WHY does business plan for the FUTURE but reward for the PAST?

Paul Williams, Warwick Business School

25 February 2008

STRATEGY AND REWARD

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PAUL WILLIAMS’ CV – 5 RADICAL CHANGE SCENARIOS

WHO WHAT WHY

NCR Data Processing Technology

HEINZ Food Retail Superbrands

GLAXO Pharmaceuticals Generics

ROLLS ROYCE Engineering Market

SMITH & NEPHEW Medical Devices Technology

SMITH & NEPHEW Japan Culture

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TYPICAL “WOW” STATISTICS

• In 1992 top US CEOs were paid 82 x blue collar pay

– $2.7 million

• In 2004 top US CEOs were paid 400 x blue collar pay

– $14.7 million

Professor Robert Daine - Stanford Graduate School of Business

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“THE BIG ISSUE”

The relentless focus on HOW MUCH Chief Executive Officers are paid diverts public attention from the real problem:

HOW they are paid

Michael Jensen & Kevin Murphy HBR

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CLASSIC PROFILE OF EXECUTIVE REWARD STRUCTURE

Element Objective Timeframes

(1) BASE PAY Personal targets - current annual/quarter

Business targets - current annual/quarter

(2) BONUS Profit targets - current annualRevenue targets - current annualROCE targets - current annualMargin targets - current annual

(3) “LONG TERM” Stock price -Earnings per share - retrospective

threeTotal shareholder return - year “roll-up”

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CLASSIC QUANTUM OF CEO REWARD (UK)

FTSE 30 FTSE 31-100 Source

Median Base £979k £690k (1)

Bonus Target £636k £448k (2)

LTIP Expected Value 2075k 669k (1)

£3,690k £1,807k

(1) The Changing Face of Senior Executive Remuneration (New Bridge Street 2007 Report)

(2) Deloittes Executive Directors Remuneration 2007 Guide

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“LONG TERM PERFORMANCE” - UK

• Performance Share Plans are currently in operation in 86% of FTSE 100 Companies

• TSR is the most popular PSP metric – 85% of FTSE 100 plans

• Median actual award to FTSE directors is 130% of base salary

Deloitte Executive Directors Remuneration Guide 2007

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“LONG TERM PERFORMANCE” – US TOP 250

Category Performance Measures Percent ofCompanies Using

Profit Earnings per share, net income 51%EBIT/EBITDA, operating incomepretax profit

Total Shareholder Return Stock price appreciation plus dividends 38%

Efficiency Return on equity, return on assets, 34%return on operating income, return oncapital, economic value added

Other Cash flow, revenue growth, 28%discretionary, individual performance

Frederic W. Cook & Co. Inc.

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WHAT ARE THE REASONS FOR THIS SHORT TERMISM?

• Financials are “concrete” and easy to communicate

• CFO and analysts are most comfortable with these numbers

• Recent corporate governance initiatives discourage subjectivity

• Relatively short-term tenure of CEOs undermines long-term perspective

• Stock options as a proxy for success encourage simplistic metrics

• Current reward structures have served incumbents well

Parc 2007 Report: Resilience – How Companies prepare for Success in the Future

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“Top managers and the main players in the financial markets have tended to become part of a “system” of connected and symbiotic interests. This system, whilst informal, is coherent and well understood by insiders and can create huge opportunities for rewarding the players”

Don Young, Founder YSC

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THE COMMON LIFE CYCLE – ALL THINGS

Maturity

Birth Maturity Demise

Renewal

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Growth

“Feed the top line”

• Organisation vitality

• Investment mentality

• High engagement & trust

• Expanding

• Acquisition

CLASSIC GROWTH v MATURITY MODEL

Maturity

“Protect the bottom line”

• Operational efficiency

• Cost mentality

• Caution & control

• Downsizing

• Divestment

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THE NEED: A NEW FRAME OF REFERENCE FOR REWARD STRATEGY

• “SUSTAINABILITY”– the ability of the organisation to sustain its current

business model

• “RESILIENCE”– the organisation’s ability to dynamically reinvent its

business model as circumstances change

Professor Sir Andrew Likierman - LBS

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THE COMMON LIFE CYCLE – ALL THINGS

