By Damion Rallis, Senior Research Associate
When American home furnishing company Ethan Allen Interiors (NYSE:ETH) announced yet another cash dividend at the end of January, we noticed that six of the company's last seven key events were related to dividends. As we began to investigate the company's latest proxy statement we noticed something quite peculiar in Ethan Allen's summary compensation table. Ethan Allen's CEO and Chairman, M. Farooq Kathwari, looks to be the equivalent of a leather Richmond sectional (retailing at about $7,000) while the rest of the company's named executive officers are Vera chairside tables (retailing at roughly $350).
While the company enjoyed a strong fiscal 2012 followed by more good news for the first quarter for fiscal 2013, board and compensation concerns are gradually eroding company's overall ESG rating and raising significant questions about its CEO's dominance. .
Currently, Ethan Allen's "C" ESG rating reflects moderate risk, but continuing board and pay concerns could result in further downgrade. Since March 2012, the furniture maker has seen its ESG percentile score fall nearly 40%, from 64 to its current score of 39. While Ethan Allen's AGR Rating-a measure of the integrity of accounting and governance practices-is currently "Average," the score plummeted about 50% from its previous rating of 81 to its current score of 42. Further, GMI Ratings' Litigation Risk model has indicated increased concern since dropping from a score of 45 in the spring of 2012 to its current score of 17, meaning "Moderate Risk." This places the company in the 17th percentile of all companies in North America, indicating higher shareholder class-action litigation risk than 83% of all rated companies in this region.
We are happy to acknowledge Ethan Allen's short-term successes but considering the dominance of its CEO, there is real concern that he will continue to consolidate power. We partly base this on the stark pay differences between Mr. Kathwari and his named executive officers (NEOs). For fiscal 2012, the CEO received nearly $7 million in total summary compensation while the NEOs received a median total summary compensation of only $338,538.Mr. Kathwari received over 20 times the NEO's reported take home pay, raising serious concerns about internal pay equity. The bulk of his total remuneration consisted of 105,000 shares of restricted stock and 300,000 stock options awarded upon the signing of his new employment agreement. Considering the fact that Mr. Kathwari will be 69 in 2013, has been CEO and Chairman since the Reagan administration, and took the company public 20 years ago, we wonder why his new employment agreement needed to entice him to stay. Where exactly was he going? What's worse is that his 'golden hello again' award is comprised of equity that simply vests after time without performance-contingent criteria of any kind.
According to the CEO's new employment agreement from 2011, the determination of annual incentive awards relies on only one performance metric-operating income. In most cases, a varied mix of performance metrics is more appropriate, not just to prevent executives from gaming results, but to ensure that they do not take actions to achieve a narrow objective that might more broadly damage shareholder interests. The terms of the most recent bonus were less than thrilling: if the company's operating income for 2012 merely matched the total from 2011 ($31,933,000), the CEO would receive $811,985 for essentially treading water. His bonus formula stipulates that the Operating Income thresholds be increased by $2 million in each fiscal year, so that in reality, his annual bonus will be tied to the business climate of 2011. Even if the overall economy were to improve dramatically his bonus would be tied to a baseline benchmark set in a down year. Further, the operating income threshold levels per his 2011 employment agreement are significantly lower than thresholds set in his 2007 employment agreement. As his new employment supersedes the previous one, the CEO is suddenly entitled to receive annual bonuses while achieving notably subpar results. The following Ethan Allen operating income totals reflect why his employment agreement was changed:
Compensation practices of this nature are clearly designed to benefit the CEO and the CEO only. After all, if he's allowed to cash in on stock options issued during a down market that will suddenly be valuable when the overall market improves, why is he also allowed to receive an annual bonus that has been targeted to deflated goals?
