As we near the peak of the 2023 proxy season, Insightia took a deep dive into the data trends emerging from the U.S. companies subjected to public demands by a primary or partial focus activist to identify which financial metrics are most favored by activists in the hunt for this year’s targets.

While stock price underperformance remains a primary red flag, the numbers show that the most vulnerable are those with strong cash flow, but that lag in terms of profitability due to heavy spending on capital expenditure, salaries, and administrations costs rather than returning it to investors in the form of dividends.

“Remember, activists are value investors,” commented Michael Fein, founder and CEO of proxy solicitation firm Campaign Management. “The more compelling targets are ones whose performance metrics lag their peers, creating opportunity for greater upside if value-creation measures are implemented.” He added that such companies also having some attractive financial fundamentals, such as positive cashflow, reflected signs of a stable underlying business to protect the stock’s downside and set the groundwork for operational improvements.

Cash is king

Cash flow has always been appreciated by activists as it indicates a company has enough financial stability, value creation potential, flexibility, and, in the long term, the ability to reward shareholders. In fact, Carl Icahn famously has a pillow in his office embroidered with the words, “Happiness is positive cash flow.”

Of the companies targeted since September 2022, 67% had above median “cash flow from operations” relative to all U.S. companies tracked by Insightia’s Vulnerability module. And given Icahn’s eye for cash, it’s not surprising that International Flavors and Fragrance, which came to a settlement with the activist in February, is ranked high on our list of targeted companies with the highest cash flow versus peers, as is Icahn’s current target Illumina.

As for cash offering downside protection, Legion Partners may have targeted fashion retailer Guess in 2022 over the risks created by sexual misconduct by the company’s founders. But even though it lost the fight, the activist first took the stake, and appears happy to retain it given that Guess has cash on its balance sheet equal to 28% of its market capitalization, according to Insightia’s Vulnerability module, versus a median 9.8% for peers.

Spending too much

Just over 70% of the companies targeted had selling, general, and administrative costs (SG&A) well above their peers. “Higher SG&A suggests an opportunity to improve performance through operational efficiencies,” noted Fein.

Such opportunities might include eliminating duplicative positions and layers of management to improve efficiency and reduce administrative costs, or reductions in non-essential expenses, including advertising, travel, and other discretionary costs, or supply chain optimization or rationalizing the brand portfolio.

Case in point is funeral services conglomerate Matthews International, which Insightia identified as vulnerable to activism in July 2022, with an SG&A-to-revenue ratio roughly twice that of its peer group, according to Insightia’s Vulnerability module and was likely to face calls to cut costs. Barrington Capital targeted Matthews in December and entered into a “consultancy agreement” with the company the following month.

And among current campaigns, RumbleOn shareholders William Coulter and Mark Tkach have focused on SG&A as a primary concern, noting in a recent presentation the company’s “lack of urgency in addressing the operational issues, such as its rising SG&A/revenue ratio and swollen inventory levels.”

Or spending it badly

Of the companies targeted, 67% had lower return on capital employed (ROCE), which indicates how effectively a company utilizes its capital to generate profits, provides investors with insight into a its financial strength and management of its capital structure.

Freshpet, for example, which is being targeted by Jana Partners, has a ROCE of negative 5.1%, according to Insightia’s Vulnerability module, versus positive 10.3% for peers.

Likewise with cash flow from financing activities, which involves debt and equity financing. Over 67% of companies targeted underperformed their peers on this basis. Light Street Capital Management touched on this issue when it proposed a recapitalization of Zendesk earlier this year.

Stock price out of focus

Longer-term stock price underperformance proved a bigger draw for activists than the traditional short-term change, with 63% of the companies targeted posting three-year shareholder returns below the peer median, and 65% over a five-year period.

Activists appear less interested in shorter-term performance this proxy season. Indeed, when it comes to one-year TSR, 55% of targets actually outperformed their peers. Masimo, which currently faces a proxy fight with Politan Capital management and California State Teachers’ Retirement System (CalSTRS), currently has a one-year TSR of 42.2%, versus 6.5% for peers.

This lack of focus on short-term performance by activists is likely because activists, as value investors, are picking companies that are already showing signs of a rebound. In any event, with many activists sitting on deep portfolio losses this year, those hedge funds could have a hard time chastising management teams over short-term weakness in the stock market.