How to think like an activist

Board advisers are always telling directors to think like an activist to avoid getting blindsided. Here’s a primer on how to get that perspective—and a hypothetical list of seven companies that our screens suggest could be on activist hit lists today. Part 2 of our Special Report on Governance
By John Greenwood

High atop a sleek downtown tower a small group of analysts is peering intently at an Excel spreadsheet. Thirtysomethings, all with dark shadows under their eyes and grey complexions, telltale signs of the 20-hour workdays demanded of staff at Activists ‘R’ Us, one of the more elite hedge funds in the country. They’ve dug through the financials of every company on the TSX, even the TSX-V, endlessly crunching numbers, parsing governance documents, in search of the ideal target.

Suddenly one in the group breaks the silence. “That’s it!” he shouts. “That’s the one. Prepare a letter to the board of directors!”

The details may be apocryphal but the scene, or something like it, is playing out at dozens of locations in Canada and the U.S. When companies are merged, or carved up and sold, often it starts with an activist investor. Not every activist is a company-killer—many institutional investors are now embracing activism as a means to boost the value of underperforming holdings—but no board wants to find itself in an activist’s crosshairs. At worst, it spells at the end; at best, it means your company’s performance, and possibly its management or board, is seen to be sub-par.

So how to avoid that fate? Start thinking like an activist: understand what makes companies appealing, assess how you measure up and change whatever needs changing so you don’t meet those criteria.

Two things to get you going: First, we asked leading governance and proxy solicitation advisers—people who often work with companies when they’re battling with an activist—what goes into an activist screen and how companies can avoid such traps. Second, we created our own screen to come up with names of a few Canadian companies that might hypothetically be on some activist hit lists right now. It’s not scientific, but it is a useful exercise to understand how activists think—and how, indirectly, boards and management might seize on the realization of their potential vulnerability to address their own governance and performance issues while there’s still time.

WHAT MAKES AN attractive activist target? The answer—or answers, because there are often many reasons—depends on which activist you talk to. First and foremost, “it would be a declining stock price,” says Andrew MacDougall, a partner at Osler, Hoskin & Harcourt LLP in Toronto. That would be closely followed by “controversial compensation arrangements, and frankly, opportunities for other means of realizing value,” he adds. Such opportunities would include the potential sale of assets or the entire business, or mergers.

Boards should be asking themselves, “Is your shareholder return sub-par or sub-optimal?” says Amy Freedman, chief executive of Kingsdale Advisors. “Are there valid reasons for the poor performance? Have management or the board made poor decisions that led to that? Are there things that you believe should be done to improve those returns?”

Stock performance is the headline metric, but beyond that activists quickly hone in on governance, and any governance issues that might explain the lacklustre results.

From a strategic standpoint, for activists to be successful they need to be confident that they can bring shareholders onto their side. And one of the most effective ways of doing that is to show a link between how the board and management conduct themselves and company’s poor results.

Governance problems come in many shapes and it can be as sim- ple as lack of diversity on the board. “If you have a board that all looks the same and talks the same, it’s probably not challenged,” says Freedman. “Do you have the right mix of people in terms of the skills matrix? Or is there something incestuous going on with the board? Do you have a bunch of yes-sayers that are just going to support the chair or the CEO no matter what?”

One obvious choke point is director and executive compensation. Companies are generally taking steps to rein in the amount they pay their top executives, but it remains a sensitive topic, fuelled by a steady stream of media reports about overpaid corporate bigwigs. The introduction of say-on-pay has helped cool some of the outrage but a handful of boards still find themselves offside with failed say-on-pay votes, and that can be a key way in for an activist.

Sometimes, the catalyst is something as basic as shareholder engagement. These days, savvy boards spend a lot more time talking to shareholders, explaining what the company is up to and getting their opinion. The process helps boards get a strong sense about how they’re perceived, while the simple fact that the board is taking such efforts also strengthens shareholder confidence. But there are plenty of companies that have yet to introduce engagement policies, and that makes them potential activist targets.

“That’s a key governance topic,” says David Salmon, president of Laurel Hill Advisory Group. Shareholder engagement “is not only about annual meetings. It should be a board process and there should be regular communication. If you’re not doing that, that’s probably the easiest sign for an activist that there might be a problem.”

Equally important is shareholder composition. In other words, do a few large players control the equity, or is it widely held? If the former, and the shareholders have a positive relationship with the company, the activist may be facing poor odds. “If there’s a controlling shareholder, then the activist may be signing up for a battle,” says Freedman. But if the shares are widely held, they are more likely to find a receptive audience.

SO WHAT COMPANIES are currently popping up on activist screens, ticking all the wrong boxes? We can’t say for sure. But we’ve done the next best thing, tapping some of the sources and advice cited above to create our own screen. And using that, we’ve generated a hypothetical list of seven companies that could be potential targets. We present them below, with a snapshot of our analysis, for demonstration purposes only—to help you think twice about the way activists might right now be looking at you.

SCREEN TEST: SEVEN COMPANIES THAT COULD BE THE APPLE OF AN ACTIVIST’S EYE

First a disclaimer: this list is hypothetical. But by comparing published data to the type of criteria activists are known to use to select targets, there’s a case to be made. Against similar criteria, how does your company stack up?

