Tuesday, June 16, 2009

A compensation policy worth studying

A number of corporate compensation policies tie executive compensation to the level of profits achieved in the year, with no attention being paid to the amount of capital that was employed to attain those profits. With retained earnings essentially free under such a scheme, executives rarely feel compelled to achieve a reasonable rate of return on capital employed. As Charlie Munger says often, incentives matter. A lot. And then some.

On that note, one of the exhibits that Western filed with it’s latest 10-Q is the employment agreement with Robert Moore, the new President of Western Sizzlin Franchise Corporation. It’s a rationally designed compensation policy that specifies, amongst other things:

a. The normal levels of cash flows expected from the business for which Mr.Moore gets no extra credit. In this case, the amount is $2.3 million annually.

b. The definition of cash flows that will be used to determine the bonus allocation, which is computed as EBITDA less capital expenditures.

c. Any exceptions to the cash flow calculation above, which includes severance payment obligations to the prior President, Jim Verney.

An item to note is the cash flow metric upon which the bonus calculation is made. The capital expenditures necessary to maintain the business’ current levels of profitability are charged against EBITDA so that the cash flow so computed is truly pre-tax “owner’s earnings”. The use of EBITDA also suggests that debt is going to be rarely used, if at all, in Western’s restaurant business. It also makes good business sense to ignore expenses in the cash flow metric calculation that are not a result of decisions made by Mr. Moore.

The most important part of the compensation policy though is the charge that is applicable to incremental capital that is reinvested in the business for growth. The compensation policy provides for a charge of 20% on any incremental capital investment. This implies that if a bonus were paid out to Mr.Moore, the pre-tax return on incrementally invested capital to Western will necessarily have been above 20%. However, it is not clear if Mr.Moore’s compensation will be penalized if the pre-tax incremental ROIC were to be below 20% i.e. does the charge for incremental capital carry over to the next year’s bonus calculation if the pre-tax hurdle of 20% is not met this year? If that were the case, this would be a truly symmetric proposition. One that provides for a reasonable payout in case the additional investment is economically attractive and a penalty otherwise. This structure encourages the investigation of potentially attractive reinvestment opportunities. The penalty, if it does exist, would act as a deterrent against actual reinvestment of significant amounts of capital except for situations where the odds highly favour the possibility of realization of an attractive rate of return on capital employed.

If you are looking for a “’til death parts us” type of security (or even otherwise), one of the first things to look at is the structure of the compensation policy. What truly counts is how the compensation amount was arrived at, not the actual dollar amount of compensation. A sensibly designed compensation policy is unlikely to come up with compensation that is not commensurate with the underlying business results.

The structure of the compensation policy can also provide a clue (often a very big one) into the way management thinks about business, the business' owners and the importance it places on capital allocation. On the basis of Mr.Moore’s compensation policy, amongst other things, it’s reasonable to expect that shareholders of Western are likely to do well over the course of the next few decades. Subject, of course, to the caveat that their holdings be acquired at sensible prices and that Sardar stays in charge of allocating capital.

Disclosure: Added to my Western position at $7/share earlier this year.