media reports appear regarding Berkshire’s “permanent” ownership of stocks like Coca-Cola and Wells Fargo.  Indeed, the lack of any mention of the recent Wells Fargo scandal in Mr. Buffett’s letter coupled with this very clear statement could be viewed as a message to managers of portfolio companies.

There are many other important topics in the letter including a lengthy discourse on the merits of passive investment for the vast majority of individuals and institutions.  Readers are encouraged to review the entire letter in full and to view the excerpts and commentary in this article as only a starting point.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. 

Interesting Reading – February 18, 2017

In this series, we suggest worthwhile reading material on a variety of topics of general interest.

Daily Journal Corporation Annual Meeting – February 15, 2017. Charlie Munger spoke for nearly two hours at the Daily Journal annual meeting in Los Angeles.  There are a number of unofficial transcripts available.  The notes linked to above were provided by Adam Blum via Mohnish Pabrai’s Twitter account. In addition, a good video of the event has been posted on YouTube by another attendee. The notes are a great way to get up to speed quickly but those who have a couple of hours to spare might prefer the video.  At age 93, Mr. Munger appears to be in good health and as is obviously as sharp as ever.  Topics ranged from the Daily Journal’s business operations to investments to life advice.  Mr. Munger’s only book recommendation was Edward Thorp’s A Man For All Markets which we plan to review in the near future.  Readers may also be interested in our recent analysis of Daily Journal as well as the company’s fiscal first quarter 10-Q.

Apple: The Greatest Cash Machine in History? – Musings on Markets, February 9, 2017.  Professor Aswath Damodaran updates his thoughts regarding Apple and revisits his previous valuation work.  There is a great deal that has been written on Apple since the company’s latest earnings release, much of which has focused on very short term factors such as the upcoming 10th anniversary iPhone release.  This article is different because it is an update of valuation work on the company that dates back to 2010.  Apple is increasingly attracting value investors who typically are not attracted to technology stocks.  The most notable recent example can be found in Berkshire Hathaway’s recent 13-F filing which revealed a very significant increase.  (As an aside, Prof. Damodaran has recently published a new book, Narrative and Numbers, which is on our list to read and possibly review.)

Snap’s Apple Strategy – Stratechery, February 13, 2017. Snap’s upcoming initial public offering has been widely discussed over the past few weeks.  Is the company the next Facebook, the next Twitter, or something entirely different? Ben Thompson believes that there are similarities between Apple’s historical strategy and Snap’s vision: “Not only is Snap not promising a traditional moat, it is in fact selling its humanity as a company. That the company and its Steve Jobs-admiring CEO in fact do understand users better than everyone else, that that will result in sustainable differentiation, and that the prize will be the top end of the advertising market.”  Readers may also be interested in our recent analysis of the Snap S-1 filing and Professor Damodaran’s much more rigorous valuation article.

Should You Always Keep Stocks for a Full 5 Years? – Gannon on Investing, February 15, 2017. Where do you draw the line between a “trade” and an “investment”?  Is this a matter of the amount of time an investment is held, or based on the investment thesis playing out irrespective of how long that process takes?  If we take Warren Buffett’s advice seriously, we should think of stocks as partial interests in an actual business.  Just as we would not buy a gas station and sell it a couple of months later, we probably should buy stocks with a view of holding for at least several years.  Geoff Gannon provides his thoughts on holding stocks for a minimum of five years and when it might make sense to bend that rule if a clearly superior opportunity comes up.  This link is to a twelve minute podcast but the text of the discussion is also available.

Six Sigma Buffett, Taxes, Fund Returns etc. – The Brooklyn Investor, February 14, 2017. This article attempts to analyze the level of outperformance of various famous managers and to compare the difficulty of compiling track records of various lengths.  While that analysis is interesting, a short digression on Warren Buffett’s views of the 1986 tax reform law might be even more interesting for readers who are trying to evaluate how current tax reform proposals might impact their investments or their personal finances.

Larry Cunningham on Kraft-Heinz Bid for Unilever – Latticework.com, February 18, 2017. Larry Cunningham shares his concerns regarding the Kraft-Heinz bid for Unilever and what Berkshire Hathaway’s partnership with 3G might mean for Berkshire’s culture in the long run.  Observers of Berkshire’s partnership with 3G have frequently noticed that Warren Buffett’s traditional style of acquisitions (friendly, no hostile actions, no bidding wars, leaving management in place) is almost the exact opposite of 3G’s standard procedure (sometimes unfriendly, haggling over price, significant restructuring).  So far, the partnership has worked well but perhaps not without risking Mr. Buffett’s legacy.  (Read our review of Larry Cunningham’s latest book, The Buffett Essays, covering the famous 1996 symposium with Warren Buffett and Charlie Munger).

The Happy City and our $20 Trillion Opportunity – Mr. Money Mustache, February 10, 2017. Although this is ostensibly a book review of Happy City by Charles Montgomery, it is really more of a general discussion regarding the less than optimal choices society has made over the years when it comes to infrastructure spending.  The cost of modern American style infrastructure  – wide roads, expansive parking lots, and unwalkable sprawling suburbs – is extremely high and may not provide good value for the money or result in any increase in happiness.  With talk of a massive new federal infrastructure spending initiative, perhaps this is the right time to think about whether the traditional approach is the best use of our scarce resources.

New Website:  The Spartan Spendthrift. The Spartan Spendthrift is a “sister site” of The Rational Walk which launched in January.  The Rational Walk is focused on investment commentary and security analysis for “enterprising investors” as well as those who just have an interest in thinking about business.  The Spartan Spendthrift is a site dedicated to personal finance and related lifestyle topics.  At this point, there are only a few articles on The Spartan Spendthrift but there will be more in the future.  Interested readers are invited to subscribe to the site via RSS feed, email, or following on Twitter (links are provided on the site).  The Rational Walk will also continue to have new content.  There is no set publishing schedule for either site and both are expected to remain free for readers.

Does Chipotle’s Valuation Offer a Margin of Safety?

