After my recent blog post on why management’s compensation matters, I’ve been wanting to give a more concrete example. VirTra Systems (VTSI, $0.11) is a company that I was initially very interested in—great product, sales are ramping up and tailwinds to continue that growth. Unfortunately, when I delved into management’s compensation it was an absolute deal breaker.
Business overview
Let’s take a step back and look at what they do. VirTra makes combat simulators for police officer and military training. They offer simple single-screen virtual shooting ranges all the way up to a 300 degree, five screen combat simulator that fully immerses the officer in a real life scenario. These scenarios are filmed with real actors (some competitors use CGI) and then played back on the video screens for the officers. Whoever is training the officer watches and alters the scenario based on the officer’s actions. So if the officer adequately talks down the offender the scenario will go one direction. If the officer pulls out his gun the offender will react much differently. Officers also get an electronic shock when fired upon to increase realism. Below is a picture that shows their largest simulator.
Pretty damn cool if you ask me. I probably spent way more time researching this company than I should have just because I was fascinated with their product. If you want to see it in action, here’s a great clip from when Anderson Cooper did a segment on VirTra. That clip will help you appreciate the need for these simulators and just how realistic they are. Some police departments that own these simulators actually let civilians come in and use them as a way to show the public just how difficult it is to make split second, life and death decisions.
Just last week, a few minutes from where I live a police officer shot and killed an unarmed man during a routine traffic stop. As police shootings like this are (unfortunately) fairly common, the demand for enhanced police training has been on the rise. Governments are pushing for more training, specifically in the use of deadly force. The problem is it’s difficult to train for real life scenarios where offenders are unpredictable. Simulators with real actors are helping this problem and creating a nice tailwind for VirTra’s products. As evidence of this, in September 2014 they won a large contract with the Department of Homeland Security.
Management
I was liking everything about the company until I came across this line in the annual report: “The Board of Directors has also approved a quarterly grant of a total of 100,000 stock options per quarter to the CEO, 75,000 stock options per quarter to the COO/Secretary, and 50,000 stock options per quarter to any board member not an employee of the Company.” This results in a minimum of 900,000 stock options granted every year no matter what. The board consists of a whopping three people—the CEO, COO and one “independent” director brought on in 2011. A three member board of directors that is controlled by the CEO and COO raises many corporate governance red flags in my mind—especially when it’s resulted in egregious stock option grants.
Now I have nothing against management getting compensated well (or even very well) if they’re performing. And option grants are a good way to align executives with shareholders. However, the majority of bonus packages that involve options have metrics that must be met in order to receive those bonuses and options. Options that are guaranteed no matter how the management team performs really doesn’t incentivize them to go out there and kick ass. One of the major purposes of a mostly independent board of directors (and completely independent compensation committee) is that management is held to certain standards and they have a pay package that rewards performance. When the CEO and COO are two-thirds of the board they have complete control over the company, including their own pay. If they decide they want a guaranteed option grant every year—done.
So how bad has the share dilution been? Current CEO and Chairman Bob Ferris became President and director in 2001 through a merger with his prior company. At yearend 2001 there were 33,992,200 shares outstanding. In 2008, Ferris took over as CEO/Chairman and in his first year implemented the automatic option grants described above. At yearend 2008 there were 136,204,154 total shares. At yearend 2014 there were 158,285,045 shares outstanding (plus another 16,129,340 options). Now some of these options over the past 14 years have been granted to non-management—everyone from debt holders and plaintiffs in lawsuits to consultants and investors. While this certainly isn’t good to see, it’s pretty common in small companies that don’t have a lot of cash flow. They essentially use their common stock as a form of payment for services. Much of the dilution, however, has been to pad the pockets of management. Just in the past four years, the following number of options were granted as stock-based compensation: 900k, 1.9M, 5.5M and 2.1M. Prior to Ferris becoming CEO the annual reports gave details on prior share issuances which they no longer do. Also, the annual report no longer lists Ferris’ stock ownership which I find odd. Both of these things I view as minor red flags that management is hiding more and more.
[11/13/15 note: A reader pointed out that they do still report Bob Ferris’ stock ownership. The company changed how this was reported and I hadn’t noticed it was moved to the very end of the 10-K. As of YE2014 he owned just under 16M shares which would currently be worth $1.6M.]
Conclusion
Virtra Systems may very well turn out to be a great investment. They have a fantastic product that (in my opinion) is better than their competitors and there are some large tailwinds pushing this industry forward. However, trusting management is at the very top of my list of investing requirements. I could never trust a team that thinks it’s in shareholders’ best interests to grant themselves that many stock options every year, regardless of performance. I actually think VirTra could be a potential target for an activist investor. Management controls the company and the board but they don’t own near enough shares to control a proxy vote. If any investors happen to start a proxy fight in the future I may get re-interested in the stock.
Travis Wiedower 