Monday, July 25, 2011

The Higher The EBITDA, The Lower The Profit

Contingent bonuses can be a great way to reward employees. But a poorly designed bonus structure can lead to disaster. As such, proper design of a compensation structure is imperative. But a flawless system is nearly impossible to design, as even the simplest of bonus structures can have less than ideal implications.

Offering bonuses to executives related to company profit levels are considered normal, in order to increase the impetus to drive bottom-line improvement. Consider Meade (which has been discussed on this site as a potential value investment), a company which recently instituted a simple bonus policy based on EBITDA levels. The bonuses paid out to executives are as follows:

≥ $112,000 < $224,000$21,000
≥ $224,000 < $336,000$42,000
≥ $336,000 < $448,000$63,000
≥ $448,000 < $560,000$84,000
≥ $560,000$105,000

Even a simple, innocent-looking bonus structure such as this one can have profound negative effects. For one thing, because the bonus is based on EBITDA, manager compensation is not hurt by depreciation charges. This could cause them to ratchet up capital expenditures (or re-classify current expenses to capital expenditures) with the intent of driving up EBITDA.

Furthermore, because no considerations are given to ROIC metrics, management is hereby incented to borrow money to help increase EBITDA. Using leverage increases risk for shareholders, but because bonuses make no allowance for risk factors, management may find incurring debt to be of great help in financing assets that may help the company achieve higher profit levels.

Finally, because of the step-up nature of the bonus escalations, one could end up in a situation where a higher EBITDA results in lower profit levels for shareholders. For example, if EBITDA before bonuses comes in at $559K, EBITDA after bonuses equals $475K. But if EBITDA before bonuses comes in higher, at say $560K, EBITDA after bonuses is actually lower than in the previous case by $20,000! In this case, shareholders are actually worse off as a result of a higher EBITDA number. Furthermore, near the edge of each EBITDA range, management is given an incentive to "manage" its reporting of expenses order to receive a windfall.

Designing a bonus structure that perfectly aligns shareholders and managers is very difficult to achieve. The best investors can hope to do is own companies in which management is also heavily invested. This is likely the only way of truly aligning manager and shareholder interests.

Disclosure: Author has a long position in shares of MEAD


Taylor said...

Interesting you mention capex. According to their most recent 10-q, MEAD may actually have to start making more capital expenditures in the future. Management made note of the old age and fully depreciated nature of the company's equipment in the report.

James Huddleston said...

You're completely right. Management with this kind of structure can increase their compensation just by changing the form of the company's capitalization. It gives them little incentive to actually improve the business. It would be better, I think, to include a clause that states that leverage must stay below a certain level for the compensation to be applicable.

Maybe you should point this out to the company's management?

Saj Karsan said...

Hi James,

There are some smart guys on the board, so they already know this. They must have had a reason for doing it this way...we are just not privy to what it is. Also, in my experience these small companies know what is being written about them, so they are likely already aware of this article.