After my love-fest, I felt a little dirty; such naked adoration for a company is never healthy. So today, I thought I'd touch on areas of concern that I have for Motley Fool Hidden Gems pick CryptoLogic (Nasdaq: CRYP ) . Many of these have to do with how I believe management is treating the equity of the company, and other areas that fall under broad headings of "Shareholder Alignment" and "Corporate Governance." It's not that I think management shouldn't be fairly compensated for delivering market-beating results. But the opacity of some of its compensation plans, I believe, should make shareholders vigilant. I'm watching with a jaundiced eye, although I'm very willing to be proved wrong.
Each year in its annual report (link opens a PDF file), management presents a scorecard of the past year's accomplishments and the goals of the upcoming year. While these are often little more than promotional materials, I'm looking forward to see how this is presented in the 2005 report. You see, one of the goals that management set for itself was to "selectively target one or two substantial international licensees."
With fewer than eight weeks left in the year, no new licensees have been signed and the company will be losing the contribution of one of 2004's new signees, Betfair, at the end of 2006. We know of at least one potential licensee (British company Virgin Gaming) that chose to go with a competitor (Wagerworks).
Insider ownership and share repurchases
I'm not convinced that CryptoLogic's management is as aligned with shareholders as it could be. As Exhibit A, I submit the latest holdings, stocks and options, of board members and senior officers of the company:
|Abony, Lorne*||Former Director||36||13,334|
|Cua, Jenifer**||VP Finance/Treasurer||3,425||45,625|
|Goetsch, Andrew||VP Poker Development||300||60,000|
|Stikeman, Robert||Chairman of the Board||5,300||57,000|
**Cua was interim CFO until August 2005.
Management, particularly the board of directors, remains rather light on share ownership (0.5% of total shares outstanding), particularly considering its option holdings. Moreover, with the company buying back nearly half a million shares over the past three months at, presumably, bargain-basement prices, you might have expected to see members of the board and management adding to their personal holdings. Unfortunately, unless you put great weight behind the chairman of the board, the CEO, and several senior executives each buying 300 shares in late August, you'll be disappointed. I don't, and I am -- and I suspect that many Fools added shares to their personal holdings during the recent troubles than did management insiders.
But what of those share buybacks? As of mid-October, the company had repurchased 493,300 shares for nearly $8.9 million -- a good use of cash, given the depressed price, right? Well, not so fast. Take a look at the period-ending share counts of the recent past.
Aside from a dilution offset, I'm not sure what shareholders have received for their $8.9 million. Moreover, with a further 1.2 million options outstanding, those shares are going to come back onto the market soon enough.
But option plans for management and board members have been defeated at each of the past two annual meetings. There are limited options still available for granting to management and directors. The question is: If shareholders continue to defeat option plans for executives, how will they continue to be compensated in the manner to which they have become accustomed?
If not options, then what?
On page 15 of the 2005 Management Information Circular (link opens a PDF file), there is a sparse write-up on the recently adopted Long-Term Incentive Plan (LTIP). While it's very early in that particular program's life, I believe it has to potential to suffer abuse.
Let's start with the good news: The Performance Share Units (PSUs) granted under LTIP are paid out in cash, so there will be no debate as to the cost of these incentives; it will be fully visible on the financial statements.
Unfortunately, the rest of the program is not so promising. LTIP grants are "generally set to achieve a total and aggregate compensation between the 50th and 75th percentile of comparable companies." During a recent conference call with CryptoLogic's Nancy Chan-Palmateer (director of communications), which I had the good fortune to sit in on with Hidden Gems co-analyst Bill Mann, Chan-Palmateer declined to comment when asked what those comparable companies were. Probably a good idea, since the last time we saw a comparables table from CryptoLogic (page 5 of the 2005 Management Information Circular as justification for the defeated management option plan), it included such notable online gaming luminaries as Research In Motion (Nasdaq: RIMM ) , Oracle (Nasdaq: ORCL ) , and ATI Technologies (Nasdaq: ATYT ) . Fine companies, perhaps, but not direct competitors.
The LTIP does not require approval by shareholders, so it has the potential to be somewhat of a black box. LTIP grants are tied to earnings per share (EPS) and share-price targets, which are not being disclosed to shareholders (red flag No. 1). Moreover, tying personal compensation to share price or EPS introduces potential agency problems. A falling share price can be underpinned by management buying back stock; that lowered share count then serves to boost reported EPS. That such an action using a company asset might also help to attain those undisclosed EPS and share-price targets, triggering extra compensation to management, should apparently be ignored (red flag No. 2).
Take a quick look at CEO Lewis Rose's compensation for the past couple of years. In 2004, an annual salary of $400,000 (Canadian) was supplemented by $595,000 in bonus and other compensation, and nearly $2.4 million from option exercise (on 167,100 options). To date in 2005, Rose has realized approximately $2.5 million from option exercise (on 120,400 options). Yet his option cache has dwindled to 142,500, or roughly what he's exercised in each of the past two years. With continued defeat of management option plans at the past two successive annual meetings, the available options that could be granted to keep Rose at the income level he has become accustomed to are getting sparser. You don't suppose the undisclosed LTIP will make up some of this, do you?
Lack of disclosure also potentially allows the compensation committee to "move the goalposts" to help executives attain compensation in that 50% to 75% level of comparables. For example, do annual targets build on one another (10% annual EPS growth), or is the hurdle reset lower for 2006 payouts because of the poor share performance? Are the 2007 targets set lower still, as the loss of Betfair comes to fruition? Plus, as options begin to be exercised, the EPS objectives can again be adjusted to target the same payouts on a lowered EPS target because of dilution. With a lack of disclosure, there is almost no end to how shareholders can envision abuse of the LTIP. I encourage CryptoLogic's board to disclose details of this plan -- if only to stop my imagination from running wild.
The Foolish bottom line
I really like CryptoLogic's industry and its business. I generally approve of how the business is handled, management's conservative approach to growth and acquisitions, and how it seems to have made the best out of the Betfair defection. In other words, I love that we seem to have a business-focused management, which is why I find it so strange that the executive compensation programs run so counter to this notion of long-term accretive value for shareholders. From the continued options profligacy to the almost complete lack of disclosure of the LTIP, these things just seem to scream "shareholder-unfriendly." So I remain watchful, with a rose-colored contact lens in one eye and a jaundiced monocle in the other.
Yang? Or Yin? You decide. CryptoLogic is aHidden Gemspick, and you can weigh in with your opinion on the Hidden Gems CryptoLogic discussion board (a free 30-day trial is required). A free trial will also give you access to more than 40 market-beating small-cap investment ideas.
Jim Gilliesowns shares of CryptoLogic. He is also short $20 Jan. 2006 CryptoLogic puts, and he has a synthetic long position made up of short $17.50 April 2006 puts and long $17.50 April 2006 calls. He's going to need a bigger disclosure section if he keeps this up. The Fool has a strictdisclosure policy.