By Damion Rallis, Senior Research Associate
Last week, Loral Space & Communications Ltd. (NASD:LORL) announced that CEO Michael Targoff will be relinquishing his role as full time CEO prior to the new year. In connection with this announcement, Mr. Targoff also informed the company that he would be selling up to 300,000 shares of Loral stock in a "tax related" transaction. The confluence of these events - especially given that no successor has been named to fill Loral's CEO role - has pushed us to take a deeper look at the company's core ratings and risk profile, as a shake-up of this magnitude could be a harbinger of other potential issues.
Mr. Targoff's resignation comes on the heels of the company's announcement in early November that it had finalized the sale of its wholly-owned subsidiary, Space Systems/Loral (SS/L), to MacDonald, Dettwiler and Associates for $968 million in cash plus a bank guaranteed three-year promissory note in the principal amount of $101 million for the purchase of certain real estate used in connection with SS/L's business. Five days later, Loral announced that in connection with the sale of SS/L, the board of directors declared a special distribution of $29 per share for an aggregate distribution of up to $899.3 million. Loral's 2012 annual report cited two operating segments - satellite manufacturing (SS/L) and satellite services (through its majority ownership in satellite communications companies Telesat Holdings and XTAR) - so by selling SS/L, Loral Space effectively eliminated one of its two operating segments.
Mr. Targoff will remain on Loral's board as Vice Chairman while also serving as a consultant to the board for strategic matters related to Telesat and XTAR. He will also provide oversight in the company's lawsuit with ViaSat, a company for which Loral has manufactured satellites. ViaSat's lawsuit against SS/L and Loral Space cites patent infringement and breach of contract against SS/L related to the unauthorized use of ViaSat's intellectual property. (The lawsuit was announced on February 21 and three days later Mr. Targoff resigned from ViaSat's board.) While no specific compensation arrangements have been announced, Mr. Targoff's consultancy and role as Vice Chairman ensures his continued participation in the company's strategic activities. From our perspective, we are concerned not only with Mr. Targoff's sudden departure but also by Loral's apparent lack of succession planning as the company has given no indication who exactly will replace Mr. Targoff.
While the company's $29 special dividend, in the short-term, could be a reason for shareholders to celebrate, we caution investors about the potential long-term ramifications associated with the distribution. First, why exactly has the company decided to suddenly sell one of its two operating segments? When Loral firstannounced its plans to sell SS/L it provided no strategic rationale other than its intent to "evaluate alternatives for returning to shareholders the after-tax proceeds resulting from the divestiture of SS/L." Our concern with the sale becomes clearer upon closer examination of Loral's ownership structure.
As previously mentioned, one of the major beneficiaries of the company's divestiture of SS/L is its soon-to-be-former CEO, Michael Targoff. Not only would Mr. Targoff greatly benefit from the special dividend of $29 per share (considering his 2.7% ownership of company shares as of the company's 2012 proxy statement), but he also sold 300,000 Loral shares on December 3 for over $24.6 million. Furthermore, per his employment agreement, since the transaction and reduction of his duties technically qualifies as a change-in-control, Mr. Targoff is entitled to a $5.3 million severance payment, almost $1 million in accelerated equity, $80K in post-termination insurance benefits, $1 million in nonqualified deferred compensation, and pension payments of over $3.5 million.
But what really concerns us about the $29 per share distribution is that the primary beneficiary is Loral's Chairman, Mark Rachesky. As of the company's 2012 proxy, Mr. Rachesky's 8,144,719 shares entitle him to an impressive dividend payment of nearly $240 million. While we acknowledge that shareholders not named Rachesky or Targoff also are also recipients of the company's special dividend, we question the company's motives. Was the divestiture simply an effort to enrich the company's primary insiders in anticipation of higher dividend tax rates? Why exactly was it necessary to distribute nearly all of the money made from the sale? Would Loral's long-term health have been better served by reinvesting some of the cash received from the sale of SS/L? Unfortunately, we don't know the answers to these questions since the company has provided scant details to its sudden urge to spin-off SS/L. (An attempt to listen to a conference call on the special distribution proved fruitless as the audio failed to load despite repeated attempts.)
While not every KeyMetrics red flag correlates to a current or future issue that will transpire into a substantive problem, the collection of warning signs is a heightened indicator of risk. After all, this is not even the company's first special distribution of 2012. After Telesat entered into a new credit agreement and increased its indebtedness by approximately $490 million, Loral declared a special dividend of $13.60 per share for an aggregate dividend of up to $421 million in late March. This means another $111 million for Chairman Rachesky and evidence of an emerging pattern. The average shareholder, however, should be concerned how this increased debt burden will affect the future performance of Loral Space & Communications.
In any case, while we can't know for sure whether the SS/L sale will be beneficial in the long-term, we know that company insiders benefited greatly from the transaction. In conjunction with ongoing governance-related red flags, Loral's overall "C" ESG Rating and "Aggressive" AGR Rating® are at risk of a further downgrade. Loral Space & Communications' AGR Rating - a comprehensive measure of corporate integrity based on an extensive evaluation of metrics which study financial results and corporate behavior - stood at 61 ("Average") at the end of 2011 and then fell to 44 in March and 12 ("Aggressive") in June. Currently, Loral continues to be rated as having "Aggressive" Accounting and Governance Risk (AGR). This places them in the 12th percentile among all companies in North America, indicating higher accounting and governance risk than 88% of companies.
