Last week the Board of Directors of Edgewater Technology Inc. (EDGW) received a letter from a shareholder, Mr. Ephraim Fields of Echo Lake Capital. In his letter Fields claimed that EDGW's stock had significantly underperformed while the company's senior management had received very generous compensation. Fields also questioned the Board's "willingness and/or ability to" fulfill its fiduciary to act in the best interests of shareholders. Finally, Fields demanded that the Board hire an investment bank to explore strategic alternatives designed to maximize shareholder value.
Over the past year, I've analyzed EDGW and spoken with its management. While I thought the company had an interesting business and an undervalued stock, I had some concerns that prevented me from buying the stock.
Let's examine some of the issues Fields raised in his letter:
Poor Stock Performance - Fields said that EDGW's stock price had declined by 55% from 2007-2011 and rose by 7% from 2009-2011. While this three and five year performance is quite poor, it's even worse when, as noted by Fields, one recognizes that during these same time periods, the stock price of EDGW's peers appreciated significantly. The end result is that EDGW underperformed its New Peer Group by 89% from 2007-2011 and by 98% from 2009-2011. This poor performance is shocking and embarrassing and I think it's reasonable to ask how EDGW's senior management managed to keep their jobs considering their poor performance.
Excessive Compensation - According to Fields, from 2007-2011, EDGW's top three executives received total compensation of $8.6 million while approximately $39 million of shareholder value was destroyed. If I were an EDGW shareholder I'd be asking the Board why it paid these executives so much money considering the stock poor performance.
Poor Capital Allocation - Fields claimed that one of the reasons EDGW's stock has performed so poorly is the Board's poor capital allocation decisions. Specifically, he claimed that EDGW has historically retained too much cash and that shareholders would have been better served had the Board returned this cash to shareholders. EDGW seems to generate strong cash flows, has no debt and has lots of cash (33% of its equity market capitalization, according to Fields). When I spoke with EDGW months ago, I never got a good answer as to what they planned to do with all their cash. Lately many companies have announced special dividends in an effort to return capital to shareholders in a tax-efficient manner and I wonder why EDGW hasn't done the same thing in an effort to create some shareholder value.
Board's Lack of Incentive - Fields asked if the Independent Board members' lack of investment in EDGW stock limited their desire to act in the best interest of shareholders. According to Fields, the Independent Board Members have a combined 45 years of service on EDGW's Board yet they collectively only own approximately 87,000 shares. I don't know why these Board members haven't personally bought more EDGW stock over the years, but their lack of investment in the company seems like a red flag to me. In addition, Fields claimed that these Independent Board members are collectively paid approximately $0.5 million annually. While I do not know what motivates these Board members, in situations like this it is not unusual to find Board members who are more interested in continuing to collect their annual board fees than in doing something (such as selling the company) which might be in the best interest of shareholders.
Why Does EDGW Remain Public - In his letter Fields states that "EDGW is an illiquid, microcap company whose stock remains undervalued and has historically underperformed. The company has failed to attract interest from the investment community and we doubt the company will ever achieve a fair valuation in the public markets. In addition, the company has no need to access the capital markets. In light of all these factors (as well as others that we have chosen not to mention at this point), we wonder why EDGW continues to expend relatively high costs to remain publicly traded when the company's shareholders receive very little benefit from it." I think that this is a very strong argument and wonder why any company this small continues to remain public.
It will be interesting to see how EDGW's other shareholders react to this letter. Considering the stock's historically poor performance, it would not surprise me if most of them were supportive of Fields' argument. Interestingly, EDGW's largest shareholder is Mario Gabelli's firm, which has filed a 13D on EDGW.
I think Fields' letter raises some very interesting and serious points. EDGW has clearly underperformed and the Board appears to have done very little to create shareholder value. Therefore, I can't help but wonder if EDGW's Board is really fulfilling its fiduciary responsibility to act in the best interest of shareholders.
I think EDGW has a very interesting business and its Board could create significant value by either returning capital to shareholders or selling the entire company. To date, the Board has not, in my opinion, done very much to create shareholder value, and that makes me reluctant to take a big position in the stock. However, if the Board were to begin to take steps to create value or if other activist funds began to buy the stock, I would seriously considering buying EDGW stock.
Given the tone of Fields' letter, I suspect this is not the last we have heard of this situation, so stay tuned.