Many aspects of life seem to have asymmetrical qualities.  One obvious example involves the amount of time and effort required to build a reputation, both from a personal and professional perspective.  It can take many years to earn the confidence needed to be considered trustworthy by friends and family, and the same is even more true in a professional setting.  However, it only takes one serious breach of confidence to ruin a reputation, no matter how much time was spent building it.  As Warren Buffett has often said, it can take twenty years to build a reputation but only five minutes to lose it.

What is true for individuals is also true for a business, particularly those that are built on brand loyalty.  It is even more true for a business that we entrust with our personal health and well being.  Although we do not think about it until there is a well publicized problem, consuming food prepared by others requires trust, and trust is based on reputation.  Perfection is impossible and it is inevitable that a restaurant company operating thousands of locations will make mistakes leading to occasional food poisoning.  This has always been the case.  However, prior to the era of social media, news about such incidents traveled more slowly and never “went viral” as it does today in Facebook and Twitter feeds.  Social media has created an even greater asymmetry between the work required to build a reputation and the lapses sufficient to ruin it.

Well publicized cases of food poisoning at certain Chipotle restaurants in late 2015 took a major toll on the company’s reputation and financial results in 2016 reflected significant damage to the brand.  We discussed Chipotle’s difficulties in an article last October in some detail, with a focus on the initial outbreak and the financial impact over the first half of 2016.  We also examined Chipotle’s previously attractive expansion economics and overall track record.  The key question at the time was whether the damage to the brand was temporary or permanent.

Chipotle released full year results for 2016 last week and it seems like an opportune time to revisit the situation.  As investors, we seek out asymmetry when making decisions regarding where to commit capital.  We are looking for situations where there is a significant amount of upside and where enough downside protection exists to limit permanent loss of capital if things go wrong.   An open question at this point is whether the significant decline in Chipotle’s stock price has provided enough downside protection for shareholders if the brand does not fully recover.  The related question is what kind of upside might exist if management’s turnaround succeeds.

Evaluating Chipotle’s Financial Performance

In our prior article, we presented quite a bit of financial data for Chipotle over the past decade and readers might want to take a look at that information before proceeding.  In this section, we will first take a brief look at key metrics for 2016 as they relate to prior year results.  However, due to the rapidly changing situation at the company, looking at full year results is not really sufficient to get a picture of the progress that has been made dealing with the crisis over the past year.  In order to do that, we must look at quarterly results.  Finally, we need to decide whether management’s guidance for 2017 makes sense given recent trends.

Full Year 2016 Results

Chipotle’s full year results were dismal, as expected, with comparable restaurant sales declining 20.4 percent and overall revenue declining 13.3 percent.  Operating metrics collapsed with gross margin declining from 26.1 percent to 12.8 percent.  Average sales per restaurant declined to $1.8 million from $2.4 million in 2015. Profitability all but vanished, as reflected by an operating margin under 1 percent, down from 17 percent in 2015. However, management did not slow expansion activity.  240 stores were added bringing the total restaurant count to 2,250, and there are plans to open between 195 to 210 restaurants in 2017.

The exhibit below provides a long term view of Chipotle’s income statement as well as the key operating metrics that drive profitability (click on the exhibit for a larger view):

We can see the 30,000 foot view of the effects of the crisis here and quickly spot the reasons for the deterioration in profitability:

  • Food, beverage and packing costs increased from 33.4 percent of revenue to 35 percent of revenue primarily because of the costs associated with improved food safety procedures, some of which generated additional waste and inefficiency.
  • Labor costs increased from 23.2 percent of revenue to 28.3 percent of revenue primarily due to sales deleveraging.  As revenue per restaurant declined, the company suffered from lower productivity.  In addition, employee costs associated with sales promotions and staffing for new restaurants inflated overall spending.
  • Occupancy costs are basically fixed in nature and increased as a percentage of diminished revenue.  As a result, occupancy rose from 5.6 percent of revenue in 2015 to 7.1 percent of revenue in 2016.
  • Other operating costs increased dramatically primarily due to higher marketing and promotional expenses.  Management spent $103 million on advertising and marketing in 2016 compared to $69.3 million in 2015.  As a result, other operating costs rose to 16.4 percent of revenue in 2016 from 11.4 percent of revenue in 2015.

The past year probably seemed like an eternity for Chipotle’s management team and looking at year-over-year results really isn’t very useful for analysts either given the circumstances.  What we really should care about is how the trends played out over the course of 2016.  Was there significant improvement as the year progressed?

A More Granular View

The exhibit that appears below is essentially the same as what we presented above but rather than looking at annual results, we have provided the relevant statistics for the past eight quarters.  The food safety crisis began partway through the fourth quarter of 2015 (click on the image for a larger view):

We should view the first three quarters of 2015 as the “steady-state” prior to the crisis, with the fourth quarter of 2015 as the transitional month and all of 2016 as the recovery.  All of the elements of gross margin, discussed above, can be analyzed accordingly, and we won’t repeat all of the quarter-to-quarter narrative provided in the company’s quarterly earnings releases.  If our goal is to gauge the overall state of the recovery, the key metrics to focus on are the changes in comparable restaurant sales and restaurant level operating margin:

  • Comparable restaurant sales represent our best way of understanding the damage to Chipotle’s brand among existing customers because it removes the effect of new restaurant openings that might bias analysis of overall changes in revenue.  We can see that the sequential trend has shown some improvement.  The effects of the crisis were immediately apparent with a 14.6 percent decline in Q4 2015 and a nearly thirty percent decline in Q1 2016, but since that point, we have seen some improvement.  We should bear in mind the fact that the 4.8 percent decline in Q4 2016 was compared to an already weakening result for Q4 2015.
  • Restaurant level operating margin is different from overall operating margin.  It represents total revenue less restaurant level operating costs, expressed as a percentage of revenue.  It is effectively a measure of store profitability excluding corporate overhead.  Prior to the crisis, restaurant level operating margin was in the 27-28 percent range.  After a particularly weak first quarter, this measure has recovered but was still roughly half of pre-crisis levels, at 13.5 percent in Q4 2016.