Cenovus Energy Inc. (TSX:CVE)
Share performance: Since 2012, Cenovus shares have lost more than 50% of their value, slipping from around $35 to less than $15 through April. Monthly dividend has fallen from 27¢ to just 5¢.
Strategy: Earlier this year, the Calgary-based company agreed to buy the oilsands assets of ConocoPhillips for a whopping $17.7 billion, significantly more than its own market value. Coming after a $500-million net loss for 2016, the deal left a lot of investors wondering whose interests are being served.
Executive compensation: Against share performance, CEO Brian Ferguson’s $8 million in total compensation in 2016 seems high; ditto for the CFO ($3 million).
Monetizable assets: At the end of 2016 the balance sheet showed $3.7 billion in cash and cash equivalents, and total assets of $25.3 billion, which could easily be returned to shareholders.

Hudson’s Bay Co. (TSX:HBC)
Financial performance: Like other bricks-and-mortar department stores, HBC is struggling, reporting losses for the past four consecutive quarters. Return on equity, a key metric, was deep in the red (-18.73%) at the end of the last quarter. Since the IPO in 2012, the shares have fallen from $17 to as low as $10 this year.
Governance: Management has sought to build value by hiving off the company’s valuable real estate assets, putting them into two REITs co-owned with a number of partners. By borrowing against the company’s properties, management has raised billions of dollars in debt to purchase other department stores like Lord & Taylor and Saks Fifth Avenue. But results continue to disappoint. Could investors be convinced a new board of directors is needed?
Shareholder base: A key downside for any activist considering an approach is that Richard Baker/the Baker family owns 21% of the outstanding shares. They’d need other shareholders to welcome change with open arms.

Barrick Gold Corp. (TSX:ABX)
Performance: Canada’s biggest gold company by production has spent the past two years digging itself out of a debt pit ($8 billion at the end of the last fiscal year). But with no significant upside in gold price forecasts, shares are vulnerable. Disappointing results in the latest quarter, for example, led to a near-8% decline. They’re still up from 2015 lows, but well off earlier peaks.
Negative surprises: Miners all hit obstacles, but a recent cyanide spill at its Veladero mine in Argentina—the third such spill there—caused a temporary shutdown and forced Barrick to commit to $500 million on upgrades.
Executive compensation: Barrick got a stern rebuke from shareholders in 2015, losing its say-on-pay vote after awarding chairman John Thornton a big pay hike (to $13 million) despite share price decline/debt issues. That was addressed, but pay remains high and shareholders have long memories.

BlackBerry Ltd. (TSX:BB)
Performance: This company’s glory days are ancient history. CEO John Chen is doing his best to bring them back, but revenue has been sliding by more than 40% a year since 2014.
Governance and compensation: In 2014, Chen took home total compensation of $89.7 million, making him the highest paid CEO in Canada that year. His paycheque has shrunk since ($3.9 million last year), but he’s still doing better than shareholders.
Monetizable assets: Shareholders might be easily convinced that they’d be better off with some of the company’s remaining cash to invest elsewhere.

Bombardier Inc. (TSX:BBD.B)
Governance and performance: Thanks to its two-tier share structure, the Beaudoin-Bombardier family has been able to run the company with little regard for the class-B shareholders. The Quebec-based plane and train manufacturer has been dogged by scandal, controversy and massive losses while securing billions in government loans along the way. Since 2012, shares have slipped from $4 to around $2.25.
Compensation: Corporate welfare is always controversial, but a 2015 $1.3-billion Quebec government handout, followed by a $370-million payment earlier this year from Ottawa, proved radioactive after Bombardier turned around and used part of the money to award its top executives 50% pay raises (largely withdrawn following howls of public outrage).
Shareholder makeup: Ordinarily, a dual-class share structure is a show-stopper for investor activists, but a few bold activists might see daylight (Exhibit A: In early May, institutional activists forced Pierre Beaudion to give up his management role as executive chairman.) Regulators are increasingly critical of dual-class structures, and with Bombardier so dependent on government/public goodwill, something might shake loose. If it did, Bombardier would be an activist’s dream.

Aimia Inc. (TSX:AIM)
Performance: Shares in the marketing and loyalty company, formerly Group Aeroplan, had been on a downward slope since 2014 (around $9 at press time, down from $20), but then recently crashed to below $4 with the mid-May announcement that Air Canada is ending its affiliation with the loyalty provider. In earlier times, Aeroplan was one of the most popular credit card reward programs, but then competition arrived and profits took a hit. The company has diversified into data and other lines of business but the new strategy has yet to gain traction. Now, the impending loss of its main client has really turned up the heat.
Compensation: Despite the sinking share price, Aimia chief executive Rupert Duchesne took home $3.8 million in 2016, making him one of the 100 best-compensated business executives in Canada.

Air Canada (TSX:AC)
Performance: Before a recent share-price bump into the mid-teens, the company’s stock had been trading in the $13-range since last fall. That’s more than double where it was in 2013—not bad by any stretch—but when you consider that the air carrier has a virtual monopoly on many of its domestic routes, some wonder why the performance hasn’t been stronger.
Governance and management: CEO Calin Rovinescu isn’t shy with his critics, last year challenging “short-term”shareholders to sell Air Canada’s stock if they didn’t like the company’s strategy. But some shareholders may be inclined to challenge back.
Compensation: In 2016, Rovinescu received $7.2 million, enough to rankle some observers, given that Air Canada is one of those companies that a lot of travelers love to hate.

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