The Bonus Threads at Jos. A. Bank

Since writing about Jos. A. Bank (NASDAQ:JOSB) three weeks ago, I've received a fair amount of email from readers insisting that the company's performance last quarter is an anomaly and not an earnings quality issue.

I've also had a couple Fools suggest that the shares are now very cheap and the inventory problems are fixable. Both are true. There is little to gain by being stubborn, and the most interesting opportunities are often among the most beaten-up stocks. With that in mind, I've decided to take another look at Jos. A. Bank.

The financial facts
The financials have caused many investors to scratch their heads over the last few years. The performance on Jos. A Bank's income statement is very impressive, but when the balance sheet and the statement of cash flows are pulled into the evaluation, the story loses its appeal. This table lists a few of the company's metrics over the last few years and the compound annual growth rate of each one.

Outside of sales growth and net income growth, it's not a pretty picture. However, one could make the case that the shares would be attractive if inventory growth slows to the level of sales growth. This would reduce investments in working capital, which in turn would increase cash flow from operations and free cash flow.

On its conference calls and in its 10-K report, the company says it keeps ample inventory on hand as part of a broad focus on customer service and experience. Because Jos. A. Bank is still opening stores at a quick clip, I think it's unlikely that its inventory-to-sales ratio will pull back closer to that of competitors Men's Wearhouse (NYSE:MW) and Nordstrom (NYSE:JWN).

An interesting view on compensation
But there is a larger reason to believe that inventory levels won't decrease anytime soon. Management has no incentive to lower them. In fact, I believe the bonus compensation structure at Jos. A. Bank gives management a reason to keep inventory levels higher than normal.

Over the last three years, the company has disclosed its basic bonus plan and its incentive bonus plan in proxy statements filed with the Securities and Exchange Commission. The basic bonus plan consists of two earnings per share (EPS) thresholds and personal/departmental goals, but if the first company EPS target is not met, there is no payment for meeting personal/departmental goals. The incentive plan is only for senior management and carries a third EPS threshold higher than the one in the basic plan, which entitles senior managers to bonuses of up to 130% of their base salary. If this higher threshold is met, senior management would not receive payments from the basic plan.

As an investor I have no problem with the dollar amounts and potential payouts, but I'm not impressed with the plans' structure and the focus on EPS, because EPS isn't a good way to determine whether shareholder value is being created. It's free cash flow, not earnings, that determines value.

With Jos. A. Bank, the bonus plans are the primary cause of higher inventory balances, because having plenty of inventory guarantees you never miss a sale, which benefits EPS, and in turn management's bonus payments. Unfortunately, the cost of tying up cash in inventory is not reflected in EPS because purchasing inventory is purely a balance sheet transaction. As long as that's the way it is, I have a hard time believing management will significantly slow inventory growth or decrease inventory balances.

I'm well aware that management's stated reason for carrying higher levels of inventory is to satisfy customer demands. It's true that carrying more inventory ensures that customer orders are always fulfilled. But given that competitors carry lower levels of inventory in relation to sales, show healthy sales growth, and don't cry about missing sales, I'm inclined to believe that the reason for carrying high levels of inventory in proportion to sales is more about compensation than customer satisfaction.

Foolish final thoughts
As you might have guessed, I'm still not convinced that Jos. A. Bank is worth an investment. The shares are relatively cheap and the business carries little or no fashion risk, because many of the company's wares can be sold during the next season if they don't sell now. However, that doesn't make up for the fact that Jos. A. Bank is run in an inefficient manner and that management has an incentive to leverage its balance sheet with inventory and debt to achieve EPS goals, at the expense of metrics such as free cash flow.

You can't compare Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), and TJXCompanies (NYSE:TJX) to Jos. A. Bank, but all sell everyday items and have limited fashion risk and businesses that are highly focused on profitable growth. If you're dying to add a retailer to your portfolio, I think all three deserve consideration before Jos. A. Bank -- at least until we can believe that management is carrying more efficient levels of inventory that maximizes shareholder value.

Wal-Mart is a Motley Fool Inside Value pick, and Costco is a Stock Advisor pick. Take a look at other picks and how they're doing with a free trial.

At the time of publication, Nathan Parmelee owned shares in Costco but had no financial interest in any of the other companies mentioned. The Fool has a disclosure policy.