Throwback Thursdays: Four Major Red Flags – King Digital Entertainment (KING) Case Study Final
This is another post in our ongoing Throwback Thursdays Series, where we share blog posts from the past to bring you a ton of value and help you learn faster.
Here we did Part 1 of this case study series on KING.
Last week we got to Part 2 of KING’s financials.
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This week, we got to four (4) major red flags I came across while reading KING’s financials that caused me not to trust its managers and stop this analysis.
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This post is a continuation of the King Digital Entertainment (KING) Case Study.
Trust that management has shareholders’ best interests at heart is the most important thing I need when researching a company for investment. More important than valuation, cash production, and margins even.
If I can’t trust management, I won’t invest in the company no matter what.
Nothing bothers me more when analyzing a company that I’m excited about researching than seeing these four things and KING hits them all.
The first is the potential for repricing options. Like in the case with Koss Corporation (KOSS) and the corruption I found researching them.
Below is an excerpt from the article, and all excerpts from past articles and issues are unedited:
Major Self Inflicted Issue and Overall Decline
In 2009 Koss found out that its vice president of finance Sue Sachdeva was embezzling money after being told by American Express that there was an odd transfer of $4 million plus transferred from Koss to Ms. Sachdeva’s personal account. It was later determined that Ms. Sachdeva embezzled around $35 million over five or six years, or about $6 million a year. The quoted area below is from this article that was published before the full extent of the embezzlement was found.
“That’s a staggering figure, especially when you consider that the company had net sales of only $38 million in fiscal 2009 and $47 million in fiscal 2008. Net profits in fiscal 2009 were only about $2 million. How does a company of this size not notice losses averaging $5 million per year, more than 10% of net sales?
The signs were apparently there. Sachdeva earned an average of $190,000 in total annual compensation in fiscal 2008 and 2009. Yet allegedly she spent millions at Milwaukee area boutiques, and the federal criminal complaint against her says there were “several large piles” of clothing with tags attached sitting in her office at Koss. Several individual price tags were in excess of $2,000.
Who allegedly found all that clothing in Sachdeva’s office, and when? CEO Michael Koss, after American Express gave him the heads up.
What strikes me as odd is the fact that Koss hadn’t seen these apparently unconcealed piles of couture before. I would consider finding so much clothing in an office unusual and noteworthy; does the fact that he’d never noticed it mean that Koss never went into Sachdeva’s office before he received the call from American Express? Koss did not respond to a request seeking comment on the situation.”
Here is a case study I found that talks about the situation in-depth for those who are interested in how things like this can happen. I completely agree with the above quote though, how do other members of the company not notice something like piles of expensive clothes with tags still on them lying around the office? Did she work in a dungeon of their corporate offices or did she have complete autonomy to do as she pleased? I am betting on the latter and of course someone in power receiving zero oversight is never a good thing.
For a full look at everything else I found researching KOSS, you should read the article.
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The second thing that bothers me researching companies is when management has excessive compensation plans like in the case of Bab Inc. (BABB).
- BAB Systems Inc (BABB) is Undervalued but Has a Glaring Issue
- BABB Vs PARF Conclusion Article
- How I Look to Have Affected Bab Inc. With My Recent Article
I’ve only seen the possibility to reprice options once – in the case of KOSS, but the high compensation in relation to size and profitability are more rampant among micro caps.
At least I’d only seen the possibility to reprice options once, until researching KING. Below is right from KING’s own financials. Emphasis is mine.
Our compensation committee may, without shareholder approval, reprice our share options or stock appreciation rights and, provided the repricing is a reduction in the exercise price, the consent of the participant will not be required. Also, with the consent of the participant, our compensation committee may pay cash or grant new awards in exchange for the surrender and cancellation of outstanding awards.
But why is this so bad? Below is another excerpt from the KOSS article linked above.
Speaking about options I found this nugget in the companies most recent proxy report that I have never seen in any other companies financials. Emphasis is mine.
The Exercise Price of each share of Common Stock which may be purchased upon exercise of any Option granted under the Plan shall not be less than 100% of the Fair Market Value of the Common Stock on the day immediately preceding the Date of Grant; provided, however, that the Committee shall have discretion, with respect to a Non-Qualified Stock Option, to establish an Exercise Price at less than the Fair Market Value on the day immediately preceding the Date of Grant to the extent that such Option is designed to comply with the requirements of Section 409A of the Code.