Maturity

Birth Maturity Demise

Renewal

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SUSTAINABILITY(S) AND RESILIENCE (R) DEMAND DIFFERENT METRICS WITHIN A TYPICAL STRATEGY MODEL

Time Horizon Drivers Metrics

SHORT • operating efficiency Profit (S)• cost control Revenue (S)• sales initiatives ROCE (S)

MID • customer focus ??? (S) & (R)• product development• marketing initiatives

LONG • technology bets ??? (R)• research bets• strategic initiatives

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A REALITY CHECK – 6 “CASE STUDIES”

• ENRON : leaders consumed by wealth creation

• NORTHERN ROCK : risk assessment sidelined by growth sirens

• GSK : expansion at huge shareholder cost

• ICI : an iconic brand: died January 2008: RIP

• Cadbury-Schweppes : Nelson Peltz and shareholder activism

• BRIC 2015 : will the same rules apply?

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BUT NO ROOM FOR COMPLACENCY: the number of Emerging Economy companies in the Fortune

Global 500

2003

2006

2010

20

40

?

-

-

-

Challenging “old” approaches to strategy & organisation

Led by Brazil, Russia, India & China

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BUT WHO CARES?

• INVESTORS?

• EXECUTIVES?

• ACADEMICS?

• CORPORATE GOVERNANCE BODIES?

• BUSINESS COMMUNITY?

• GOVERNMENT?

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SOME POSITIVE IDEAS FOR DEBATE & FURTHER RESEARCH

1. THE DOMINANT SHORT TERM CITY MINDSET CAN BE CHANGED

2. NED ROLE SHOULD BE MORE INTRUSIVE

3. CORPORATE GOVERNANCE BODIES SHOULD ADD MORE VALUE

4. HR EXECUTIVES SHOULD STAND UP AND BE COUNTED

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1. THE DOMINANT SHORT TERM CITY MINDSET CAN BE CHANGED

In 2004 the Enhanced Analytics Initiative (EAI) was launched by institutional investors to examine the obstacles to investors taking a longer term and more rounded assessment of corporate performance – in particular to take a hard look at the current focus of much sell-side research.

In City jargon the intention is to give more emphasis to “extra-financials and intangibles” which in the words of Peter Moon, CIO of one of the founding members (USS Ltd) “can account for a significant proportion of the value of a company, especially over the long term”.

Current members of EAI include amongst others;

ABP Pension FundBNP Paribas Asset ManagementBT Pension SchemeHermes Pensions ManagementInvestec asset ManagementDeutscher Investment Trust/Dresdnerbank Investment ManagementUniversities Superannuation Scheme

EAI member institutions collectively own or manage more than US$ 2.6 trillion in assets

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2. NED ROLE SHOULD BE MORE INTRUSIVE– Board role can learn from Private Equity model

• “Buy, build, and sell” strategy

• Flexible ownership mindset

• Stronger Chairman role

– Remuneration Committee should be pro-active/demanding on strategy metrics

3. CORPORATE GOVERNANCE BODIES SHOULD ADD MORE VALUE– Should worry less about “fat cats”

– Should worry more about “relevant growth” and strategy delivery

– Should establish and promote “best practice”

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4. HR EXECUTIVES SHOULD STAND UP AND BE COUNTED

– Exploit their exposure to RemCo and NEDS

– Utilise their technical expertise to design better schemes, e.g.

• 5 year vesting with better use of ROIC

• Bigger retained shareholding for executives

• Strategic targets for CEO and CFO

• Significant metrics for talent management

• Negative penalties for non-achievement – escrow accounts and bonus deferral

• Sharpening of objectives clarity

• Higher profile for risk assessment

• Influencing the CEO/CFO to sell a broader picture to analysts

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TWO QUOTES FROM MICHAEL PORTER

“In essence the job of the strategist is to understand and cope with competition. Often, however, managers define competition too narrowly as if it occurred only amongst today’s direct competitors.”

“The conversation between investors and executives (should) focus on the structural not the transient. Imagine the improvement in company performance – and in the economy as a whole – if all the energy expended in “pleasing the Street” were redirected towards the factors that create true economic value”

HBR January 2008

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AND FINALLY …………

NOT EVERYTHING THAT COUNTS

can be counted

NOT EVERYTHING THAT CAN BE COUNTED

counts”

Albert Einstein