Management’s Forecasts

Management has provided a number of forecasts regarding operating results for 2017, both in the company’s recent 10-K filing and in the latest conference call.  Although best taken with a grain of salt, the key forecasts are as follows:

  • Comparable restaurant sales are forecast to increase in the “high single digits” for the full year.
  • Restaurant operating costs as a percentage of revenue are expected to decline for the full year, with food, beverage and packaging costs decreasing to the “low 34 percent range” due to more favorable food management and lower avocado prices.  Advertising and marketing spending is  expected to decline to about 3 percent of sales for the full year compared to 4.7 percent of sales in Q4 2016.  Occupancy costs are expected to decline to “just over 7 percent of sales”.
  • Restaurant operating margin in the 20 percent range was characterized as a “stretch goal” that is achievable based on current sales volume.  Management believes that if average sales per restaurant can return to the ~$2.5 million range that prevailed prior to the crisis, restaurant operating margin could return to the 26-27 percent range, or higher, implying that restoration of pre-crisis economics is not out of the question but unlikely to occur in 2017.
  • Earnings per share of $10 as a “stretch goal”.

Are these goals realistic?  Well, that is the million dollar question at the moment and it is difficult to know based on an extrapolation of the recovery seen up to this point.  During the conference call, CFO John Hartung provided some insight into trends that were seen in January 2017 and the overall news seems to be positive:

During December, we recorded positive monthly comp of 14.7%, which includes a 60 basis point benefit for deferred revenue related to Chiptopia. The sales comparisons ease in January as we’re comparing to a down 36% versus a down 30% in December of 2015.

But the dollar sales trends continued from December into January, and the January preliminary comp improved to 24.6%, which included a negative trading day of over 100 basis points, slightly offset by 20 basis points positive related to Chiptopia. For the first 28 days in January, the comp was 26%. But in the last three days of January, we traded a Friday and Saturday from last year, two of our highest volume days, for a Monday and Tuesday this year, two of our lowest volume days of the week.

Of course winter weather in January often results in choppy trends day-to-day and week-to-week, but when we analyze the underlying comp trends, the January sales held up well, especially considering January had the lowest promotional activity of the past 12 months. We’ll compare against a comp of down 26% in February and March, so expect the comp will ease accordingly during the rest of the quarter.

In order to achieve the “stretch” goal of restaurant level operating margin of 20 percent and earnings per share of $10, it seems like management must execute on all cylinders throughout the year.  Earnings per share of $10 implies net income of close to $300 million and pre-tax income of around $500 million.  Management has not provided a total revenue forecast for 2017, but they have indicated that comparable restaurant sales should increase in the high single digit range and there are plans to open around 200 restaurants during the year.  If this results in total revenue in the $4.3 billion range, $500 million of operating income implies an operating margin of around 11.6 percent.  This would be far below the pre-crisis operating margin in the ~17 percent range but a big improvement over the 3 percent operating margin posted in Q4 2016.

Margin of Safety

As investors, the asymmetrical deal we are looking for is uncapped upside potential with limited risk of permanent loss of capital.  Does Chipotle represent such an opportunity?  Is there a reasonable margin of safety for those who purchase shares around $410?

Chipotle has always traded as a “growth stock” with a very high market capitalization relative to trailing earnings.  Investors have been willing to pay up for the shares due to the attractive expansion economics demonstrated over many years (which we described more fully in our previous article).  Expansion was made possible due to the power of the Chipotle brand coupled with the capabilities of management to grow the business efficiently.

While management’s capability is not in question, the resiliency of the brand is very much in doubt.  It is not so much a question of whether the brand will survive.  Recent sales trends demonstrate that the company has the ability to remain profitable.  Key metrics have shown improvement.  Memories do not last forever and customers will return.  The major question for investors is instead whether the pre-crisis economics can be restored for existing stores and whether sufficient expansion opportunities exist to keep the growth going in the future.

Management has set a “stretch” goal implying the possibility of earnings per share in the $10 range for 2017.  Shares are trading at over 41 times that stretch goal.  The goal itself is highly questionable given that the implied operating margin required to achieve it is far higher than what has been demonstrated in the recent past.  Management has not increased prices in three years and currently has no plans to do so.  As a result, all of the margin improvement is going to have to be delivered through various forms of cost efficiencies.  This is a tall order, and it doesn’t even get the company back to pre-crisis economics.

At the same time, the company might be running out of good expansion opportunities.  With a presence in most metropolitan areas, Chipotle might have to select poorer locations in the future that could fail to deliver the unit economics of existing locations.  International expansion is in its infancy and attempts to expand the Chipotle operating model to other brands has not gained traction, as evidenced by management’s abandonment of the ShopHouse concept.  The company’s foray into “better burgers” with the Tasty Made concept has generated lukewarm reviews at its first location which opened last year.

Conclusion

Chipotle’s management could very well turn around the Chipotle brand and restore pre-crisis economics, continue expansion of the brand, and even extend its operating model to other concepts.  However, it is also very possible that Chipotle never regains the economics of the past.

Market participants appear to have priced in a significant amount of recovery potential into the shares already.  It is not difficult to project scenarios where 2017 earnings could be less than half of the stretch goal that management has set.  If that ends up happening, the market could lose confidence in management’s ability to engineer a recovery and resume growth.  If investors end the year looking at a company that has earned only $5 per share (as an example), and has less exciting prospects for growth, a share price of $400 would be untenable.

It is easy to see downside in excess of fifty percent if things do not go well this year while upside is more modest because the market has already given management the benefit of the doubt.  From a value investing standpoint, it seems better to observe from the sidelines and remain ready to act if the market does mark down the shares substantially.

Of course, there are plenty of successful investors who completely disagree with this assessment.  Bill Ackman’s Pershing Square Capital Management has maintained its large investment in Chipotle and now is represented by two members of the company’s board of directors.

Disclosure:  No position in Chipotle. 