To me this sounds a lot like the option repricing which is outlined in very good detail here.
For those of you who do not want to read all that, here is a cliff notes version quoted from that page. Again emphasis is mine.
Options backdating is the practice of altering the date a stock option was granted to an earlier or later date, usually a date on which the underlying stock price was lower. This is a way of repricing options to make them valuable or more valuable when the option “strike price” (the fixed price at which the owner of the option can purchase stock) is fixed to the stock price at the date the option was granted. Cases of backdating employee stock options have drawn public and media attention.[1]
While options backdating is not always illegal,[2] many options in corporations are granted to upper management. Backdating has been called “cheating the corporation in order to give the CEO more money than was authorized.”[3] and a way of “rewarding managers when stock prices fall”.[4] According to a study by Erik Lie, a finance professor at the University of Iowa, more than 2,000 companies used options backdating in some form to reward their senior executives between 1996 and 2002.[5]In an “uncanny number of cases,” the “companies granted stock options to executives right before a sharp increase in their stocks.”[1]
So while not outright illegal, option repricing is used by management to make their future shares more valuable, at the expense of “normal” shareholders and the company.
The management also had an uncanny, i.e. possibly nefarious, practice of doing this right before share prices rose fast.
I don’t want to be a part of owning any of this.
But these aren’t the only things bothering me while reading KING’s financials.
The second thing that’s a huge red flag to me is overcompensating executives and management.
Don’t get me wrong. My goal is to become rich. I’m sure everyone who reads this blog has the same goal. So I’m not against people making a lot of money.
What I am against are people who use the companies they own or run to make themselves rich at the expense of the company. Below is right from KING’s financials.
The aggregate compensation to our executive directors, executive officers and key management personnel, a total of ten individuals, for the year ended December 31, 2014 was $105.3 million, which includes $78.0 million of share-based payments, as well as pension, health insurance and life insurance benefits.
Yes, I know most of this is due to the IPO, but until next year’s financials come out, I want no part of this either.
But there’s still more that bothers me about KING.
The third red flag is complicated share and compensation structure, which KING also has. Look at the following excerpts from KING’s financials.
Registration Rights Agreement
On March 25, 2014, Riccardo Zacconi, John Sebastian Knutsson, Patrik Stymne, Lars Markgren, Thomas Hartwig, Melvyn Morris, Stephane Kurgan, a trust associated with Stephane Kurgan, entities associated with Apax Nominees and Index Ventures, and the Company entered into a Registration Rights Agreement (Registration Rights Agreement). The Registration Rights Agreement contains customary registration rights, including:
Demand Registration Rights. Certain of such holders have the right to request that we register their shares for sale, subject to customary underwriter’s cutbacks. These holders are entitled to a specified number of demand registration rights six months following our IPO. Those holders that do not have demand registration rights will be entitled to include their shares in any such registrations once a demand request is made.
Shelf Registration Rights. After we are eligible to use a “shelf” registration statement, certain of such holders shall have the right to request that we file a shelf registration statement. We will not, however, obligated to file a shelf registration statement if we have already effected a specified number of shelf registrations or if a shelf registration statement is not available for such offering by holders wishing to participate. Those holders that do not have shelf registration rights will be entitled to include their shares in any such registrations once a shelf request is made.
Piggyback Registration Rights. If we propose to file a registration statement for a public offering of our securities, then we must offer the parties to this agreement an opportunity to include in such registration all or part of their shares, subject to customary underwriter’s cutbacks. Such holders shall have first priority to sell in any such offering (other than the shares we sell) over the shares of any other holders.
Expenses of Registration. We will pay specified expenses related to any demand, piggyback or shelf registration pursuant to the Registration Rights Agreement other than underwriting commissions and discounts.
Indemnification. We will have certain indemnification obligations in connection with the registration rights under the Registration Rights Agreement.
