Throughout my many years of stock market investing, I have come across multiple companies in a number of industries, and throughout this process a simple guiding principle has shown me that great managers often align their interests with those of the shareholders, instead of considering their companies as "cash cows" to sustain an extravagant life style. Those managers act and behave as owners do. This is why I always start my research on potential new investments through reading about the compensation practices of the target company. This is an issue that is frequently overlooked by investors and can often signal potential red flags.
This article will be part of a series reviewing the compensation practices, communication policies and boards and management alignment with shareholders' interests at Canadian O&G companies. My focus on the Canadian O&G sector is largely due to my current activist involvement at Equal Energy (EQU), where excessive CEO compensation and dismal share performance go hand in hand.
To facilitate an easy comparison, I will compare CEOs absolute levels of compensation, I will compare shareholders total return, I will compare managements and boards insider ownership, and I will compare shareholders alignment policies.
The two companies I will start with are: Equal Energy and Zargon Energy Trust (ZARFF.PK). I have chosen to compare those companies because they do have a very similar size with both producing between 8000 barrels and 10000 barrels per day during the comparison period. Not to mention my activist involvement at Equal Energy has made me intimately familiar with this company.
The comparison period will mainly cover the year 2010 and 2011. While it is possible to go further, I believe that the last two years comparison should suffice in demonstrating my point.
Pay vs Performance
As can be seen from the above, Craig Hansen, CEO of Zargon Energy, was able to deliver returns that were better than the S&P Capped Energy Index which declined by 4.2% during that period, yet he was paid 59% less than Don Klapko, CEO of Equal Energy, even though Equal shares have vastly underperformed Zargon and the S&P Capped Energy Index.
Equal Energy stock returns graph from the company proxy circular:
Based on the above, during our comparison period $26 invested at Equal Energy on December 31st 2009 would be worth $18 exactly two years later.
Zargon Energy stock returns graph from the company's proxy circular:
Based on the above, during our comparison period $102 invested at Zargon Energy on December 31st 2009 would be worth $102 exactly two years later.
Zargon's management and board of directors own 400% more shares in their company than Equal's management and board of directors. What is of interest is that Zargon's management and board members have been net buyers of their company stock in the open market to the tune of $1.7m over the last 12 a months, during a period of market turmoil in a show of confidence in their company and their stock. Zargon's biggest buyer was the CEO, Mr. Craig Hansen, who purchased $971.8K worth of stock over the last 12 months:
Source: INK Research
Meanwhile, Equal Energy management and board have not purchased a single share in their company over the last 12 months, but on the contrary they have been net sellers with the CEO Don Klapko leading the charge and unloading $156.K worth of his company stock on the open market:
Source: INK Research
Minimum Ownership Requirements
It is important to note that both companies have a very different approach to simple shareholder alignment through the enforcement of basic minimum ownership policies. Zargon, for example, has the following ownership policy for its directors and chief executive officer:
Directors (other than our President and Chief Executive Officer) are expected to own common shares
having a market value of at least four times the amount of their annual board retainer. Directors are required to attain the minimum ownership level within a period of two years from the date of approval of the guideline or the date of their election or appointment, whichever is later.
Our President and Chief Executive Officer is expected to own common shares having a market value of at least two times his annual base salary. Our President and Chief Executive Officer is required to attain the target ownership level within a period of two years from the date of approval of the guideline or the date of his appointment, whichever is later.
Equal Energy has no such policy for the Chief Executive Officer and had no such policy for the directors, until last year. However, in the 2011 circular a decision was taken to enforce a minimum shareholding requirement for the directors at 3 times their annual retainer within a three year period of their appointment. While not as strict as that of Zargon, it is a positive development nonetheless.
Both Equal and Zargon don't hold conference calls; however both companies follow a different approach in communicating their progress, their goals and their vision to their shareholders through their respective investor presentations:
Business Plan And History
Zargon clearly explains on slide 6 of its corporate presentation which business plan the company is pursuing. In the following slides the company expands on its oil focused strategy as well as elaborates on its past acquisitions and dispositions history. On the other hand Equal energy's management limits their strategy information in their corporate presentation to few bullet points in slide 18. Zargon's corporate presentation covers up to 8 years of production history, reserves per share evolution, dividend history and reserve life changes, while no history of any kind is mentioned in any of Equal presentations.
Net Asset Value And Comparison to peers
Zargon presentation goes to great lengths to explain the company's net asset value, argues in detail why the stock presents good value at current levels, and in subsequent presentations even a comparison was made between Zargon's trading levels and its peers vs NAV. In Equal's presentations no attempt is made to explain the company's net asset value, compare to peers or argue why the management perceives the company stock to be a good investment (Having such little investment in the stock themselves, perhaps it is hard to make such a case).
Zargon's presentations are comprehensive documents with 72 slides; the management team goes to extreme lengths to educate investors about their projects, their economics and their geological features. Equal's presentations on the other hand are short documents often not exceeding 20 slides and usually lacking vital information about the company's properties. For certain assets, such as the Lochend Cardium, Equal investors are often compelled to study rival companies presentations to better understand their own assets economics.
On August 13th 2008 Equal's CEO, Mr. Don Klapko, wrote those lines in his first letter to shareholders:
I am pleased to submit my first letter to unit holders as President and Chief Executive Officer of Enterra. One of the key objectives we stated in our 2007 Annual Report was to provide timely, reliable and comprehensive communications to our investors. So far in 2008, we have demonstrated our efforts through conference calls, presentations and frequent news releases.
Alas those promises were not kept: conference calls were cancelled within two years of his appointment, presentations steadily declined in quality and communications with the company shareholders have often been inadequate, abrupt and uninformative.
Mr. Klapko ended his letter with the following line:
As our accomplishments and our ability to deliver results and improve Enterra are recognized, we feel that the results will be reflected in unit holder value.
The shares have certainly reflected something. Since that line was written, Equal Energy's shares have lost approximately 50% of their value, meanwhile Mr. Klapko has been awarded $10.37m in salaries, bonuses, options and incentive shares since he was appointed CEO on June 30th 2008. If this is not misalignment with shareholders, I am not sure what is.
Compensation policy, communication policy and management alignment with shareholders interest vary greatly from one company to another; shareholders are generally better served when their managers demonstrate sensitivity to shareholder value, and when they stand by their shareholders and heavily invest in their companies when their stocks are undervalued. The shareholder friendly, Zargon Energy, delivered vastly superior returns to Equal Energy over the past 2 and 5 years period despite facing similar energy prices challenges to Equal and having a similar NG to Oil split at the start of the comparison period.
It is not surprising that Equal Energy has experienced an activist process; at some point lack of alignment with shareholders and lack of performance does have consequences. It is a fallacy to think that executives of public companies are transparent and more accountable vs. managers of private companies; private companies' managers are readily accountable to their owners and lack of performance is often sanctioned by lower pay or complete replacement. However, in public companies inadequate management doesn't only stay in its job, but actually benefits from higher pay and increased incentives.
Should Equal Energy choose to remain independent at the conclusion of its strategic review, such weak governance won't be tolerated anymore: shareholders require compensation policies to be aligned with shareholder returns, incentives to be correlated with results and the company board of directors need to include real company owners and not only lined with the technocrats who may or may not have an interest in creating shareholder value.
Venues such as Seeking Alpha makes it much easier for shareholders to hold their managers and their boards accountable, and the small print hidden in lengthy proxy circulars can easily be brought to light through articles such as this. The media is sometimes labeled as the "watchdog" of democracy; perhaps digital media such as Seeking Alpha should be labeled as the guardian of corporate accountability and shareholders rights.
Disclosure: I am long EQU.