Snap Pitches Hopes and Dreams, Shuns Accountability

Snap Inc., the parent company of the popular Snapchat app, has officially filed the paperwork required to go public in an offering expected to raise up to $3 billion.  Characterizing itself as a “camera company” that has reinvented the way in which people will live and communicate, the S-1 filing provides a great deal of information regarding Snapchat’s five year history and meteoric rise in active daily users.  From a standing start, the company has reached an average daily user base of 158 million people who create over 2.5 billion pictures or videos called “snaps” every day.

The company’s success in attracting users was accomplished initially by providing a social network where people could share pictures for a very limited amount of time after which point they would disappear.  This reduced the friction usually involved in sharing photos because people did not have to worry about potentially unflattering (or compromising) pictures remaining alive for years or decades.  Predictably, young people were attracted to the platform.  To build the user base further, the company added video capabilities, enabled “filters” and other features that allowed for playful renditions of images, implemented “stories” to encourage viewing of multiple photos, and allowed for “memories” to be persistently stored by users who wanted to keep their photos and videos for posterity.

With 158 million users worldwide, Snapchat clearly has quite a bit of room to grow, although management notes that the rate of growth is likely to slow from the very rapid increases in recent years.  The business model generates revenue through creative forms of advertising, and management sees significant opportunities to tap into a growing pool of advertising spending targeting mobile devices.  The filing estimates that worldwide advertising spending is projected to grow from $652 billion in 2016 to $767 billion in 2020, with mobile advertising expected to nearly triple from $66 billion in 2016 to $196 billion in 2020.

The business summary of the S-1 provides many insights into the history of the company and management’s philosophy regarding how to develop products and address user needs.  In this article, we will not spend much more time discussing the product or business model but instead focus our attention on what the offering might suggest in terms of overall market sentiment.  Specifically, we will look at corporate governance issues, particularly related to the fact that Snap plans to issue non-voting shares to the public.  What we will not do is attempt to actually value Snap’s business or predict how the shares might perform.

As The Pendulum Swings … 

In The Most Important Thing, Howard Marks devotes quite a bit of space to developing his idea of viewing shifts in market sentiment as the swings of a pendulum:

The mood swings of the securities markets resemble the movement of a pendulum.  Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there.  Instead, it is almost always swinging toward or away from the extremes of its arc.  But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later.  In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.  

Depending on the mood of the market, conditions are either unfavorable or ripe for companies with short track records to offer shares to the public.  During times of unfavorable sentiment, most private companies will try to remain private until conditions improve.  Profitable private firms with adequate free cash flow can remain private indefinitely, although outside funds might be desirable for expansion or to provide liquidity for investors of employees.  Unprofitable early stage companies could look to the private equity and venture capital markets for liquidity and cash flow to fund operations and growth.

From the viewpoint of existing management of an early stage company, going public offers liquidity and potential capital for future growth, but carries a number of burdens that can often outweigh the benefits.  Elon Musk’s email to SpaceX employees regarding the downside of going public is a good summary of the pitfalls (for more on Elon Musk, please read this article).  Given the downside, the continuing Founder/CEO of a private company would want to ensure that shareholders are receiving full value or more.

Snap’s Offering

Snap is expected to raise approximately $3 billion from the initial public offering and the value of the company, based on year-end estimated value of $16.33 per share is about $21 billion.  However, the valuation assigned by the market once shares start trading could be significantly higher if investor enthusiasm translates into high demand for the shares.  Companies offering shares typically want to leave some room beyond the offering price for shares to “pop” on the first day of trading.  This also allows the investment bank that controls allocation of the offering to reward chosen customers with the opportunity to purchase shares at the IPO price and then flip them to the general public one the prices pops up in trading.  This has nothing to do with “value” but is pretty typical for IPOs.  As a result, we should probably assume that Snap’s valuation will be at least $25 billion once shares start trading.

As is the case with most technology companies, the $25 billion valuation cannot be justified by traditional valuation metrics.  Snap is not profitable and has been investing aggressively in expansion over the last several years which has resulted in impressive growth of active users, as we can see from the charts below:

The name of the game in social networks is scale.  Once you achieve a certain scale, network effects build momentum and the platform becomes essential for the targeted user base (which in Snap’s case is mostly younger people).  In order to build that user base, the product was offered free of charge.  However, management started to experience escalating costs of doing business and, quite naturally, decided that there was a need to monetize the platform to make the growth phase of the company’s development at least partially self-sustaining.

The initial attempt at monetizing the platform was to adopt a “freemium” model where users were asked to pay for special features such as new “filters”, which are amusing overlays that are applied to photos.  However, results were disappointing and few users were willing to pay for this additional functionality.  This makes sense given the fact that most competing social networks are free of charge to the user.  So management turned its attention to many creative ways of showing advertisements without alienating the user base (the S-1 contains some very interesting information regarding how they went about this).  No doubt, the urgency to monetize also was driven by Snap’s desire to prove that the business model can be profitable eventually.

The following charts demonstrate that management has been successful in rapidly increasing average quarterly revenue per user, especially in North America:

Although average revenue per North American user of $2.15 in Q4 2016 was impressive relative to prior quarters, it is still far below Facebook’s average revenue per user of $19.81 in Q4 2016 for the U.S. and Canada.  Nevertheless, the trends for Snapchat in recent quarters provide the following reasons for optimism:

  • Rapidly increasing number of active daily users, although the percentage rate of increase is slowing.
  • Proven ability to begin monetizing users, especially in North America with the same model, presumably, being something that management will deploy in Europe and other developed economies.
  • Significant headroom in terms of revenue per active user relative to Facebook.

The company is far from profitable, but we can clearly see the increase in revenue driven by the favorable trends in active users and revenue per user:

The company has gone from a standing start in 2015 to generating significant revenue by the end of 2016, albeit on an unprofitable basis.  Investors who are comfortable evaluating early stage technology companies might, at this point, begin developing financial models and attempt to project when the company will become profitable and what margins might eventually look like.