What kind of garbage is this? But there’s still more…
Share Options
As of December 31, 2014, we had outstanding options to acquire 22,879,801 ordinary shares which were granted to employees, directors and consultants (i) before the date of our IPO in exchange for equivalent options granted by Midasplayer International Holding Company p.l.c. pursuant to individual share option agreements and (ii) following our IPO, pursuant to our 2014 Plan. The options have a weighted-average exercise price of $14.72 per share and generally expire ten years after their grant (or in the case of options granted before the date of our IPO, on the tenth anniversary of the original issuance of the options to purchase shares in Midasplayer Holding Company p.l.c.).
Restricted Share Units
As of December 31, 2014, we also had outstanding 1,799,515 RSUs, which were granted to employees, directors and consultants pursuant to our 2014 Plan since the date of our IPO. Upon vesting of each RSU, an ordinary share is issued to the holder subject to payment of the nominal value of $0.00008 per share. Participants in our 2014 Plan are generally required to pay one U.S. Dollar, or a unit of their local currency, in consideration for the grant of an option or an award of RSUs.
Share Options with Linked Shares
In January 2014, pursuant to individual option agreements, we granted “D1” options to purchase our ordinary shares (Linked Options) to certain employees and in connection with such Linked Option grants, the optionholder also was entitled to subscribe for an equivalent number of “D3” ordinary shares at the fair market value for such ordinary share. Immediately prior to our IPO, the D3 ordinary shares converted into our ordinary shares, subject to contractual restrictions with respect to transfer, voting and the right to dividends, to participate in any bonus issues of shares or to receive notice of, and vote at, general meetings (Linked Shares). This linking of an option to subscribe for ordinary shares with an equivalent number of Linked Shares is intended to allow for a more favorable tax treatment of the holder’s gains upon a sale of our ordinary shares and not to otherwise provide additional economic value in addition to the value delivered by the option over ordinary shares. The terms of the Linked Options substantially mirror the provisions of the other outstanding share options described in “Share Options” above.
Of the outstanding options to acquire 22,879,801 ordinary shares as of December 31, 2014 referenced above, 13,999,650 are Linked Options, and of the 321,958,914 ordinary shares outstanding as of December 31, 2014, 2,535,097 are Linked Shares.
A portion of the Linked Options are subject to market-based vesting conditions based on our achievement of an average target price per share over a specified time period, which is either $25.54, $31.54 and $37.54. These Linked Options will vest in three tranches over seven years depending on our share price.
Upon exercise of vested Linked Options, the optionholder will either receive value through the “release” of Linked Shares or the exercise of the Linked Options, depending on the share value at the time of exercise. Each option agreement contains a formula to determine how many Linked Shares will be released from the Linked Share restrictions in order to deliver to the optionholder the in-the-money value of the Linked Option (i.e. market value of our ordinary shares less the exercise price). If the in-the-money value of the vested Linked Options is delivered by the release of Linked Shares, we will cancel the corresponding number of Linked Options. To the extent the optionholder does not hold a sufficient number of Linked Shares to deliver the in-the-money value of the Linked Options being exercised, then the Linked Option will be exercised with respect to ordinary shares. For more information about these Linked Options and Linked Shares, reference is made to our final prospectus filed on March 27, 2014 pursuant to Rule 424(b) under the Securities Act relating to the Registration Statement on Form F-1, as amended (File No. 333-193984).
If an optionholder holds Linked Shares that are unreleased and leaves the company, the unreleased Linked Shares may be acquired by an employee benefit trust set up by us, generally for the lesser of (1) the price paid for such Linked Shares or (2) the market value of such Linked Shares less 25%. We may also at any time require the executive to transfer such shares that are no longer capable of being released to an employee benefit trust. Generally, in such events, the price payable will be the lesser of (1) the price paid for such Linked Shares and (2) the market value of such Linked Shares less 25%. If an optionholder’s employment is terminated in connection with a sale of our company, 100% of the Linked Options will vest immediately prior to the sale.
I literally got a headache reading and trying to understand what this all meant, then I came across this peach of info also from its financials.
