Tuesday, March 9, 2010

An Uphill Battle

As previously discussed, value investors can benefit from investing along with other value investors. But the presence of another value investor as a major shareholder does not guarantee that a company will be run in a shareholder-friendly way. Sometimes, management and board practices can make life difficult for even the most active of value investors.

As an example, consider ITEX Corporation (ITEX), which offers a marketplace for businesses to exchange goods and services. ITEX boasts two major value shareholders, including Sardar Biglari and The Polonitza Group, who own a combined 21% of the company. Unfortunately, the company is not currently structured to succeed, with an extremely poor governance structure that tilts the balance of the company's power towards management at the expense of shareholders.

First of all, there are only three board members, one of which is the CEO. Neither of the remaining two board members can reasonably be considered independent, having received compensation from the company in return for consultatory services. Furthermore, there has been no turnover at the director position in almost 8 years! When one of the aforementioned shareholder groups suggested a change at director due to a lack of independence, it appears the company responded that "they are not very close friends and maintain independent thoughts and ideas" and that "they do not frequent each other’s houses or family events". Unfortunately, this hardly assuages shareholder fears, as the issue is not how buddy-buddy these guys are, but how the board's incentives (due to the fact that they provide executive and consulting services to the company) are not aligned with those of shareholders.

As a result, the CEO sits on the audit committee! The other two directors, who receive or have received payment for consulting services from the company, sit on the compensation committee! For all we know, the board is doing a terrific job, but the structure reeks of conflict of interest. But is there any evidence that this might be hurting shareholders?

Well, as these value investors began buying up shares, it appears the board/management went into defensive mode. In 2009, the company protected the CEO from a buyout by guaranteeing some payments to him of a few hundred thousand in the event of a change of control. Furthermore, they recently amended company by-laws that restrict the rights of outside shareholders.

Finally, the company appears rather generous in handing out shares to management, which dilutes existing ownership. The company only has 18 million shares outstanding, but consider the following handouts:

  • In 2001, Mr. White received 250,000 shares for services rendered to ITEX as an independent consultant.
  • For services as a director of ITEX from 2003 through 2007, Mr. White was compensated by an annual grant of 40,000 shares of common stock.
  • For services as a director of ITEX in 2008 and 2009, Mr. White was compensated by an annual grant of 30,000 shares of common stock.
  • On May 3, 2004, and again on July 6, 2006, Mr. White was awarded 300,000 shares of common stock for services rendered ITEX as Chief Executive Officer.
  • On December 13, 2005, Mr. White was awarded 50,000 shares of common stock as consideration for his collateralized personal guarantee of ITEX obligations incurred in order to fund a corporate acquisition.
  • On October 8, 2009, Mr. White was awarded 195,000 shares of restricted common stock for services rendered ITEX as Chief Executive Officer.
Even though value investors may be major shareholders of a corporation, they may still face an uphill battle. Before jumping on board, potential shareholders would be wise to investigate whether management is playing nice, or entrenching themselves.

Disclosure: None


Robert Pio Molloy said...

I don't think you're being entirely fair on Steve White and ITEX.

Steve White took over as CEO of ITEX in 2003. Barring the recent financial crisis, White has consistently built shareholder value and increased the share price since then. While I wouldn't go as far as saying that his compensation is cheap, I certainly don't think it's egregious considering his long-term performance, and the nature of the business ITEX is in (the company wouldn't be where it is now if it wasn't for the dealmaking that White has done).

Secondly, ITEX is sill only a tiddler with a market cap of $15 million. When you're at that scale, is there really much added-value in having a larger board with company outsiders? If the company has proven performance, I'm not entirely sure.

Also, I wouldn't go as far as saying White is entirely shareholder-unfriendly. During the last annual meeting, he consulted shareholders on increasing value. When some suggest a buyback, he instituted one despite his reservations.

The only thing I am unhappy with (that you have mentioned) is the "poison pills" that the board have tried to insert to entrench management and deter any takeover. If Sardar Biglari (or anyone else for that matter) wishes to buy the company, it's the shareholders decision to choose to accept or reject the offer.

Saj Karsan said...

Fair enough, Robert, thanks for your comments. I'll continue to keep an eye on this company.