Obviously, it would be simple enough to create a number of spreadsheets forecasting the number of users over time, the average revenue per user, the resulting aggregate revenues, and then making yet more assumptions about the cost structure.  This is precisely what the investment banks do and what management will discuss with investors during road shows.  It is easy to come up with models that have the aura of precision, but the truth is that no one really knows if or when the company will become profitable or if profitability will ever occur at all. 

Lacking any means of estimating profitability of the company, it is difficult to even contemplate valuation.  One can look at more mature social media companies that are public, such as Twitter or Facebook, and try to figure out what the market might value Snap at in five years but much of this is just speculative.  We will make no attempt to value Snap in this article but wanted to at least take a quick look at the drivers of revenue and recent rapid growth to understand the mindset of investors who will be bidding for shares once the company is public.

Clearly, very nice castles in the air can be constructed if estimates are justified based on hopes and dreams.  The “pendulum” is on the upswing for a $25 billion valuation to even be in the realm of possibility for Snap.

Corporate Governance

Although a $25 billion valuation itself is clearly very high, what makes it clear that the pendulum is swinging toward an extreme involves Snap’s corporate governance and the voting rights of the shares being offered to investors.  Snap has three classes of common stock.  Class A common stock, which will be offered to investors, has no voting rights whatsoever.  Class B stock is entitled to one vote per share.  Class C stock is entitled to ten votes per share.  The following exhibit shows the current ownership base of 5 percent stockholders and selling stockholders:

Founders Evan Spiegel and Robert Murphy own Class C super-voting shares and, as a result, control the overwhelming majority of the voting power in the company.  What is remarkable about this situation is that the founders were able to maintain this level of control throughout the time the company was funded by venture capital.  This was accomplished through the issuance of Class B shares to venture investors.

In October 2016, the company issued a dividend of one share of Class A non-voting common stock for each Class B and Class C share outstanding.  This will further consolidate voting power with the founders in the future as it creates a currency that can be used for further issuance of shares to the public and to employees via equity compensation without diluting voting control.  Effectively, the founders have the ability to retain their overwhelming voting control while giving up economic interests in the company over time.

The use of dual-class stock is not new and has been used frequently to ensure that the founders of technology companies can retain enough control to ensure that their vision is implemented and to encourage long term thinking.  In fact, Google implemented a dual class voting structure when the company went public, as described in the Founder’s 2004 IPO letter.  In the case of Google, the Class A shares offered to the public had one vote per share while the Class B shares held predominantly by the founders had ten votes per share.

What is new in Snap’s case is the fact that the shares being offered to the public have no voting power whatsoever.  As the S-1 warns readers, no doubt driven by legal requirements, this attempt to push the envelope in terms of voting control has been untested in prior IPOs and may result in shares not being valued as highly by the general public.  We have no way of knowing whether that will be the case until shares start trading.

A Half Century of Control Without Accountability? 

The founders of Snap are still in their 20s and the share structure they have put in place effectively gives them a lifetime of control over the resources of the corporation without being accountable to other shareholders.  There are provisions in the offering that will trigger an automatic conversion of the Class C stock to Class B in the event that either founder dies or their Class C common stock held falls to less than 30 percent of the Class C common stock.  However, should either event occur, voting power would be further consolidated with the remaining founder.

From an economic standpoint, all classes of shares have the same rights but we need to remember that the founders are in a position to control the management of the company as well as influence their own compensation.  The S-1 provides insufficient information regarding the structure of the board of directors in the future, specifically their level of compensation on an ongoing basis.  However, we can see what non-employee board members were paid just in 2016 and the level seems egregiously high for a money-losing start-up:

What is even more egregious is the employment agreement with Evan Spiegel:

In October 2016, we entered into an amended and restated offer letter agreement with Evan Spiegel, our co-founder and Chief Executive Officer, with respect to his continuing employment with us. The offer letter provides for an annual base salary of $500,000, which will be reduced to $1 on the effective date of the registration statement in connection with this offering, and an annual cash bonus of $1,000,000 based on achievement of performance criteria to be mutually agreed on by Mr. Spiegel and our board of directors, provided that, after our initial public offering, Mr. Spiegel will not be entitled to any bonus except as may be determined by our board of directors. Under the terms of his offer letter, Mr. Spiegel will be granted an award of RSUs for shares of Series FP preferred stock representing 3.0% of our outstanding capital stock on an as-converted basis on the closing of this offering, which will be fully vested on the closing of this offering and such shares will be delivered to Mr. Spiegel in equal quarterly installments over three years beginning in the third full calendar quarter following this offering. For the purposes of Mr. Spiegel’s offer letter, outstanding capital stock includes shares sold by us in this offering and all shares subject to outstanding restricted stock units that, on the closing of this offering, have met the performance condition and service-based vesting condition. Our board of directors approved the award to Mr. Spiegel in July 2015 to motivate him to continue growing our business and improving our financial results so that we could undertake an initial public offering, which we regard as an important milestone that will provide liquidity to our stockholders and employees. (emphasis added)

It is unclear why it would be necessary to provide a large award of RSUs to one of the co-founders of the company who will continue to have every incentive to remain “motivated” to grow the business over time given his level of ownership in the business.

Compensation over the past two fiscal years hasn’t exactly been modest, especially for Chief Strategy Officer Imran Khan who was awarded stock with fair value of over $145 million when he was recruited to join the company in 2015.  Mr. Khan was previously a Managing Director in the Investment Banking Division at Credit Suisse which happens to be one of the underwriters for the offering.

Conclusion

Snap has made remarkable progress in building a social media platform over the past five years and has a large established base of young users which represents a favorable demographic for targeted advertising.  Recent trends show that the user base continues to grow while management has successfully begun to monetize that growth.  Investors who feel comfortable making longer term projections can make various assumptions regarding the key variables and attempt to justify the likely $25 billion valuation.

