Quiet ambition justifies juicy valuation

I'm going to get drawn into a whinge today, because I drove all the way to York for Animalcare's AGM, mostly to find out how much it has agreed to pay its two executive directors. It is far from clear, at least to me, from the company's annual report.

But first, I want to dwell on what an interesting company Animalcare is, which is why I cared enough to go there.

On the face of it, it's pretty boring. It's a distributor of generic drugs and pet paraphernalia (technically "companion animals", including horses) to wholesalers that supply veterinary surgeries. It's doing well to slowly grow revenue, profit and cash flow, despite the increased buying power of its customers, which are merging, or joining together in buying groups.

The world's major suppliers are also merging into multi-billion dollar entities, with enormous product ranges that are difficult to compete with, but there is opportunity. Giants like Elanco, part of Ely Lilly, and Boehringer Ingelheim, which is swapping its human health business for Merial, Sanofi's animal health business, cannot focus on their lesser products, and it's this tail Animalcare can attack, by developing its own drugs.

Landmark year

Twenty-sixteen was a landmark year. It launched or relaunched three drugs, the first in a wave of generic and not so generic products from its own development pipeline, rebooted three years ago. The company doesn't manufacture the drugs, or even develop them. It identifies potential candidates, and manages the process of formulating, testing, licensing and manufacturing them.

The first three are all generic. It switched the manufacture of Aqupharm I.V. Fluids, Animalcare's biggest product, to a more accommodating manufacturer, a move that lost it the distribution rights for a general anaesthetic, Isocare, which Animalcare has replaced with its own product.

Animalcare's quiet ambition justifies its somewhat elevated valuation

Both Aqupharm and Isocare were only licensed in the UK, but as a result of the development and registration process, Animalcare has authorisations to sell the newly registered products in parts of Europe too. The other product launch was Acecare, a premedicant, the first generic acepromazine on the UK market. Acepromazine is used to prevent anxiety during veterinary treatment or pet grooming, and it can also help with motion sickness.

Animalcare says it will take longer for a drug to enter the market if it has reformulated it or improved on the way it is packaged. These enhanced generics will start dribbling out of the pipeline after five years, perhaps in two years' time. In 10 years, Animalcare could be selling novel drugs it has developed.

So far, it's experienced the cost, but not the benefit of its development programme. From now on it will be earning revenues. Potentially, we have a strong, viable business financing the development of an even better one.

Elevated valuation

Perhaps Animalcare's quiet ambition justifies its somewhat elevated valuation. A share price of 295p values the enterprise at £58 million, or about 21 times adjusted profit. The earnings yield is 5%, which isn't a particularly generous return if growth in the future is as modest as it has been in recent years. But with its own improving intellectual property, Animalcare may be able to extract bigger profit margins from a bigger customer base. As long as the shares aren't obviously overpriced, therefore, they could still be good value.

The Long Term Incentive Plan (LTIP) worries me a bit though. Explaining the mechanism by which large amounts of shares will be handed to Animalcare's chief executive and chief financial officer is beyond me.

Directors will be straining every sinew to make sure it doesn't fall, which is why I object

It was also apparently beyond the chair of the remuneration committee who referred me to the chief financial officer, one of the beneficiaries, when I asked for an explanation. He preferred to explain the LTIP without referring to the explanatory notes in the annual report because, I surmised, they would only confuse the matter. They already had.

The long and the short of it is that at a time of his choosing after 27 June 2017 the chief executive will receive shares worth 5% of the difference between the company's market capitalisation and £39 million, a hurdle set 20% higher than Animalcare's market capitalisation three years earlier. The CFO's LTIP compensation is slightly more complicated, and slightly less generous.

In case you are wondering how much the incentive is worth, the company's current market capitalisation is £63 million, £24 million more than the hurdle. The chief executive's entitlement, 5% of £24 million is £1.2 million.

If the share price rises over the next year, then the bonus for three years work will be higher. If it falls, it will be lower.

One can only imagine the directors will be straining every sinew to make sure it doesn't fall, which is the basis of my objection to the LTIP.

Judging performance

The company has ambitions to develop drugs. Even generic drugs take three years to develop, but after three years the company will only be beginning to earn revenues. Enhanced and novel drugs take much longer, up to 10 years.

LTIP is an acronym made up of four words. The fourth is 'performance', but we can't possibly judge the performance of the executives in achieving the objectives of the company after three years. It will barely have made any money for its efforts.

I have a proposal for Animalcare's remuneration committee. Give them a pay rise!

The third word is 'incentive'. But the incentive is wrong. It encourages executives to act to prop up the share price in the short-term (three years), not make investments that will mature after their payday. That Animalcare's executives are developing a pipeline is testimony to their fortitude in doing so while being offered a massive incentive not to, because investment is costly and likely to depress profit and therefore the share price in the short-term. Perhaps they plan to hold on to the shares, although it's not required.

The first two words are 'long-term'. I don't think I need to explain this is a lie, which I think would be a more appropriate word to go with the first letter of the acronym.

I hate LTIPs for their complexity, for all the reasons above, and because they make me suspicious of companies that may otherwise be exemplary and executives who may well be doing a grand job. Figuring out businesses is enjoyable. Figuring out LTIPs is depressing, and often harder.

Incentivising directors

Increasingly though, LTIPs are pervasive, even among smaller companies. While executives are bound to negotiate themselves good terms, they're only part of a system that has normalised these arrangements and shareholders, particularly fund managers who wield the power to the stop them, are complicit.

When Amimalcare's LTIP has run its course, I wonder what it will do next to incentivise its directors.

I have a proposal for Animalcare's remuneration committee. Give them a pay rise! Animalcare's chief executive earned a comparatively modest salary of £143,000 last year and the CFO earned £102,000.

Don't make incentive payments based on short-term (three-year) targets. Instead, the extra pay should be paid in shares and the executives should be compelled to hold them until such time has passed that the value of the shares reflects the achievement of the company's long-term goals, or the executives are no longer able to influence the firm's performance because they have left it. Making a success of the business over the long-term should be a good incentive.

It's not a new idea. In 2012, John Kay proposed a similar policy in his government-sponsored review of the stockmarket and its failings. The UK Individual Shareholders Society has also published recommendations on executive pay. It, too, would abolish LTIPs for smaller companies.

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Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.