This article was originally published on TMFEldrehad's blog.
Let's face it; reading SEC filings is often about as riveting and exciting as Ben Stein's economics lecture in the film Ferris Bueller's Day Off. Often, however, one's diligence in reading these filings reveals some pretty important pieces of information -- certainly well worth the cost of the triple espresso and Red Bull chaser it sometimes takes to keep me awake long enough to get through them.
Case in point: Cherokee Inc. (NASDAQ:CHKE)
Cherokee Inc. licenses such popular apparel brands as Cherokee, Sideout, and several others. While there's a lot to like about this stock with a current 5-star CAPS rating (as many of my fellow CAPS players' pitches attest), in doing some research for my CAPS stock picking blog I came across something in the 10K regarding the CEO's bonus structure that raised my eyebrows.
"The management agreement also provides that, for each fiscal year after fiscal 2000, if our EBITDA for such fiscal year is no less than $5.0 million, then Mr. Margolis will receive a performance bonus equal to (x) 10% of our EBITDA for such fiscal year in excess of $2.5 million up to $10.0 million, plus (y) 15% of our EBITDA for such fiscal year in excess of $10.0 million."
My first thought was that this bonus structure seemed to me to be a bit generous, but if it aligns the CEO's interests with those of the shareholders and motivates performance it's a good thing, right? Maybe so, but let's look at the definition of EBITDA and how it applies specifically to Cherokee's business.
EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization.
Cherokee acquires trademarks and licenses them to retailers. The cost of these acquisitions is initially recorded on the balance sheet as an asset and charged against income over time as amortization expense (the "A" in EBITDA). The CEO's bonus, however, is calculated on earnings before amortization expense. This means that the CEO's bonus calculation completely ignores the acquisition costs of these trademarks. If you're still looking for a couple of toothpicks to keep your eyelids propped open, consider this: what would happen if the company grossly overpaid for a trademark? Since the royalty revenues the trademark would bring in would be part of EBITDA, but the cost to acquire that stream of royalty revenues would not be, the shareholders would be taking it on the chin while the CEO would be flush with extra cash.
We're not done yet though. Things get even stickier since EBITDA also excludes the "I", interest expense. Not only could the company grossly overpay for a trademark, but if it should also add insult to injury by doing so via debt financing, the interest expense associated with that debt financing would also be ignored in the CEO's bonus calculation.
I'm not suggesting that Cherokee is a bad company, or a bad investment, or that the CEO has ever acted in a way so as to maximize his bonus at the expense of the shareholders. What I am saying, though, is that with this particular bonus structure lays the potential for a conflict of interest between the CEO and the shareholders. I believe that this potential is something every investor or prospective investor in Cherokee should at least be aware of, and it's the kind of thing that investors will likely only know about if they make the effort to read the company's SEC filings.
Are SEC filings boring and tedious at times? You bet. My advice, however, is to grab a cup of your stimulant of choice (legal, of course!) and grind through them. You just might find some important nugget of information that you otherwise could have missed.
You may know Fool contributor Russell Carpenter better as TMFEldrehad, the longest-running top-ranked player in our CAPS community investment database. He does not own shares in any company mentioned above. Click here to see how he has managed to outperform the market and more than 60,000 registered CAPS players. Also, be sure to check his new CAPS stock-picking blog for investing ideas. The Fool's disclosure policy scores off the CAPS charts.
