YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

How noble - $1 annual compensation

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We’ve been keeping our eye on Copart, Inc. (CPRT) as a potential investment for quite some time. It’s a fantastic business – very profitable with high cash flow and low capital needs, no debt, very high margins, great management, the list goes on. Their main business is to be the liaison for insurance companies to sell salvage vehicles to auction buyers (used vehicle dealers, junk yards, rebuilders, etc.).

Last Thursday, the Board decided to consider a proposal to have senior management forego their current $750,000 salary for a salary of $1 plus 2,000,000 stock options that would vest over a 5-yr. period. It sounds pretty noble to work for $1. But believe it or not, this current proposal looks like it will actually hurt shareholders.

Issuing stock options when their stock has been hit so hard is like giving away gold. In the likely scenario where their stock does well from this price level ($27-29), they are taking a lot of money away from shareholders as they dilute their shares. Instead of a salary less than a million, their $1 salary will likely turn out to be millions in disguise. As shareholders, we’d rather pay them salary plus cash bonus incentives based on targets of which they have much more control.

Suppose we’re wrong and the stock is way overvalued from this point and their stock option compensation turns out to be less than $750k. Even still, we don’t like the idea. True, issuing options at peak stock prices are like issuing toilet paper, but that’s the problem. Even if it saves shareholders lots of money in terms of salary to senior management, it can really stint the value of the business. In this scenario, managements’ interests are definitely not aligned with shareholders. If the stock does not perform well over the next 5 years and their options are deep underwater, management will have every incentive to swing for the fences because they will either make lots of money, or nothing at all. Instead of becoming long-term oriented, management thinks of ways to hit the jackpot despite the risk level. The other possible reaction is their morale drops significantly because they view it as hopeless…“no matter how hard I work, I won’t end up making money here anymore.” To make matters worse, stocks can underperform temporarily for many reasons that are not in managements’ control. Thus, you can still get this negative outcome even if the stock is undervalued because it may not converge upward to its true value for years.

Simply put, overvalued or undervalued, compensating with stock options is just a bad idea. Whether the stock price does well or poor, there will be negative consequences. Either there is over compensation at the expense of shareholders, or there will be unintended consequences – perverse incentives and/or demoralizing management. In both cases, options do very little to align with shareholders interests because they simply don’t have much control over the stock price. That’s why we tend to vote ‘No’ on nearly all stock option proposals.

Despite these comments, we still give a thumbs up for the management team at Copart. We just don’t think a $1 salary is as noble as it may seem.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | March 16, 2009 | Permalink

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