Additionally, upon a change in control, Mr. Kathwari would be entitled nearly $8.8 million while the other four NEOs would be entitled to an aggregate total of only $182,113. On top of that, the NEOs would receive nothing in the event of any other kind of termination, whereas the CEO would be entitled to a minimum of $3 million in the case of four other termination scenarios. Also, the CEO's 2012 equity award was valued at over $3.7 million while the other NEOs aggregate equity award came to only $112,913. Lastly, Mr. Kathwari's base salary remains above the limit for tax deductibility under Section 162(m) and he continues to receive generous perks in the form of life insurance premiums, legal fees paid by the company relating to his new employment agreement, company match under Ethan Allen Retirement Savings Plan, and personal service of company staff.
None of these details were lost on Ethan Allen shareholders as the company's 2012 Say on Pay vote received the support of only 57% of shares (down from 96% in 2011). Out of 2,367 recorded 2012 U.S. Say on Pay votes, only 101 companies fared worse than Ethan Allen. Considering that only seven Russell 3000 CEO's recorded higher pay ratio discrepancies in their last proxy statement, there is little mystery surrounding current shareholder discontent. After all, If Mr. Kathwari is worth over 20 times the median Ethan Allen NEO, how exactly are we meant to value the contribution other executive officers?
Given the startling pay discrepancies, it appears by design that no other executives are being groomed for the office of CEO. With such little pay compared to their boss, what this say about the relative influence of NEO's? Moreover, even if shareholders tried to effect actual change, the obstacles remain high. The company's board is classified, which would make more difficult and lengthy for any attempt to gain control of a majority of board seats. Additionally, there is a poison pill in place. The combined effect of these mechanisms is to thwart outside influence.
Mr. Kathwari's long tenure is also buffered by the board's current configuration. Three of six directors at Ethan Allen have served for over a decade, including the entire Compensation Committee and the chairs of all three of the board's standing committees. One of the company's long-tenured directors is Kristin Gamble, who serves as the lead independent director and chairs the Compensation Committee. While we see the value in experience, it is increasingly difficult to consider board members independent after so many years of service. Moreover, a recently named director James W. Schmotter, who was appointed in 2010, serves as President of Western Connecticut State University. Not coincidentally, Mr. Kathwari serves as a board member on the Western Connecticut State University Foundation. Conflicts such as these in combination with a committee structure saturated with long-tenured directors raise serious concerns about the board's ability to provide independent and effective oversight. .
It is also important to note that the Chairman and CEO is the company's principal stockholder, with 3,944,909 shares (or about 14% of the company's outstanding shares) as of the company's most recent proxy statement. Without his shares included in the tally, Say on Pay at Ethan Allen would theoretically have received only 43% approval. The CEO's significant share ownership also means that the company's latest regularly quarterly cash dividend of $.09 put $355,041 into Mr. Kathwari's pocket (pending option rights). According to the company's latest quarterly report, Ethan Allen paid out nearly $20 million in cash dividends for the six months ended on December 31, 2012 compared to about $4 million for the same time period in 2011. While most shareholders are more than pleased to cash a dividend check, we always question a company that pursues an aggressive dividend policy when its principal shareholder is also its CEO and Chairman. Including the company's special cash dividend of 41 cents in November, Ethan Allen issued five dividends for a total of $.82 in 2012, which was effectively another $3 million bonus check for Mr. Kathwari.
To reiterate, Ethan Allen is not at imminent of risk of failure. From all indications, the housing market is gaining traction as home builders are seeing a resurgence over the past year. Increased home building and home purchases typically means good news for the home furnishing industry. However, a full housing recovery to pre-financial crisis levels is far from certain, and the home furnishings business remains at the cyclical whims of the broader business cycle. From the face of it, there are no obvious internal candidates being groomed to become CEO. Furthermore, neither Ethan Allen's proxy statement nor its annual report hint at any CEO succession plan whatsoever. Mr. Kathwari seems intent on holding on as long as he can, and the board seems happy to oblige, as they continue to increasingly reward him for decreasing standards of performance. In the long-term, maintenance of this path could mean significant risk to shareholders, particularly if the company hits hard times, needs to effect a broad strategic shift but cannot displace the old regime. After all, when the CEO has his own promotional website, the symbolism should be taken seriously.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.