The total number of authorized shares by class is as follows:
| 2014 | 2013 | 2012 | ||||||||||||
| A ordinary shares | – | 2,237,175,000 | 2,237,175,000 | |||||||||||
| B ordinary shares | – | 49,460,000 | 49,460,000 | |||||||||||
| C ordinary shares | – | 23,687,500 | 23,687,500 | |||||||||||
| D1 ordinary shares | – | 158,815,925 | 25,033,293 | |||||||||||
| D2 ordinary shares | – | 30,642,738 | 15,321,368 | |||||||||||
| D3 ordinary shares | – | 58,097,805 | – | |||||||||||
| E ordinary shares | – | 21,310,000 | 21,310,000 | |||||||||||
| Deferred ordinary shares | – | 750,912,170 | 40,354,660 | |||||||||||
| A preference shares | – | 169,385,000 | 169,385,000 | |||||||||||
| B preference shares | – | 21,222,500 | 21,222,500 | |||||||||||
| Ordinary shares | 1,000,000,000 | – | – | |||||||||||
| Preferred shares | 12,500,000 | – | – | |||||||||||
| Euro deferred shares | 40,000 | – | – | |||||||||||
| Total | 1,012,540,000 | 3,520,708,638 | 2,602,949,321 | |||||||||||
There are 13 classes of shares,all with different rights, and all with different ownership structures; I’ve never seen anything like this before.
Ugh. Now I have a migraine.
But this still isn’t all.
I talked at length about related party transactions and why they bother me so much in this article about Wendy’s. Related party transactions are the fourth and last major investment red flag I want to talk about today.
Again, from KING’s financials below.
Directors’ Borrowing Powers
The directors may exercise all the powers of our company to borrow or raise money and to mortgage or charge its undertaking, property, assets and uncalled capital or any part thereof, and subject to the Irish Companies Acts to issue debentures, debenture stock and other securities whether outright or as collateral security for any debt, liability or obligation of ours or of any third party, without any limitation as to amount.
Service Agreements
In 2011, 2013, and 2014 Midasplayer AB entered into various agreements with Joshsthlm AB, an entity affiliated with John Sebastian Knutsson, our Chief Creative Officer and a member of our board of directors, pursuant to which we received, or continue to receive, certain developer, project management and design consulting services and a software license. Joshsthlm received $367,000, $838,000 and $1,633,000 for these services in 2012, 2013 and 2014, respectively. The 2014 agreement superseded the 2011 and 2013 agreements. The 2014 agreement includes a $1.6 million commitment by King with respect to services in 2015.
In May 2013, we entered into a management services arrangement with Apax Partners LLP (my note: Apax is the largest shareholder of KING owning 43.8% of the company.), an advisor to our largest shareholders and an entity affiliated with Roy Mackenzie and Andrew Sillitoe, members of our board of directors, pursuant to which we paid £3,000 per day for certain management services. This arrangement concluded on November 30, 2013. The terms of this arrangement were determined through arms-length negotiations among the parties.
Loan Agreements
On June 14, 2013, we entered into a loan facility agreement with Mr. Kurgan. Pursuant to the loan facility, we loaned Mr. Kurgan £600,000, with an initial interest rate of 4% per year, to fund Mr. Kurgan’s purchase of a property. The aggregate principal and interest accrued under such loan was repaid in full on October 28, 2013. The terms of this loan facility were determined through arms-length negotiations among the parties.
Again, like I said in the Wendy’s article; this doesn’t mean KING is doing anything illegal.
But this, combined with all the above, means that everything is convoluted. The potential for nefarious acts are possible. Especially in the case of options repricing.
Any one of these would scare me away from researching a company further, but KING has problems with all four issues that I want no part of. There’s zero chance I’m going to invest in or keep researching KING.
It doesn’t matter how undervalued a company is, how much cash it has, and how great its margins are; if I don’t trust that management has shareholders’ best interests at heart I won’t invest in it.
If you want to keep reading about KING, the rest of the notes I took on them are below.
A serious thank you to Amit for recommending KING and giving me the headache : )
But seriously, this was a great learning tool.
Not only is it important to find things positive about a company, but it’s more important to know the negative things affecting a company so you can spot potential danger.
Thank you Amit.
If anyone else has recommendations on companies they’d like to see me research and analyze please let me know in the comments below.
P.S. Improve your value investing knowledge and check out our FREE book On Float. If you pay the shipping I’ll pay to get you the book anywhere in the world so you can learn about this ultra-valuable and hidden investment concept to gain a huge advantage over other investors.
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