Due to the company's decision to distribute the cash earned from its sale of SS/L to shareholders, the "Liquidity: Cash Ratio" metric, which is a company's ability to cover its current liabilities with cash and equivalents, has heavier influence on the AGR. This metric is the most stringent test of short-term liquidity. Relatively low cash ratios indicate possibly low liquidity for a company. By only including cash and equivalents, the quick ratio concentrates on the most liquid assets, with value that is fairly certain. It helps answer the question: If all sales revenues should disappear, could the business meet its current obligations with cash on hand? As of the period ending June 30, Loral's ratio of cash and equivalents to total current liabilities fell dramatically to 0.050 compared to its industry median of 0.590.
Our Litigation Risk model is following a similar trend, having fallen from a 37 (meaning "Negligible Risk") to its current score of 20 ("Moderate Risk"), places Loral in the 20th percentile of all companies in North America, indicating higher shareholder class action litigation risk than 80% of all rated companies in this region.
One of the reasons for our criticism is the composition Loral's board of directors. For instance, the board is highly insulated from its shareholders. Most notably, director Hal Goldstein received a particularly large majority of votes withheld (66%) at the company's 2012 annual meeting. Mr. Goldstein and Chairman Rachesky are co-founders and managing principals of MHR Fund Management, the company's largest stockholder and prime beneficiary of its most recent special dividend. However, since the company has a plurality election standard without a resignation policy, he would have been reelected even if he had received only one vote of approval. Directors who receive a majority withheld votes and who are allowed to remain on the board represent a direct contravention to shareholder objectives. Additionally, the company's board is classified, which means that each director is not subject to shareholder election on an annual basis. As a result, this structure makes it substantively difficult and lengthy to gain control of a board majority. The company also has charter and bylaw provisions that would make it difficult or impossible for shareholders to achieve control by enlarging the board or removing directors and filling the resulting vacancies. The combined effect of these mechanisms is to effectively reduce shareholder oversight.
Currently, we note that Loral Space's board, with only six directors, is relatively small. As a consequence, only two board members serve on three of the board's four standing committees, negating one typical benefit of committee service, which is to allow a subset of the board to devote extra attention to an issue and develop expertise in that area. Out of the six board members, half consist of insider Michael Targoff and the two representatives (Mr. Goldstein and Chairman Rachesky) of the company's largest stockholder. Moreover, John Stenbit is director at ViaSat where he previously served with Mr. Targoff, and John Harkey serves as director at Leap Wireless International along with Mr. Targoff and Chairman Rachesky and at Emisphere Technologies again with Chairman Rachesky, raising additional concerns about intra-board relationships that can compromise non-executive directors' ability to act individually and independently. Once again, these features call into question the board's ability to act as an effective oversight body.
Such board composition can contribute to policies which are a clear disregard of rank and file shareholders. Loral's executive compensation practices reflect this possibility. Mr. Targoff's fiscal 2011 base salary of nearly $1.1 million is over the limit for deductibility under Section 162(m) of the Internal Revenue Code. While the CEO received no equity grants for 2011, he received a mega-grant of 825,000 options pursuant to his 2006 employment agreement that vested simply over time without performance-contingent criteria. On top of that, Mr. Targoff realized nearly $32 million on the exercise of over 600,000 options in 2011 bringing his total realized compensation amount to $38,636,350. Equity awards should have performance - vesting features in order to assure proper alignment with company performance. Additionally, market-priced stock options in many cases simply reward executives for market correlated stock appreciation, rather than any specific aspect of individual performance. This means that no compensation granted to Mr. Targoff for fiscal 2011 was directly tied to the company's long-term performance. Mr. Targoff also received $60,000 in director fees as part of his "all other compensation." This is a highly unusual compensation arrangement as CEOs are rarely paid for their board service.
Also, 33.3% of the bonus opportunity for three named executive officers was based on individual performance evaluations, which are frequently subjective in nature. While certain objectives may be quantifiable in nature, discretionary elements can undermine the credibility and effectiveness of a well-structured incentive plan. Discretionary incentive bonuses of this nature undermine the integrity of a pay-for-performance compensation philosophy.
Considering the emerging pattern of special distributions at Loral Space & Communications, the question is whether company insiders are overly focused on their own personal short-term gains as opposed to the company's long-term viability. The question is whether the company is winding down and starting to turn off the lights as key members tinker from the inside to ensure payouts of significant magnitude, or merely shedding its skin as it strategically rids itself of underperforming (or future underperforming?) units while giving its shareholders (including some fortunate insiders) a healthy payout? While Loral Space is not the only corporation seemingly fast-forwarding its dividend payments - there has been some evidence that companies are "moving dividend payments into 2012 from 2013 to avoid potential tax increases" - it is not yet known whether this use of company cash will be a detriment to long-term prosperity.
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