Snap certainly could “grow into” a company that fully justifies a $25 billion valuation based on fundamentals but, at the moment, that valuation can only be justified based on hopes and dreams.  It would be one thing to truly partner with a management team that was committed to expanding the reach of the platform and the financial results of the company over the long run.  However, providing funding to a company while having no influence whatsoever in how the company is run is not a true partnership.  Furthermore, the need for a founder to receive high levels of compensation to provide additional “motivation” to lead the company is troubling, as is the high level of director and executive compensation for a money-losing firm.

As Benjamin Graham often said, there is nothing necessarily wrong or immoral about speculation provided that you recognize what you are doing and that the speculation is intelligent.  At the very least, one would have to demand that an intelligent speculation include having some say in the governance of the company, especially if things go wrong in the future.  Intelligent speculation does not involve handing a check to a 20-something founder of a technology start up and also acceding to dictatorial powers over the affairs of the corporation, possibly for decades to come.  These concerns might not be relevant to someone interested in buying shares in the IPO and flipping them shortly after, but are certainly relevant to a prospective long term investor.

How to Review a Proxy Statement

“The compensation committee relies on its own good judgment in carrying out its duties and does not waste shareholder money on compensation consultants.”

— Daily Journal Corporation 2017 Proxy Statement

Reading primary sources of information remains the single most important activity that investors should focus on in their daily work.  Although the financial news media often produces valuable content, we should always remember that the current business model of the vast majority of news outlets centers on building a broad readership base that is attractive to potential advertisers.  By necessity, the mainstream financial media attempts to cover a wide range of companies.  Even the most competent reporter who intends to offer an objective view of a given topic has numerous constraints, and not all reporters are informed or objective.  Furthermore, as investors, we cannot expect to gain the special insights needed to outperform a passive index fund simply by reading what everyone else is reading.

The Rational Walk recently published an article on how to read a 10-K annual report effectively and, perhaps surprisingly, the number of people who read that article and commented on it via social media far exceeded recent articles on specific companies.  This led to a question regarding whether readers would want to see a similar article on proxy statements:

The article on 10-K reports focused on steps that an investor can take to achieve basic understanding of a company in a short period of time in order to be exposed to as many companies as possible.  The investment process can be visualized as a funnel, with very few companies that go into the top emerging from the bottom as potential candidates for further study.  However, once a company passes an initial step, one must dig deeper.  The 10-K needs to be reviewed again, this time with a fine toothed comb rather than taking shortcuts, and not just a single 10-K but reports going back a reasonable number of years.  Additionally, recent quarterly results, conference calls, and presentations are important to review.

Taking a step back, let’s consider a case when a 10-K report is reviewed and there is some interest but the investor does not yet know whether significant additional time is justified.  In such cases, one important step that can provide a great deal of clarification is a basic review of the company’s annual proxy statement.  Stated simply, a proxy statement is a document that a company’s management is required to send to shareholders prior to an annual or special meeting where owners will be asked to approve corporate actions.

Reading a Proxy Statement

Proxy statements contain a wealth of information that is completely absent from annual reports.  Specifically, in order to learn about the compensation provided to directors and management, as well as the governing incentive systems, one must review the proxy statement.  Unfortunately, the deadline for proxy statements is usually a couple of weeks after the 10-K deadline and, except for very large companies, proxy statements are rarely covered in the mainstream financial media.  Even in the case of large companies, reporters tend to ignore proxies unless the level of pay is egregious or some major change in corporate governance is taking place.  For example, reporting on the departure of Gary Cohn from Goldman Sachs to join the Trump Administration necessarily drew information from the company’s proxy.  But usually the proxy statement flies well under the radar.  Shareholders receive proxy statements either in the mail or electronically and many individual investors do not even bother to vote.  Institutional investors often take their cues from proxy advisory firms.

Just as voting in elections is the responsibility of the citizen, we would insist that reviewing a proxy statement and voting is a core duty of an informed shareholder (at least one who cares about his or her net worth).  A company with a shareholder base that doesn’t care about executive and director compensation invites an exacerbation of the already ever-present agency problem.  When things get bad enough, an activist may enter the picture to force changes, but not usually before shareholders are harmed.  Any potential investor thinking about allocating funds to a company must put himself in the shoes of existing investors and the only way to determine whether an agency problem is likely to negatively impact results is to review the proxy.

Finding Proxy Statements

In this article, we will use the 2016 proxy statement filed by America’s Car-Mart which we discussed in an article last month.  Car-Mart is a relatively simple small-cap company and the proxy statement is quite straight forward and mostly free of much of the superfluous marketing that is very common in larger companies that employ public relations firms.  In general, the size of a proxy, and the amount of public relations marketing, is highly correlated with the size of a company.  To keep this article to a reasonable length, we picked a simple proxy, yet not one that is as simple as the proxy filed by Charlie Munger’s Daily Journal Corporation which is a model for intelligent corporate governance.

Proxy reports can either be found on the company’s website or retrieved via the SEC’s Edgar search tool.  Although Car-Mart does provide convenient access to the proxy in PDF format, not all companies do so.  The SEC search screen is shown below:

Submitting this query using the ticker symbol for Car-Mart yields the following results:

We can see several of the company’s recent filings in the results screen, including the company’s latest 10-Q quarterly report as well as other types of reports.  However, we do not see the proxy statement in this list.  A proxy statement is known in the SEC system as a Form DEF 14A filing so we need to filter on that type of document, as shown in search field highlighted in red below:

We are now presented with a list of all of the proxy statements that the company has filed over the years.  For purposes of our review, we would like to review the latest proxy statement which was filed on July 22, 2016, so we would click on the Documents button for the first entry to bring up the actual report, or alternatively, we can review the PDF file available on Car-Mart’s website.  Since the PDF file is more readable and has a nicer presentation, that is where the subsequent screen shots in this article were taken from.  The file is 32 pages long which compares favorably to more complex proxies (Goldman’s 2016 proxy is 104 pages).

