Monday, May 6, 2013

hhgregg Management Rips Off Shareholders

hhgregg has always struck me as a rather shareholder-friendly company. So it caught me off-guard when hhgregg's management decided to re-price its underwater options. Such actions are a huge red flag for investors.

The handout of options to managers is always justified on the premise that it aligns manager and shareholder interests. What is often glossed over, however, is the fact that options contain an inherent asymmetry in their outcomes: a poor outcome, even an extremely poor one, results in option values that never go below zero, whereas a positive outcome results in positive gains. Because of this asymmetry, managers who are paid in options are incentivized to take far more risks than shareholders would deem appropriate. This is no small issue; as I've written before, the use of options likely contributed to the downfall of Lehman Brothers.

So even left untouched, options already provide perverse incentives to management. But by re-pricing options, as hhgregg just finished doing, the incentives become even worse. Rather than option values that go to zero when the stock price gets pummeled, management actually gets long-term benefits from a felled stock price! For example, CEO Dennis May just saw the strike price on 75,000 of his options go from $28.31 to just $13.56!

The explanation offered up by the company is that these strike price reductions were accompanied by a three-year increase in vesting periods, encouraging employee retention. But that sounds like a lame excuse; by providing even more time before the options expire, the options become even more valuable. For example, in the Dennis May example cited above, his options went from being worth 7 cents each to being worth over $3.50/option! (Calculations are based on this Black-Scholes option value calculator.)

Instead of expiring in 2017, his options will instead expire in 2020. Did shareholders really benefit from this extra vesting period? Probably not, I would venture.

The strange thing is, this company has otherwise behaved in a rather shareholder-friendly manner. Management owns a considerable number of shares, only grows when it is profitable to do so, and buys back shares when the stock is cheap. But this option re-pricing appears nothing more than a cash grab. Going forward, this company should be closely monitored for more unscrupulous activity.

Disclosure: Author has a long position in shares of HGG


Mayukh said...

Thanks Ben, I was looking at hhgreg briefly but haven't done a deep dive into it.

> Given where their current stock price is perhaps $28 is too far for the CEO to have a realistic shot at making any $$, so basically the options were worthless and the company has in effect issued a new comp plan. What is troubling is that they have now set the precedent for moving the goal post in the future
> He can't sell these options on the open market right ? So does it matter what the options are worth?

Really enjoy reading your blog!

Anonymous said...

You ought to look at IGOI.

Appears that the company has $2 in net cash value (cash minus total liabilities) but trades for $2.40.

The company has negative operating cash flow.

Saj Karsan said...

Hi Mayukh,

Who's Ben?

It matters because someone is paying for that increase in his wealth. Also, someone is at risk of being a victim of poor manager incentives. In both cases, that someone is the shareholder.

Hi Anon,

I've discussed IGOI here: