Here’s a great story from investor Jay Schembs about Adams Golf Inc (NASDAQ:ADGF), which will be familiar to anyone who has spent some time sifting through net net screens for the last few years. Jay has had a position in ADGF since late 2008. After sitting through one too many conference calls listening to platitudes from CEO Chip Brewer about “shareholder value,” Jay decided to send a letter to ADGF’s largest shareholders pointing out the perfect inverse correlation between management’s equity grants and share price performance. Here’s Jay’s letter:
Dr. John Gregory
Mr. Joseph Gregory
SJ Strategic Investments
340 Martin Luther King Blvd., Suite 200
Bristol, Tennessee 37620
Mr. Roland Casati
Continental Offices, Ltd.
2700 River Road, Suite 211
Des Plaines, Illinois 60018
RE: Adams Golf
Dear Messrs. Gregory and Mr. Casati,
I am writing to voice serious concern regarding the alignment of management and shareholders of Adams Golf, Inc. (ADGF).
First and foremost, we as shareholders are suffering a slow death, quarter after quarter, as we endure a consistent erosion of ownership. From December 31, 2006 to September 30, 2011, due to equity grants given to management (primarily CEO Chip Brewer) fully diluted shares have increased 31%. During that time, the company’s share price has decreased 31% and shareholders have received zero cash distributions. How that performance should entitle management to ongoing equity compensation for a “job well done” is beyond me.
One of the primary concerns with regards to measuring management performance is the use of EBITDA. From ADGF’s 2010 proxy statement:
Our Annual Management Incentive Compensation Plan provides our named executive officers and key employees an opportunity to earn a semi-annual cash bonus for achieving specified performance-based goals established for the fiscal year. In 2009, 2010, and 2011 the Compensation Committee has established performance objectives for the named executive officers based on targeted levels of revenue growth and EBITDA (earnings before interest, taxes, depreciation and amortization). We believe that focusing on revenue growth is important because there are distinct advantages to revenue and profitability scale in the golf equipment business, such as the ability to advertise on network-televised golf events, to sponsor professional tour pros, and the ability to compete for strong research and development talent. We believe that focusing on EBITDA is important because it is the most widely accepted metric for the cash flow generated by a business. The performance objectives allow the named executive officers to earn a cash bonus up to a specified percentage of their base salary if Adams Golf achieves at least a specified threshold of the above metrics.
In the long term, shareholders only benefit to the extent the enterprise generates cash available for distribution. In stating “EBITDA is important because it is the most widely accepted metric for cash flow generated by a business,” you are ignoring taxes, capital structure, and investments required in fixed and working capital. ADGF does not require much investment in fixed assets, but does require substantial ongoing investments in working capital. As such, EBITDA fails to account for these cash outflows necessary to support growth.
A more sophisticated way to measure performance would be to look at the after-tax operating profit generated by the business in relation to the amount of capital investment required to generate those returns. From FY2006 through the last twelve months (“LTM”) ending September 30, 2011, ADGF has averaged a 4% return on invested capital.
As I mentioned earlier, during this same period, the share price has declined 31%. Certainly some of this share performance is attributable to broader economic and financial market woes. In my opinion, however, ADGF’s share underperformance is due primarily to the ongoing dilution described above as well as shareholder value destruction caused by generating returns below the company’s cost of capital.
My suggestion is to significantly overhaul the management compensation structure. Base management performance metrics on true creation of shareholder value (utilizing Economic Value Added or a similar metric), rather than simplistically focusing on revenue growth and EBITDA.
The significant equity grants to CEO Chip Brewer have enabled him to build a sizable ownership in ADGF. Mr. Brewer’s ownership on a fully diluted basis stood at 9.6% as of the 2010 proxy filing. Shareholders hopeful that Mr. Brewer’s ownership puts them on the same side of the table, however, are dismayed to find that since December 31, 2009, Mr. Brewer has purchased zero shares. During that same period, he has sold nearly 183,000 shares. This is hardly a ringing endorsement that we as shareholders have the CEO on our side.
In quarterly earnings calls, Mr. Brewer frequently talks about “creating shareholder value.” He encounters the question of this ongoing shareholder dilution more frequently on these calls, but always sidesteps a true response to shareholder concerns. One wonders how consistently diluting existing shareholders at the expense of management while failing to earn an acceptable rate of return on capital creates shareholder value.
I currently own slightly more than 1.5% of the fully diluted common equity outstanding. As such, while I certainly cannot influence any corporate decisions, I do take a keen interest in the affairs of the corporation. I am not representing a larger cabal or a hedge fund with greenmail or other ulterior motives. I would like to remain a long-term shareholder, but am reaching a level of frustration that will ultimately result in a sale of my shares if these concerns are not addressed.
What I ask is that you as the largest non-management shareholders seriously reconsider the current management compensation structure. Adams Golf has a great brand name, has overcome its legal issues, and in my opinion has a very bright future as a continued leading and innovative golf equipment company. If the board of directors cannot truly align the interests of management, the board and the broader shareholders, you will be left with consistent shareholder turnover and a stock price that continues to lag, as no long-term investors will be willing to commit their capital to a partner they cannot trust to truly represent their interests.
Disclosure: I am long ADGF.
The good news is that the letter had immediate impact. Here’s Jay:
Earlier this week, I sent a letter to two of Adams Golf’s largest shareholders – the Gregory family and Roland Casati. I also published the letter on Seeking Alpha here. In the letter, I impored (sic) these shareholders to recognize the ongoing dilution and inadequate returns on capital generated by CEO Chip Brewer.
On Thursday, the Gregory family and Mr. Casati released an SEC form 13-D, wherein Mr. Casati has irrevocably pledged to vote his shares with the Gregorys. In total, they represent nearly 35% of the outstanding equity. More importantly, they will be voting against Mr. Brewer as a director on the board in next year’s proxy, and indicated they may submit “other possible related proposals to present to the stockholders.” While vague, taken in context with the vote against Mr. Brewer indicates to me they are hearing the shareholder frustration.
I can only hope my letter helped expedite what has been a long time coming.
I love to see a small shareholder getting results.
Greenbackd Disclosure: No position.