The Cost of Entrenchment

The Cost of Entrenchment

  The Cost of Entrenchment by The Activist Investor

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Entrenchment brings many costs. We think of all manner of indirect costs when executives appoint directors and control the election process. Directors in turn shield executives from shareholder scrutiny, the essence of entrenchment.

Costs include wasted capex, executive perks, excessive corporate expenses, and crappy deals. A couple of years ago, we proposed a framework for thinking about the range of agency costs that arise from this unfortunate situation.

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What about direct costs? The actual expense of fending off investor efforts to influence a company? We have a real live instance where these costs matter, at Chico’s FAS (CHS). As it happens, entrenchment costs real money, material to this company’s financial results.

Just another proxy contest

CHS is a women’s clothing chain, one of many, and not the only one with disastrous financial results and a plunging share price as consumers move online. Earnings from continuing operations dove from a high of $180 million in FY13 to just above zero in FY16. The shares have behaved accordingly, falling from almost $20 in early 2013 to about $10 today. We activist investors have seen this many times before.

Barington Capital is an aggressive and constructive activist investor, with an emphasis on retailers and a decent track record. They own about 1.5% of the outstanding shares of CHS, and followed the share price down since 2013. Not the first underperformer, for Barington or many other activist funds.

A few months of private discussions between CHS and Barington about improving the business evidently went nowhere. About eight weeks ago, Barington began the process of seeking better investor representation on the BoD, and suggested some suitable director candidates. After CHS declined to nominate these individuals, five weeks ago Barington nominated three individuals for the BoD, for election at the annual meeting in July 2016. Happens all the time.

Not just another proxy solicitation

CHS has some choices here. It could work with Barington and other investors to appoint some new directors. It could easily solicit suitable nominees from shareholders, which includes Cliff Robbins’ Blue Harbour (another effective, constructive activist) and several large institutions.

Instead, CHS chose to torch a significant sum of shareholder money on this year’s annual meeting and board election.

Stunningly, the CHS proxy statement reveals the company plans to spend $5.9 million on the proxy solicitation. It reports already spending $3.1 million. It does not disclose the timing for that expense:

  1. ?Maybe it started in March 2016, when the CHS proxy statement discloses the first meeting with Barington, which means it spent about $180,000 per week since then, which seems excessive just for a few conference calls

  2. ?Or maybe it really started in mid-May 2016, after Barington notified CHS of its intention to nominate directors, which means it spent about $450,000 per week, which also seems excessive just to put together a proxy statement.

What does almost $6 million buy? CHS retained Innisfree, a pro proxy solicitor, to round up votes. In 2015 (and for years before that), it did not hire a proxy solicitor. Innisfree plans to charge a fee of $600,000 plus expenses for 50 people to work the phones. There’s at least a cool million.

CHS also hired corporate PR lackey Joele Frank. Before May 2016, its news releases listed only its internal IR and PR executive, so it (obviously) retained the firm for this purpose. When a company hires Joele Frank, it gets extensive media contacts, fancy presentations, and even a slick video of the CEO defending the company. That could easily cost $250,000 per month, call it another cool million from April through July.

As for the legal bill, it beggars belief to think what the company will spend on lawyers, and what it will receive. If it spends $4 million on attorneys, that’s like $1 million per month. That buys the company 8-10 full-time lawyers from a high-end firm. What will they do? What will they work on? How many lawyers could it possibly take to revise a proxy statement or proof a news release?

Barington indicates it will spend its own money (of course) on this. It retained Okapi at a fee of $300,000 plus expenses. Barington could end up spending twice that on this endeavor. Why does the company need to spend a multiple of that?

CHS can’t afford this, and doesn’t need to

CHS doesn’t break out SG&A in any meaningful way, which is probably deliberate given investor criticism of its high corporate overhead. Instead, in FY16 it reported about $1.3 billion in SG&A against about $1.4 billion in gross profit. $6 million seems hardly material.

Yet, in FY16 it reported $1.9 million in income from continuing operations. So, it plans to spend three times last year’s profit on resisting shareholders, when it appears to have spent a fraction of that in past years.

It shouldn’t spend any of that. Barington now wants to elect two directors, on a nine-person BoD. No fiduciary duty or anything else obligates CHS to spend any sum of money resisting any shareholder effort, especially one as modest as this one, to elect directors.

Clearly CHS worries Barington will win the election. It spent much less on past annual meetings, and would not spend even close to this much if it had confidence in its executives, BoD, financial results, and share price.

How much better would it look, and be, for CHS to appoint a couple of directors that large shareholders suggest, and save the money? Or spend it on better projects more central to its business?

There’s the real cost direct cost of entrenchment.

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