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Alpha Pro Tech Ltd: Expensive Executives (APT)

February 11th, 2011
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Last week I discussed Lakeland Industries, Inc (NASDAQ:LAKE) here, a company that manufacturers and markets disposable safety garments and accessories. I have also come across Alpha Pro Tech, Ltd (AMEX:APT) which operates in the same space and is also a microcap (Market Cap around $40m). I was initially attracted to the company by its lack of debt, low P/E (7.3x ex-cash), share repurchase program and low price in relation to NCAV. It wasn’t until I found this note in its recent 10-Q that I gave up investigating further:

The Chief Executive Officer and President are each entitled to a bonus equal to 5% of the pre-tax profits of the Company, excluding bonus expense.

I have often given up on companies when I find situations of executives being paid outrageous amounts, but it is truly a rare occasion that that I come across a situation structure in this manner. In the company’s defence, the CEO and President chose to forgo their bonuses in 2010, but let’s look at the effect a resumption in their bonuses would have on the company.

The company has TTM EPS of $0.21. Pre-tax, this is $0.31 (TTM Pre-tax earnings of $7.21m over average shares o/s of 22.915m). If the President and CEO each took their 5% bonuses, this would reduce pre-tax earnings to $0.279. The average effective tax rate for the last four quarters was 36.55%. Using that figure and the new pre-tax earnings, we would get EPS of $0.177. Using the P/E ex-cash of 7.3x, this would translate to $1.29 and then we would add back the cash and get a value per share of $1.50.

$1.50 is a 14% decline from its recent $1.74 (the price on publication may differ from what this was written). A 14% decline would knock $5.4million off the market cap of this company if the P/E held steady. The only way the value of the company would stay stable would be for a concomitant multiple expansion.

I am sure there are a lot of ways to look at this situation, and I have presented only one scenario (for example, perhaps it would make more sense to use normalized earnings and average P/E multiples for the company). Other scenarios may make the situation look better or worse than the one I have presented, but the fact remains that poor corporate governance policies (and executive compensation is a big part of these) can have a real, practical effect on an investment.

I should also note that this is not a sitaution where the company’s executives are paid little by way of salary and options. In 2009, the top four executives earned a combined total of $3.34 million, of which $1.6 million was salary. This is a year when the company earned a total of $9.0 million, so the executive compensation outside of their bonuses comprised approximately 10.4% of net income. Including the bonuses, the figure is closer to 19.4%!

Talk to Frank about APT

Author Disclosure: No Position

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  • http://frogskissbyandrewaugust.blogspot.com/ Andrew

    Out of curiosity, why don’t you view this as an alignment of incentives? They make more money if the company makes more money. Everyone is entitled to make a living, although I do agree that it seems excessive.

    My thinking is that clearly a large ownership stake is the best incentive, but this pay set up in not exactly a disincentive. In order to make sure the mechanism of this pay structure is actually building shareholder value, you can look at shares outstanding and debt. Share count is a little lower than a couple years ago and it doesn’t have a leveraged risk-it-all balance sheet. Do you just conclude that such a set up is a huge mark against the integrity of the management?

    • Frank Voisin

      Hi Andrew

      You may very well be right that the incentives are correctly aligned (though it is by no means certain) but my article is simply pointing out the effect of the policies on the share price.

      For executive compensation, I do want to see it tied to the long-term performance of the company, and so I’ll do my best to consider whether the plan encourages managers to act in the long-term interests of shareholders (i.e. the approach you have taken to considering APT’s compensation structure). When the plan is so expensive as to have a material impact on the share price, I have a tough time saying it is in the shareholders’ interests even if it does encourage management to improve the bottom line. An argument could be made that when the level of compensation is excessive, it deprives the company of capital which is not in the shareholders’ interests (this is really only a small cap phenomenon, since executive compensation can be a large expense relative to operation income).

      I try not to judge management’s integrity solely on the compensation policies (these guys did give up their bonuses last year). I am only concluding that I think the compensation level is too high relative to this company’s operating performance and I think I’ve shown the calculations to support that.

      Frank

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