HOLT: Linking Corporate Performance and Valuation to Management Incentives. March 2014 HOLT

Transcription

1 : Linking Corporate Performance and Valuation to Management Incentives March 2014 Michel Lerner Head of EMEA credit-suisse.com/holtmethodology Analysis

2 SUMMARY Principles of the Management Incentives Scorecard State of the European and US landscape Thematic focuses: - EPS-focused plans - Return-on-Capital measures and its risks - The Good, the questionable and the bad of focusing on sales growth - Plans that incorporate non-operational items - What constitutes a long-term focus? - Companies with changes being introduced 1

3 Management should be incentivized by metrics and goals that drive incremental shareholder value creation Reward CFROI = Margins X Op. Profit Turns = X Sales Sales IAGI Measure & Evaluate 2

4 Management Incentive Scorecard Construction 3

5 The Remuneration Scorecard allows for quick sector benchmarking to see whether management is incentivised to manage its business for value Positive flags Carlsberg L'Oreal Beiersdorf Nestle Pernod Overall Score Financial criteria include operational drivers (eg Sales, Margins, cash flows, ROE) but not returnbased x x x x x x x x x x x x x x measures (1) ROIC, ROCE, EVA, CFROI are mentioned as a criteria (2) xx xx xx TSR relative to a sector peer group is used (1) x x x x x x x x x Long term plan which includes financial criteria to determine payout (1) x x x x x x x x x x x x Long term plan vesting period. Score 1 if above 4 years (1) x x x x Top 2 quintiles of the Scorecard on Operations (1) x x x x x x x x x x Clawbacks in comp structure x x x x x x x Financial Criteria have improved? x x P&G Reckitt SAB BAT Coca Cola Unilever Henkel Colgate Diageo Pepsi Heineken Financial Criteria have worsened? No Disclosure (7) No numerical financial targets at all are disclosed (1) x x x x x x x x x Negative flags EPS is the only financial criteria in EITHER the short or long term plans AND EPS is a poor proxy for Gross Cash Flows (<50% 3 year median) (1) In addition to traditional accounting multiples, the company also uses non operational financial criteria (e.g. net debt, dividends) (1) Option expense as a % of sales FY0> europe median (1) (Europe median is 0.22%) x x x x x No long term plan or long term plan based only on TSR with no financial criteria (1) x x TSR peer group is too broad i.e. not sector peers x 4

6 Management incentive plans state of the landscape 5

7 Only 1/3 of firms have a balance sheet focus, only 8% have performance measurement periods longer than 3 years in Europe, 1% in the US Europe US Measure Frequency % Financial criteria include operating drivers (sales, margins, earnings, cash flows, Roe) % Return on Capital Measures % TSR relative to a sector peer group 99 33% Long term plan with Financial criteria % Long term plan performance>3 years 24 8% Clawbacks 87 29% 6

8 Disclosure is generally lower in Europe than in the US Measure Frequency % No disclosure 4 1% No numerical financial targets % EPS as the only criteria in the short or long term plan 32 11% Non operating criteria used to determine pay 22 7% No long term plan 56 19% TSR peer group is broad 41 14% Frequency of Use Measure in S&P 500 % No Disclosure 2 0% Numerical financial targets not disclosed 32 6% EPS is the only financial criteria in EITHER the short of long term plans AND EPS is a poor proxy for Gross Cash Flow (<50% % year median) In addition to traditional accounting multiples, the company also uses non operational financial criteria (e.g. net debt, 0 0% dividends) Option expense as % of sales FY0>US median (US median is 0.38%) 54 11% No Long Term Plan or LT Plan Performance Period is less than 3 years % Source: 7 Europe US

9 Management Incentive Scores Number of Companies US Europe Score 8

10 UK, Netherlands, Switzerland have higher standards, Spain fares worst 9

11 Retailers fare best at a sector level (but beware of off-balance-sheet growth see page 19) 10

12 Stocks with top scoring remuneration plans and top operational quality Ops Remuneration Accounting Risk Com pany Nam e Ticker Quintile Quintile Quintile SHIRE PLC SHP 5 4 Good EASYJET PLC EZJ 5 4 Good ROTORK P.L.C. ROR 5 4 Good SYMRISE AG SY1G 5 5 Above Average HALMA P.L.C. HLMA 5 4 Above Average JOHNSON MATTHEY PUBLIC LIMITED COMPANY JMAT 4 4 Above Average GEBERIT AG GEBN 4 4 Good NOVOZYMES A/S NZYMb 4 4 Good TECHNIP TECF 5 4 Above Average SULZER AG SUN 4 5 Good 11

13 Firms heavily incentivized by EPS 12

14 EPS is widely used across pay plans, yet it is the easiest accounting ratio to distort through accounting choices 70% 60% 50% 40% 30% 20% 10% 0% Top 10 Performance Measurement Criteria In Europe P/E Ratio (FY1) % -50% 0% 50% 100% Earnings Growth (FY0 to FY1) R 2 =

15 Pressure to deliver short-term results is institutionalized 14

16 EPS is the only financial criteria in EITHER the short or long term plans AND EPS is a poor proxy for Gross Cash Flows (<50% 3 year median) Company Remuneration Score Accounting Quality Net Income % of Gross Cash Flow REGUS PLC 1 Below Average 12.0 TALKTALK TELECOM GROUP PLC 1 Poor 24.9 FRESENIUS MEDICAL CARE AG & CO. KGAA 0 Below Average 30.1 WOLSELEY PLC 0 Poor 32.6 BAE SYSTEMS PLC 1 Poor 46.6 G4S PLC 1 Below Average 7.1 SHANKS GROUP PLC 1 Poor 34.5 GKN PLC 2 Below Average 49.4 INTERNATIONAL CONSOLIDATED AIRLINES G2 Below Average 51.4 LINDE AKTIENGESELLSCHAFT 2 Below Average 33.6 WOLTERS KLUWER NV 2 Below Average 37.5 BUNZL PUBLIC LIMITED COMPANY 3 Below Average 51.3 RIO TINTO PLC 4 Poor 14.4 COBHAM PLC 5 Below Average

17 Pernod Ricard: EPS growth trending upwards since Basic Earnings Per Share (excl. extra) : the level of profit from recurring operations compared with budget projections and the net debt ratio were sufficient to offset [ ] the absence of a variable portion linked to change in net earnings per share. 16

18 Pernod Ricard: CFROI including goodwill shows a different story CFROI (Transaction), %

19 Pernod Ricard: Multiple items flattering the EPS 18

20 Pernod Ricard: Deep dive into the Accounting Risk 19

21 Return on Capital Measures 20

22 The framework and CFROI metric are well suited to measuring shareholder value creation Asset Life and Mix CFROI Accounting Operating Return and Net Invested Capital Cash and Gross Invested Capital ROIC Inflation Adjustments CROGI CROIGI whereas these metrics are more consistent with building shareholder wealth ROE EPS difficult to measure shareholder wealth creation and easy to manipulate 21

23 A focus on return-based measures should theoretically signal a superior focus on wealth-creation principles. In practice, only 1 in 3 show an improving CFROI trend vs. the longer-term Name Country Market Cap (bil) 22 CFROI 2012 CFROI 2013e CFROI Ratio of 2013 less CFROI 3 3 yr Year to 7 CFROI Year Median Median REED ELSEVIER NV NLD NOVO NORDISK AS DNK RTL GROUP BEL LEGRAND S.A. FRA IMI PLC GBR HENKEL KGAA DEU SPIRAX-SARCO ENGINEERING PLC GBR KERRY GROUP PLC IRL ASHTEAD GROUP PLC GBR CONTINENTAL AG DEU BERENDSEN PLC GBR SANDVIK AB SWE ROCHE HOLDING CHE EASYJET PLC GBR GEA GROUP AG DEU CENTRICA PLC GBR JOHNSON MATTHEY PUBLIC LIMITED CGBR KONINKLIJKE PHILIPS NV NLD NOVOZYMES A/S DNK AKZO NOBEL N.V. NLD AHOLD NV NLD BAYER AG DEU WHITBREAD PLC GBR MONDI PLC GBR TATE & LYLE PLC GBR LINDE AKTIENGESELLSCHAFT DEU BODYCOTE PLC GBR PIRELLI & C SPA ITA ELECTROLUX AB SWE ARKEMA GROUP FRA SAINSBURY (J) PLC GBR FRAPORT AG FRANKFURT AIRPORT S DEU STMICROELECTRONICS NV FRA

24 Novo Nordisk s long term incentive plan is one of the few to explicitly look at R&D efficiency Novo Nordisk A/S: Relative Wealth Chart 23

25 Significant amounts of capital are off-balance sheet how good are the return metrics that are even used? ROCE may be less meaningful for Pharma stocks ROCE may be less meaningful for Retailers Beware of asset sweating Accounting assets typically used for ROC metrics 24

26 Return-based metrics are part of comp plans potential questions Name Country Market Capitaliz ation (bil) [Local] CFROI 2012 CFROI Median - Three Year Accounting Quality - Asset Quality Accounting Quality - Depreciation Accounting Quality - Special Items Capitalized R&D / Assets (%) Leased Property / Assets (%) 2012 ADECCO SA CHE Above Average Above Average Average 42 AGGREKO PLC GBR Above Average Good Below Average 16 ARCELORMITTAL NLD Below Average Below Average Below Average 1 ASML HOLDING NV NLD Below Average Good Below Average 25 4 BABCOCK INTERNATIONAL GROUP PL GBR Poor Above Average Poor 1 40 BASF SE DEU Average Average Below Average 11 4 BG GROUP PLC GBR Below Average Below Average Below Average 7 COCA COLA HBC AG GBR Above Average Below Average Poor 14 CRH PLC IRL Average Below Average Below Average 18 DEUTSCHE LUFTHANSA AG DEU Good Average Poor 4 EXPERIAN PLC GBR Average Good Poor 14 FUGRO NV NLD Poor Below Average Below Average 41 KALI & SALTZ AG DEU Average Average Poor 1 6 KINGFISHER PLC GBR Above Average Average Below Average 44 MAN SE DEU Below Average Good Poor 17 8 MARKS AND SPENCER GROUP PLC GBR Above Average Below Average Below Average 25 MILLICOM INTERNATIONAL CELLULAR SWE Average Average Below Average 9 MORRISON (W M) SUPERMARKETS GBR Good Average Below Average 6 NOVARTIS AG CHE Poor Good Below Average 44 3 PEARSON PLC GBR Poor Good Below Average 28 REXAM PLC GBR Below Average Average Poor 1 5 ROCHE HOLDING AKTIENGESELLSCHACHE Poor Good Poor 52 3 SAINT GOBAIN FRA Average Below Average Poor 3 19 SANOFI S.A. FRA Poor Good Poor 43 2 SKF AB SWE Average Good Poor 8 9 STMICROELECTRONICS NV FRA Below Average Poor Poor 24 3 TESCO PLC GBR Good Above Average Poor 29 TOTAL SA FRA Below Average Below Average Below Average 2 4 TRAVIS PERKINS PLC GBR Good Above Average Below Average 56 VIVENDI SA FRA Poor Above Average Below Average 6 10 WEIR GROUP PLC (THE) GBR Average Above Average Below Average 4 19 Asset quality: this is determined based on region relative rankings for yoy changes in asset utilization, aging assets, large exposure to goodwill Depreciation: the rating is determined based on yoy changes and materiality of depreciation expense and asset life Special items: the rating is determined based on frequency and materiality of one-off items 25

27 Tesco: ROCE vs. CFROI trends don t match because of off-balance sheet growth Off balance sheet stores % Assets PP&E % Assets Variable pay: trading profit (i.e. internet sales, UK lfl sales, working capital), working capital (prev. UK ROCE) Long-term: EPS growth ex property profits, ROCE 26

28 Saint-Gobain: ROCE flattered by asset sweating and impairments? ROCE represents 60% of variable pay defined as Operating Income/Total Assets. Total assets include net PP&E, working capital, net goodwill and other intangibles but excludes deferred tax assets from nonamortizable brands and land 27

29 The good, the questionable and the bad of focusing on top line growth 28

30 The good: Unilever added a top line growth component to its comp plan in

31 High growth/value creating firms with sales growth in their compensation plan Name Symbol Country Market Capitaliz CFROI ation Transacti (bil) on LFY [EUR] CFROI 2012 Transaction CFROI / CFROI Sales Growth (5-year) Remuneration Score RANDGOLD RESOURCES LIMITED RRS GBR % 36 3 ARM HOLDINGS PLC ARM GBR % 17 2 HERMES INTERNATIONAL SCA HRMS FRA % 16 1 RIGHTMOVE PLC RMV GBR % 16 1 SHIRE PLC SHP GBR % 15 0 RICHEMONT (COMPAGNIE FINANCIERECFR CHE % 14 1 VOLKSWAGEN AG VOWG_p DEU % 13 1 ESSILOR INTERNATIONAL COMPAGNIEESSI FRA % 12 1 SERCO GROUP PLC SRP GBR % 12 2 LVMH MOET HENNESSY LOUIS VUITTOLVMH FRA % 11 0 DASSAULT SYSTEMES SA DAST FRA % 10 0 ATOS SE ATOS FRA % 9 1 KABEL DEUTSCHLAND HOLDING AG KD8Gn DEU % 9 1 KONE OYJ KNEBV FIN % 9 1 ADIDAS AG ADSGn DEU % 8 1 SONOVA HOLDING AG SOON CHE % 8 0 ABB LIMITED ABBN CHE % 7 0 DRAX GROUP PLC DRX GBR % 7 0 GEMALTO N.V. GTO NLD % 7 1 NOVARTIS AG NOVN CHE % 7 4 SEB SA SEBF FRA % 7 2 SWATCH GROUP AG UHR CHE %

32 The questionable: Sainsbury s like-for-like sales growth focus = possible incentive that will negatively impact margins and/or asset efficiency Key issues: - impact of refurbished stores/extended stores on sales vs. margins - impact of inc. VAT in sales growth given change of mix from food to non-food - inflation 31 - discount and vouchers

33 Value-destroying companies that include sales growth as a pay criteria Name Symbol Country Market Cap CFROI 2012 OCADO GROUP PLC OCDO GBR No STMICROELECTRONICS NV STM FRA Yes VESTAS WIND SYSTEMS AS VWS DNK No NOKIA CORPORATION NOK1V FIN No UNITED UTILITIES GROUP PLC UU GBR No NESTE OIL OYJ NES1V FIN No SAINSBURY (J) PLC SBRY GBR Yes BT GROUP PLC BT GBR No MORRISON (W M) SUPERMARKETS MRW GBR Yes DSM N.V. DSMN NLD Yes DEUTSCHE TELEKOM AG DTEGn DEU Yes VALLOUREC VLLP FRA Yes Returnbased Comp 32

34 The bad (WPP): acquired growth becomes organic within 12 months CFROI inc. goodwill is significantly lower 33

35 Companies that include top line as a pay criteria and where acquisitions have generated material goodwill Name Symbol Country Market Capitaliz CFROI ation Transacti (bil) on LFY [EUR] CFROI(L FY) Ratio Transaction CFROI / CFROI IMPERIAL TOBACCO GROUP PLC IMT GBR % RECKITT BENCKISER GROUP PLC RB GBR % WPP WPP GBR % PUBLICIS GROUPE SA PUBP FRA % CAPGEMINI S.A. CAPP FRA % REED ELSEVIER PLC REL GBR % SODEXO EXHO FRA % SAGE GROUP PLC (THE) SGE GBR % CARLSBERG AS CARLb DNK % BRITISH AMERICAN TOBACCO P.L.C. BATS GBR % REXEL S.A. RXL FRA % PANDORA A/S PNDORA DNK % DANONE SA DANO FRA % PEARSON PLC PSON GBR % HALMA P.L.C. HLMA GBR % SAP AG SAPG DEU % WOLTERS KLUWER NV WLSNc NLD % DIAGEO PLC DGE GBR % SOFTWARE AG SOWG DEU % LEGRAND S.A. LEGD FRA % UNILEVER PLC ULVR GBR % SCHNEIDER ELECTRIC SA SCHN FRA % 34

36 Incentive Plans based on non-operating items 35

37 Companies that include non-operating items in their pay structure 5 4 Remuneration Score SUEDZUCKER ASTRAZENECA VOLKSWAGEN PIRELLI H&M GALP BMW PERNOD RICARD BAE SYSTEMS THYSSENKRUPP 36

38 Astrazeneca fares OK on dividends Dividend Growth (5-Year) 37

39 The CFROI trend shows a significant need to replenish the product pipeline 38

40 Are the dividend payouts coming at the expense of reinvestment? 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% R&D % sales R&D % Sales (2012) 39

41 Long-Term Incentive Plans (LTIP) 40

42 Long-term Incentive Period (LTIP) 81% of European firms have a LTIP that include financial criteria, but only 10% of these have a measurement period > 3 years. Vesting period vs. long term measurement period. The former incentivizes management to stick around until pay day, the latter ensures that pay is based on long-term wealth creation. Why does this matter? Governance should be focused on creating long-term shareholder value. Short-termism emerges and quarterly or annual accounting metrics become the focus. Companies that have a long-term plan that exceeds 3 years and has more than TSR as a measure ( Remuneration Score) DASSAULT SYSTEMES NOVOZYMES A/S H & M HENNES & ANHEUSER BUSCH BHP BILLITON PLC L'OREAL LUNDIN PETROLEUM BOUYGUES SA RWE AG DEUTSCHE TELEKOM PUBLICIS GROUPE SA SODEXO BASF SE FRESENIUS SE INFINEON JOHN WOOD GROUP SANOFI S.A. MAN SE RIO TINTO PLC Lufthansa HEINEKEN NV E.ON SE 41

43 Ladbrokes has a long-term incentive plans based on the share price performance in the 30 days following publication of FY results End of 30 day period following 2012 preliminary results Profit warning issued LAD LN Equity 140 the committee will retain responsibility to amend the targets if necessary to take into account exceptional factors [ ] which would otherwise render the targets inappropriate 42

44 61 European firms have no long-term incentive schemes or a plan based only on TSR and 14 of these rank in the bottom 2 quintiles in Europe on Operational Quality Overall Ops Mom Val Com pany Nam e Ticker Quintile Quintile Quintile Overall Quintile VOEST-ALPINE AG VOES INFINEON TECHNOLOGIES AG IFXGn SUEDZUCKER AG SZUG GLENCORE XSTRATA PLC GLEN SVENSKA CELLULOSA AKTIEBOLAGET SCAb RANDSTAD HOLDING NV RAND ADECCO SA ADEN TULLOW OIL PLC TLW KONINKLIJKE PHILIPS NV PHG RHOEN-KLINIKUM AG RHKG METRO AG MEOG LINDT & SPRUENGLI AG LISP RENTOKIL INITIAL PLC RTO BG GROUP PLC BG

45 Firms with negative changes to their incentive plans 44

46 41 firms introduced positive changes to their pay plan in

47 8 others introduced changes that represent a step back in terms of alignment with shareholder interests Name CFROI LFY in Lowest Quintile? CFROI Change is Negative Managing for Value is Negative ENRC NEXANS SA MICHELIN SCA E.ON SE RED ELECTRICA CORPORACI A SCHINDLER HOLDING AG APR ENERGY PLC NOVOZYMES A/S ENRC: TSR benchmark is now 100% based on the FTSE 350. Mining benchmark removed. Michelin: long-term remuneration plan removed Schindler: criteria used in the long-term plan no longer disclosed Novozyme: unclear whether or not ROIC as a criteria has been removed Nexans: ROCE replaced with FCF as a criteria E.ON: removal of value add as a critera APR Energy: Adjusted EBITDA criteria dropped. EPS kept as the sole criteria 46

48 Global Market Commentary Disclaimer References to Credit Suisse include all of the subsidiaries and affiliates of Credit Suisse AG operating under its investment banking division. For more information on our structure, please follow the attached link: This material has been prepared by individual traders or sales personnel of Credit Suisse and not by Credit Suisse's research department. It is intended only to provide observations and views of these traders or sales personnel, which may be different from, or inconsistent with, the observations and views of Credit Suisse research department analysts, other Credit Suisse traders or sales personnel, or the proprietary positions of Credit Suisse. Observations and views expressed herein may be changed by the trader or sales personnel at any time without notice. Credit Suisse accepts no liability for loss arising from the use of this material. This material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a limited view of a particular market. It is not investment research, or a research recommendation, as it does not constitute substantive research or analysis. The information provided is not intended to provide a sufficient basis on which to make an investment decision and is not a personal recommendation. While it has been obtained from or based upon sources believed by the trader or sales personnel to be reliable, each of the trader or sales personnel and Credit Suisse does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising out of errors, omissions or changes in market factors. This material is provided for informational purposes and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. It is directed exclusively at Credit Suisse's market professional and institutional investor clients (e.g. QIBs) as defined by the rules of the relevant regulatory authority, and must not be forwarded or shared with retail customers or the public. It is not intended for private customers and such persons should not rely on this material. Moreover, any investment or service to which this material may relate will not be made available by Credit Suisse to such private customers. This material may have previously been communicated to the Credit Suisse trading desk or other Credit Suisse clients. You should assume that the trading desk makes markets and/or currently maintains positions in any of the securities mentioned above. Credit Suisse may, from time to time, participate or invest in transactions with issuers of securities that participate in the markets referred to herein, perform services for or solicit business from such issuers, and/or have a position or effect transactions in the securities or derivatives thereof. Information provided on any trades executed with Credit Suisse will not constitute an official confirmation of the trade details, and all preliminary trade report information is subject to our formal written confirmation. FOR IMPORTANT DISCLOSURES on companies covered in Credit Suisse Investment Banking Division research reports, please see To obtain a copy of the most recent Credit Suisse research on any company mentioned please contact your sales representative or go to Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is made regarding future performance. Backtested, hypothetical or simulated performance results have inherent limitations. Simulated results are achieved by the retroactive application of a backtested model itself designed with the benefit of hindsight. The backtesting of performance differs from the actual account performance because the investment strategy may be adjusted at any time, for any reason and can continue to be changed until desired or better performance results are achieved. Alternative modeling techniques or assumptions might produce significantly different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor a guarantee of future returns. Actual results will vary from the analysis. Investment principal on securities can be eroded depending on sale price or market price. In addition, there are securities on which investment principal may be eroded due to changes in redemption amounts. Care is required when investing in such instruments. Disclaimer The methodology does not assign ratings or a target price to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively called the valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default variables and incorporated into the algorithms available in the valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. These adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is produced by the valuation model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variables may also be adjusted to produce alternative warranted prices, any of which could occur. The warranted price is an algorithmic output applied systematically across all companies based on historical levels and volatility of returns. Additional information about the methodology is available on request CFROI, CFROE,, Lens, folio, Select, HS60, HS40, ValueSearch, AggreGator, Signal Flag, Forecaster, Clarity is Confidence and Powered by are trademarks or registered trademarks of Credit Suisse Group AG or its affiliates in the United States and other countries. is a corporate performance and valuation advisory service of Credit Suisse Credit Suisse Group AG and its subsidiaries and affiliates. All rights reserved. For region specific disclosures, including information about applicable registrations and certain regulatory disclosures, please follow the links below: Americas: Europe: (Credit Suisse Securities (Europe) Limited is authorized and regulated by the Financial Services Authority.) Asia: General investors in Japan should open the following link and read it: Please note that this is market commentary and not a research publication. 47