This week, P.F. Chang’s Bistro [(PFCB) – $40.35] reported disappointing earnings for Q1 2011. The company’s $0.44 fell well short of the consensus estimate and the stock price took a hit. What was even more disappointing was the fact that Q1 2011 was the company’s easiest 2-year profitability comparison for the year (see pages #2 and #3 in our company Data Packet here). It only gets more difficult for PFCB in the quarters ahead.
Here’s where it gets interesting. In FY 2009, PFCB management unveiled a 3-year Performance Unit incentive for its Co-CEOs that is simply tied to the company’s stock price relative to the Russell 2000 (IWM). The measurement dates are February 17, 2009, and January 1, 2012. As of today, both the Russell 2000 (861.75 today versus 428.90) and PFCB ($40.38 today versus $20.15) have almost exactly doubled since the plan’s inception.
Which now begs the question. Why do management teams tie a material bonus incentive to the stock price? We understand that investors want management to have the same incentives as investors (i.e. stock price). That’s a noble thesis. But, this bonus plan introduces a set of perverse and conflicting managerial incentives as we get closer to the January 1, 2012, measurement date.
For example, PFCB will report Q3 2011, earnings in late-October 2011. PFCB management will be heavily incentivized to shift expenses out of Q3 2011, and into Q4 2011, (e.g. shift bonus accruals into Q4 2011).
What if a key member of the management team wants to leave the company in early-December? Maybe this information would instead be announced in January 2012.
What if the company’s CFO decides that its annual EPS guidance range needs to be lowered in early-December? Well, PFCB’s Co-CEO’s would have a MAJOR incentive to wait until January 2012 to make that announcement.
Finally, did PFCB management artificially deflate earnings in Q1 2011, in favor of reporting stronger numbers in Q2/Q3 2011, as the company gets closer to the January 1, 2012 measurement date (i.e. does the company want to ensure that it’ll report strong numbers in Q3 2011, just two months ahead of the measurement date)? We were forecasting EPS of $0.58 in Q1 2011, as the company lapped easy profitability comparisons.
We’re not saying PFCB management would do any of the above. It is our belief that the company’s management team has always been honest and transparent in their dealings with investors. But, a material performance unit incentive that is tied to the company’s stock price introduces a dynamic this year that will force investors to question how the events of the next 8-9 months unfold.
We would have preferred a bonus plan that was tied to comp store sales AND operating margin improvement. PFCB was coming off a dismal year in FY 2008, as its Restaurant Margin and EBIT margin hit all-time lows. Material improvement versus those lows could have been incorporated into a bonus plan that rewarded management for its operational improvements (the top-line at the core chain has continued to decline since FY 2008).
The irony is that the flagging stock price could actually help the company achieve its annual EPS guidance range. Why? Per the company’s 10-K filing, $5.8 million had been accrued for the performance units through Q4 2010. If the company’s stock price underperforms the Russell 2000 (basically, from this point forward), that $5.8 million accrual will be reversed.
It’s going to be an interesting period over the next 8-9 months at PFCB. Do the Co-CEOs at PFCB have a real-time Russell 2000 ticker flashing on a computer screen in their office? We would. But, this could have been avoided with a more compelling performance unit structure that was tied to top-line and operational improvements as opposed to the company’s stock price.
Here’s the company’s Performance Unit disclosure in the most recent 10-K filing:
During fiscal 2009, the Company awarded 600,000 performance units to each of the Company’s Co-Chief Executive Officers pursuant to the Company’s 2006 Equity Incentive Plan. Each award will vest on January 1, 2012, at which time the value of such awards, if any, will be determined and paid in cash.
The cash value of the performance units will be equal to the amount, if any, by which the Company’s final average stock price, as defined in the agreements, exceeds the strike price. The total value of the performance units was originally subject to a maximum value of $12.50 per unit. During December 2010, the outstanding performance unit award associated with one of the Co-Chief Executive Officers was modified such that the maximum value per unit was reduced to $9.00 per unit. All other terms remain the same as specified in the original award agreement. The fair value of the performance units is remeasured at each reporting period until the awards are settled. At January 2, 2011, the fair value per performance unit was $8.30 per unit for the units with a maximum value of $12.50 per unit and $6.41 per unit for the units with a maximum value of $9.00 per unit. At January 3, 2010, the fair value per performance unit was $6.54. The fair value is calculated using a Monte-Carlo simulation model which incorporates the historical performance, volatility and correlation of the Company’s stock price and the Russell 2000 Index. At January 2, 2011 and January 3, 2010, the performance unit liability, reflected in other liabilities in the consolidated balance sheets, was $5.8 million and $2.4 million, respectively. There were no performance unit awards granted during fiscal 2010.
Total cumulative expense recognized for the performance units from date of grant through January 2, 2011 was $5.8 million based on the current estimated fair values of $8.30 and $6.41 per unit. If the value of the performance units at settlement date is the maximum value per unit, the Company would recognize additional share-based compensation expense of $7.1 million during fiscal 2011. The amount and timing of the recognition of additional expense will be dependent on the estimated fair value at each quarterly reporting date. Any increases in fair value may not occur ratably over the remaining four quarters of the award term; therefore, share-based compensation expense related to the performance units could vary significantly in future periods.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.