Notice of Annual Meeting of Shareholders

The proxy typically begins with a letter from either the Chairman or CEO of the company providing information on the annual meeting, where and when it will occur, and the purpose of the meeting.  The main elements of an annual meeting usually involves a short presentation by management followed by a vote to elect directors and approve the company’s auditors.  The Dodd-Frank financial reform law of 2010 also mandated that shareholders have an opportunity to vote on executive compensation on an advisory basis, meaning that it is rather toothless and non-binding (this is akin to an employee setting her own pay and giving the boss an advisory vote, feeling free to disregard that vote when desired — give that a try at your next annual review!)

Car-Mart’s annual meeting was scheduled for August 31, 2016 for the purpose of electing seven directors and to vote on executive compensation and the selection of Grant Thornton as the company’s independent auditor.  The letter is signed by William Henderson, the company’s CEO.  At the time of the proxy, Car-Mart did not have a Chairman, although one has been appointed since that time.

Following the letter, shareholders are given information on how to vote.  Shareholders not attending in person are instructed to vote by proxy, which is a form that comes with a physical proxy statement and is mailed back to the company’s transfer agent or entered online.  Rules regarding the actual voting procedures, including the definition of a quorum, is provided.  Most of this section is self explanatory.

Security Ownership of 5% Owners and Directors/Officers

The section on beneficial ownership of securities is where the proxy statement goes from dull to very interesting.  Any owner or potential owner of a company should be very interested in the composition of the major shareholders and whether directors and officers have meaningful financial states, or “skin in the game”.  The Car-Mart table of security ownership appears below:

The first three entries representing the company’s largest shareholders are financial institutions.  Invesco and BlackRock are very large institutions that should be immediately recognizable to most readers.  For most companies, it is normal to see a list of large institutions in the shareholder list, and this is often even more true for small companies.  With a $337 million market capitalization, it doesn’t take a huge investment for a large institution to wind up with a large percentage of shares outstanding.

The company’s second largest shareholder is Bares Capital Management which is run by Brian Bares.  This institution is not a household name but we recognized it immediately because Mr. Bares is someone who has been interviewed in The Manual of Ideas in the past and has also appeared in videos explaining aspects of his investment philosophy incorporating the ideas of Warren Buffett and Charlie Munger.  As of September 30, Bares Capital Management owned 1,133,217 shares of Car-Mart which indicates that part of the position held at the time of the proxy filing was sold at some point between July 12 and September 30, 2016.  Knowing that a 18.9 percent shareholder reduced his stake in the company is valuable information and can be easily discovered by searching for 13-F filings.

Turning our attention to management and directors, we must exercise more caution when looking at the numbers in the tables.  “Beneficial ownership” includes options that are exercisable within 60 days of the filing date.  Holding options to purchase shares is not the same thing as actually owning shares, yet the SEC allows the two types of holdings to be conflated in the table.

For example, CEO William Henderson beneficially owns 466,734 shares representing 5.7 percent of shares outstanding.  However, let’s take a look at the small print in footnote 5:

Of the 466,734 shares “beneficially owned”, 389,000 represent exercisable options which means that 77,734 shares were owned outright on the date of the report.  Although option grants represent upside to Mr. Henderson, they have no downside risk (other than potentially expiring worthless).  In terms of “skin in the game”, he has 77,734 shares which are worth around $3.3 million currently.  If we took the number presented in the table at face value without looking at the footnote, we would incorrectly consider his “skin in the game” to be nearly $20 million, obviously a huge difference.

The use of stock options is common and this type of situation will exist in the presentation for most companies.  There is a good case to be made that the distinction between options and outright ownership should be visible in the table rather than only in the footnotes but unless that change is mandated by the SEC, investors simply have to be sure to examine the footnotes carefully.

Election of Directors

The next section deals with the election of directors.  Readers should focus on the frequency of elections for directors and the length of a director’s term.  In the case of Car-Mart, directors are elected to serve for one year until standing for re-election at the following annual meeting.  This is a good practice.  Many companies have staggered boards where directors are elected for longer terms, typically three years, and not all directors face re-election at the same time.  This can impede potential changes in control and effectively protect incumbent directors and management from the concerns of owners.  Although having staggered terms is not an automatic disqualification, companies that have both staggered terms for directors and very low insider ownership should be examined very closely when it comes to other aspects of corporate governance.

Generally, readers should attempt to determine whether directors are likely to be interested in the operations of the company, have necessary business background, and have incentives aligned with shareholders through a reasonable amount of ownership, as specified in the ownership information described above.  Many larger companies have elaborate presentations in this section where all kinds of information that is tangential to the key factors are discussed such as the ethnic and gender make-up of the board.  Investors can differ in terms of their opinion regarding such factors and there is obviously some social benefit in a diverse board, but the primary factors should involve whether a director’s biography and ownership show that he or she can actually contribute meaningfully to oversight of management.

Board Structure, Organization, and Compensation

The proxy contains a discussion regarding the board’s structure and organization including a description of the manner in which the board goes about conducting its business.  We learn that the board held nine meetings in its last fiscal year and that each incumbent director attended at least 75 percent of the aggregate number of meetings held by the full board and committees on which the director serves.  This isn’t really that insightful but at least validates that there are no totally disengaged directors seeking re-election.

Further description of the leadership structure, including the company’s separation of the CEO, Chairman, and Lead Director roles is provided.  Car-Mart separates the CEO and Lead Director roles, and subsequent to the proxy, named a Chairman.  The separation of the CEO and Chairman roles is a critical factor.  Unless a CEO is either a founder of the company or a very significant stockholder, the Chairman role should almost always be held by someone else.  The Chairman’s biography also must demonstrate that the individual has both the necessary business experience and the gravitas to influence the CEO’s conduct.

The various committees of the board are discussed in some detail, including the members who serve on each committee and the frequency of meetings.  In the case of Car-Mart, there are committees charged with audit, compensation, compliance, and board nominations.  Generally, there is limited to no insight to be gained from committee membership and it is questionable whether functions such as the audit committee are really equipped to oversee a complicated company’s financial statements over the course of a few meetings.   Nevertheless, it is good to verify that committee members are plausibly qualified for the roles in which they serve.

