7 Rules for Keeping Activist Investors Away

7 Rules for Keeping Activist Investors Away

The following 7 rules apply to public companies across a variety of industries – particularly to Enterprise Software, FinTech and Information Services companies.

1.) Make Your Numbers

2.) Regular, Transparent Investor Communication

3.) Drive Expanding Operating/EBITDA Margins

4.) Don’t Stockpile Cash

5.) Control Waste

6.) Use Debt as a Tax Shield

7.) Board Composition – More Insiders

1.) Make Your Numbers: Always. At a minimum, it is imperative to meet the revenue and earnings guidance you have provided Wall Street. It is a bit of a game – we know. Making your numbers for 10-20 consecutive quarters doesn’t qualify you as a “great company”, simply as one that is adept at setting appropriately conservative guidance. However, try missing your numbers for 2-3 consecutive quarters. This is a surefire way to lose your CEO chair and to simultaneously put the company in play. Consider this table stakes.

2.) Regular, Transparent Investor Communication: Provide investors with measurable milestones beyond revenue and EPS targets. For example, if Company ABC has consistently invested 8-10% of revenue in Product Development each year for the past several years, investors would likely expect this to be the case for the foreseeable future. Should an opportunity present itself where the Company believes it to be in its best interest to accelerate Product Development to 12-13% for 4 quarters, the Company ought to frame the incremental investment in this manner for investors: “…12-13% Product Development investment to capitalize on XYZ opportunity which we believe will drive 2-3% incremental revenue growth in year 2 and beyond. This investment will be partially offset by holding G&A expense flat on an absolute dollar basis during the investment period. Net net, we anticipate $X dollars of pre-tax dilution which translates to ($0.01) EPS dilution for the duration of the investment period.”

3.) Drive Expanding Operating/EBITDA Margins: It is difficult to pick a fight with a company that consistently drives year-over-year operating margin expansion. But what to do when you hit the operating margin ceiling? Surely operating margins can’t expand in perpetuity. This is where a well-executed M&A strategy can provide a financial benefit – acquisitions provide companies with the opportunity to reset operating margins. IHS – now IHS Markit ticker “INFO” – was famous for this. For example, let us assume your operating margins are at 35% and you prefer not to take them higher as to do so would be to under-invest in the product portfolio. Perhaps there is a target acquisition that carries 15% operating margins. You believe that with scale and supervision the target company could achieve 30-40% operating margins over the next 3 years. Post acquisition close, depending upon the size of the target company, your corporate operating margins will fall below 35%. As you scale the acquired company and improve its efficiency, you will grow your diluted margin from its low point to something closer to 35% or higher. Thus, you can continue to tell your margin expansion story to investors.

4.) Don’t Stockpile Cash: Investors aren’t paying you to be a bank – particularly cash-rich Enterprise Software companies. How then to invest surplus cash? Hopefully as CEO organic revenue growth and product development excites you. Innovation ought to excite you. Technology companies are supposed to innovate after all. Innovation begets revenue growth which is re-invested in product development and the cycle repeats. Perhaps you have just completed an especially heavy innovation cycle and plan to limit product investment for the next 3-4 quarters. In that case acquisitions, dividends and share buybacks are three options for investing surplus cash. We prefer strategic acquisitions and dividends to share buybacks. Buybacks imply the company in question does not have a better investment alternative. This should rarely if ever be the case for a technology company. Think about it – in buying back stock you are giving shareholders who “want out” an out (I borrowed that comment from George Needham some 10-12 years ago).

SS&C Technologies (SSNC) and CoStar Group (CSGP) come to mind in terms of companies that have effectively used M&A to augment organic revenue growth.

5.) Control Waste: It is natural for the administrative state to want to grow. We see this with governments and with companies – especially at corporate headquarters. Former GE CEO Jeff Immelt used to travel with two corporate airplanes in tow – one for the business trip, one to shuttle him to his destination of choice post-business trip – this qualifies as waste. Current GE CEO John Flannery recently announced the company’s turnaround plan. It shrinks HQ and puts far more autonomy in the hands of the operating units. We are fans of decentralized operations when a company consists of multiple standalone business units. Give the business unit head the authority to run it as he/she sees fit. Let the business unit stand on its own two legs and be accountable. Accountability is a natural waste removal agent.

6.) Use Debt as a Tax Shield: This especially applies to cash-rich software companies. Why not shield a portion of your profits from the taxman? Take on a comfortable level of debt that you could repay if we were to have another 2008-like credit crunch. Interest expense is tax deductible. Plus, the additional cash could grow your M&A war chest.

7.) Board Composition – More Insiders: The trend that’s existed for the past decade or so is for the CEO to be the only Board insider and for the remainder of the Board to consist of outside Board members. As a result, Boards lack what I would consider a requisite level of industry knowledge and operational-understanding. Netflix (NFLX) has attempted to address this issue by having Board members sit in on operating reviews. My preference is to re-stock Boards with insiders. Not exclusively so, but approximately half of the Board ought to consist of insiders. Moral hazard you say? They’ll just fall in-line with the CEO? Well, if the company has compensated these insiders correctly, they’ll have substantial equity at stake. This ought to inspire them to call out the emperor when he/she’s devoid of clothing.

Our recent podcast on the subject: