Telstra - the CEO Performance issue

The latest spat between the Federal Government and Telstra brings into stark relief the question of performance and the part it plays (and should play) in remuneration. Sol Trujilo's $8.7m annual pay cheque included a large chunk of performance based pay - whether it was for a specific outcome, a general 'bonus' or contractually agreed shares. These were awarded in a year during which the share price plummeted and profits were OK but below most analysts expectations.

The argument - and it is repeated ad nauseam in the press at this time of year - is that the only real performance indicators at this level are profit and share price. In most Long Term Executive Incentive plans (LTI's), these are indeed the two indicators that are captured via the generic measure Total Shareholder Return (TSR). TSR is a composite of share price improvement and dividends and is expressed as a percentage increase over time. LTI shares are usually awarded on the proviso that the TSR growth over a three or four year period exceeds that of at least half of a pre-determined peer group of companies. The peer group is ranked based on each of their respective TSR growth rates and, for an executive to get any shares, their company has to be in the top half of the list.

At Kapitis we are increasingly being asked to amend, augment, adjust or completely review these arrangements. This is not only because the target award of shares is rarely received (because of the severity of the measure) but also because TSR ignores a number of other measures which may be just as and perhaps more indicative of success. Compared to TSR, some of these other measures are harder to understand, less useful as a means of conveying the Boards objectives, or more specific to a particular time frame, company type, industry focus or organizational development phase. Having said that, these measures carry the advantage of providing a more accurate picture of achievement than does TSR on its own.

Some of the measures we've helped companies inject into their remuneration plans include:

• Return on Capital Employed
• Earnings per share
• Return on Assets
• Price/Earnings ratio
• Return on Equity
• Gross Profit Margin
• Net Profit Margin

Indeed, we have found it a very useful exercise to examine the historical correlation between all of these measures and the movements in Executive pay. We can chart the growth in each measure and compare it to the growth in Total Remuneration (TR) for the Executive group and, if we can present it visually, we can see the correlation (or lack of it) between remuneration and performance. Here's an example taken from the annual reports of 17 ASX50 companies covering a range of industry sectors over the past several years:

What this shows is that none of the measures grew faster than the rate of executive remuneration increase over this three year period. It should be noted that the relatively impressive net profit increase is a reflection of the economic conditions that pervaded corporate Australia during this three year period and occurred at the same time that the generic share price indices also were steadily increasing. Taken together, though, there is little justification - on the basis of the indicators of performance that are shown in the graph - for an average 26% increase in Executive remuneration that took place over this period when none of the measrues got even close to this rate of growth. Having said that, there is not much wrong when companies steadily and regularly increase profits by alomost 20% a year, that boast a return on equity averaging a tick over 15% a year and which can extract a predicably increasing net profit margin.

It should be recognised that a number of the companies that were selected in the sample were heavily impacted by the three most influential non-controllable factors in business - declining industry conditions, volatile commodity price fluctuations and unpredictable natural events. For example, CSR which is in the sample happened to be impacted by the downturn in the housing construction market, world sugar prices going all over the place and a couple of errant cyclones which ripped through the sugar cane fields where it grows or buys its raw materials. This raises the very interesting question of "negative success". Should the Executive be rewarded for not allowing the company's fortunes to get any worse than they might otherwise have got during periods when the environment has not been cooperative? Put simply, not allowing the P&L account to descend into losses under these circumstances may well have been considered by the Board to have been an exceptional performance worthy of the remuneration increases evidenced above.

The media has a tendency to simplify that which is quite complex in order to extract the sensational headline. Shareholders and shareholders associations need to be smarter than that. It is important that they address the remuneration issue, which they are now asked to do at every AGM, with an open and informed mind.

Author:  Greg Brogan

Date: 28 Sept 2006