The proxy goes from dull to interesting again with the discussion of director compensation.  Only outside directors, that is, those who are not on the management team, are compensated for serving on the board.  Typically, companies provide board members with a cash retainer that can vary based on their committee assignments along with some form of equity compensation.  The director compensation for Car-Mart appears below:

The cash retainer varies from $40,000 to $50,000 per year and is pro-rated for partial year service.  In addition, each director who served the full term received an award valued at $87,690.  The footnotes provide information regarding the total number of options held by each director.

Evaluating director compensation is not a simple task.  The goal should be to fairly compensate directors but we would also prefer to see directors whose real “compensation” comes from capably executing their duties as directors because they are also major shareholders.  However, it is quite rare to see directors with large shareholdings that are not provided by companies in the form of options or restricted stock.

Ultimately, directors need to be individuals with strong personalities and a financial stake in the success of the business.  Standing up to a CEO is not for the faint of heart in most companies and there is usually no shortage of egos in a boardroom.  The compensation at Car-Mart appears to be generous but not set at an egregious level.  A more thorough understanding of how the compensation might influence individual directors would involve examination of how an individual director might feel about losing their compensation.  For example, is a director dependent on the director fees to fund a majority of his or her personal expenses?  However, that type of analysis is beyond the scope of an initial review of a proxy statement.

Executive Compensation

We now get to the heart of the proxy when discussion turns to executive compensation and the rationale behind it.  Pretty much every company will include language indicating that they hope to align incentives of management with shareholders but obviously the details need to be read with some sense of informed skepticism.  Here are the stated goals of Car-Mart’s executive compensation program:

Only the “named executive officers” of the company are included in this review.  In the case of Car-Mart, the officers are CEO William H. Henderson and CFO Jeffrey A. Williams.  It should be noted that there could be executives who are paid more than the named officers at certain companies (although not likely at Car-Mart).  For example, at Berkshire Hathaway, executive pay for subsidiary management is known to be far higher than the compensation of the named officers.

Car-Mart has employment agreements with Mr. Henderson and Mr. Williams that govern their base salary and incentive compensation, as well as benefits they will receive due to any potential change in control of the company that results in loss of employment.  Many companies use compensation consultants to develop elaborate pay schemes along with lengthy explanations that appear in the proxy, but Car-Mart has a more concise presentation.

The board attempted to set base salary at a level that would attract qualified management along with incentives based on a simple performance metric: GAAP fully diluted earnings per share.  Short term cash incentive compensation is based on the degree to which management achieves “projected” diluted GAAP earnings per share.  Target payments range from 15 to 29 percent of base salary depending on the extent to which projected GAAP earnings are met or exceeded.  Long term incentives are comprised of both stock options and restricted stock and are awarded on a periodic basis rather than annually.  The latest option grant was made at the 2015 annual meeting and will vest, depending on performance, at the end of fiscal 2020.  A portion of the options are time vested while the remainder are performance based.

The table shown below provides a summary of the compensation of Mr. Henderson and Mr. Williams for the past three fiscal years:

To the company’s credit, neither executive has earned short-term bonus payments over the past three fiscal years because the projected GAAP earnings per share metric was not satisfied.  Many companies will still grant bonus payments to executives even when performance falls short, citing “retention” or other factors as a justification, so it is good to see a company that actually does what it says it is going to do.  We also can see that salary increases have been relatively restrained.  The fair value of the stock option grant made at the 2015 annual meeting appears in the table but no cash will be received by either executive until the options vest, if they vest at all, at the end of fiscal 2020.

Although management earns a healthy base salary, overall compensation does not appear egregious compared to many other similarly sized companies and long term compensation seems reasonably well aligned with shareholder interest.  Here are the terms under which the performance-based portion of the options will vest:

For the performance-based option, if the Company’s cumulative consolidated net income growth, calculated on a compound basis, for the five fiscal years ending April 30, 2020 is equal to 10% or more, the option will vest in full (20,000 shares) on April 30, 2020. If the Company’s cumulative consolidated net income growth, calculated on a compound basis, for the five fiscal years ending April 30, 2020 is equal to 5% or more but less than 10%, one half of the option (10,000 shares) will vest on April 30, 2020. If the Company’s cumulative consolidated net income growth, calculated on a compound basis, for the five fiscal years ending April 30, 2020 is less than 5%, the option will be forfeited.

Of the 30,000 options granted to each executive, 20,000 are performance vested based on the criteria above while 10,000 are time vested, meaning that they will vest on April 30, 2020 if the executives remain with the company until that time.  The proxy contains a table of outstanding equity awards that shows the overall number of options outstanding for each executive:

Here we can see that in addition to the recent option grant, both executives have significant grants that are already fully vested and exercisable.  Incidentally, the total number of exercisable options in this table should tie to the footnotes provided in the beneficial ownership table discussed earlier.  For example, we can see the 389,000 vested options that Mr. Henderson owns in this table which ties to the options reported in the beneficial ownership table.  Also, we can see that the vested options are significantly “in the money” with a strike price well below the recent share price of $42.  This is important because options that are significantly out of the money can either lack incentive value or cause executives to take desperate steps to increase the stock price before the options expire.

Conclusion

In this article, we have attempted to highlight the areas of a proxy statement that intelligent investors should carefully study as part of their due diligence process.  An annual review of the proxy for existing shareholders is critical as well.  In the case of Car-Mart, the proxy is quite simple and obviously has not been afflicted by the work of public relations firms.  Additionally, all things considered, compensation for both directors and executive officers seems to be reasonable and incentive systems seem to be aligned with shareholder interests.

There isn’t any way to fully gauge the quality of board oversight from the outside looking in.  The best we can do as minority shareholders without sitting on the board ourselves is to critically examine the proxy statement and look out for potential pitfalls.  We ideally also need to examine past proxies to see if the criteria has changed, which has not been done in this exercise.  While the annual report and 10-K rightfully take priority when an investor is getting to know a business, the proxy should never be ignored when a company becomes a more serious investment candidate.  Knowing the people running the business and the incentives they operate under is a big part of the investment process.

Disclosure:  No position in America’s Car-Mart. 

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