Download Southern Employee Benefits Conference

Southern Employee
Benefits Conference
Beyond Stock Options
Long-Term Incentives in a Volatile
or Protracted Bear Market
Copyright © May 7, 1998
Overview: Stock options have become the dominant form
of long-term incentive compensation today.

More companies use options than
any other form of long-term
incentive.

The value of option grants
continues to increase.

Levels of participation have
expanded.

Long-term incentives now make
up a major portion of total pay.
Overview: Stock options have become the dominant form
of long-term incentive compensation today.
Prevalence of Long-Term Incentive Plans
Phantom 3%
5%
Stock
Restricted
Stock
More companies use options than
any other form of long-term
incentive.

The value of option grants
continues to increase.

Levels of participation have
expanded.

Long-term incentives now make
up a major portion of total pay.
1986
1997
21%
28%
48%
Performance
Plans
37%
89%
Stock
Options
0%

87%
20%
40%
60%
80%
Percent of Companies
100%
Overview: Stock options have become the dominant form
of long-term incentive compensation today.
More companies use options than
any other form of long-term
incentive.

The value of option grants
continues to increase.

Levels of participation have
expanded.

Long-term incentives now make
up a major portion of total pay.
222,000
1993
262,500
1995
313,500
1997
0

100,000
200,000
300,000
400,000
Median Expected Value of Long-Term Incentives
($300,000 Base Salary)
Overview: Stock options have become the dominant form
of long-term incentive compensation today.
Prevalence of Long-Term Incentive Plans
More companies use options than
any other form of long-term
incentive.

The value of option grants
continues to increase.

Levels of participation have
expanded.

Long-term incentives now make
up a major portion of total pay.
1.27%
1988
1.69%
1991
1.8%
1994
2.4%
1997
0.0%

0.5%
1.0%
1.5%
Workforce Eligibility
2.0%
2.5%
Overview: Stock options have become the dominant form
of long-term incentive compensation today.
Prevalence of Long-Term Incentive Plans
1989
1997
0%
20%
31%
24%
37%
26%
LTI
Bonus
Base
21%
40%
60%
80%
Percent of Companies
More companies use options than
any other form of long-term
incentive.

The value of option grants
continues to increase.

Levels of participation have
expanded.

Long-term incentives now make
up a major portion of total pay.
Benefits
8%
7%
46%

100%
Overview: Stock options have become the dominant form
of long-term incentive compensation today.
“[T]he proliferation of stock-option
grants, combined with the rise of
cushy retirement deals, sign-on
bonuses, and ironclad severance
packages for CEOs, have made a
mockery out of many attempts to truly
link pay to performance.
“The upshot: Good, bad, or
indifferent, virtually anyone who
spent time in the corner office of a
large public company in 1997 saw
his or her net worth rise by at least
several million.”
Source: Business Week, April 20,
1998.
Impact:

Heightened scrutiny by
shareholder groups and the press.

Heightened interest in LTI
alternatives.
Overview: The pros and cons of management stock
options.
Pros
 Direct alignment of management
and shareholder interests.

A truly long-term perspective.

Better appreciation and
understanding of value drivers.
Cons
 Not line-of-sight.

Can’t differentiate management
performance from industry
fortune.

Lack stimulus during economic
downturns.

Perceived internally and
externally as a game of chance.
The Challenge: Making long-term incentives work in a
volatile or a protracted down market.
The Prevailing Methods

Design cash-based long-term
incentives to address stock option
deficiencies.

Design better stock options.
The Challenge: Making long-term incentives work in a
volatile or a protracted down market.
The Prevailing Methods

Design cash-based long-term
incentives to address stock option
deficiencies.

Improved metrics.
Almost all metrics are
variations on the same
theme...
The Challenge: Making long-term incentives work in a
volatile or a protracted down market.
RI = Operating Profit - Opportunity Cost of Running the Business
–
–
–
Sales
Cost of Sales
Overhead
EBIT
Tax on Operations
NOPAT
The return (or expectation)
foregone by not investing in a
comparably risky portfolio of
projects—the weighted cost of
debt and equity capital.
Opp. Cost = Cost of Capital
x Beg. Capital
An Integrated Measure of Performance: Residual Income
Residual Income = NOPAT - c* x Beg. Capital
Residual income can also be expressed as:
RI = (Return on Capital - Cost of Capital)
x
Beg. Capital
Residual income introduces four powerful incentives:

Improve efficiency, and thus returns.

Grow, but only if new investments can earn the cost of capital.

Redeploy capital from underperforming operations.

Manage risk, and therefore the cost of capital.
Value Proposition: Residual Income Drives MVA
Value
Value
PV
RI
C
PV
NOPAT
C
PV CF3
MVA
PV RI3
PV RI2
PV RI1
Capital
PV CF2
PV CF1
Discounted Free Cash Flow



Discounted Residual Income
The discounted present value of a company’s expected residual income is its market value premium or discount
to book value (“MVA”).
A company’s discounted residual income plus its level of capital employed will always equal the discounted
present value of expected Free Cash Flow.
Residual income is the only integrated measure of growth and profitability which relates directly to stock value.
The Challenge: Making long-term incentives work in a
volatile or a protracted down market.
The Prevailing Methods

Design cash-based long-term
incentives to address stock option
deficiencies.

Improved metrics.
It all boils down to...

Adopting a metric which works
well with your company.

Conceptually simple.

Difficult to manipulate.

Economically rigorous.
The Challenge: Making long-term incentives work in a
volatile or a protracted down market.
The Prevailing Methods

Design cash-based long-term
incentives to address stock option
deficiencies.

Improved metrics.

Improved implementation.

Focus on controllable,
company-specific value
drivers. Line-of-sight.
Improved Implementation:
Making performance measures “line-of-sight”
Price
Revenue
Volume
NOPAT
Tax
Operating Expenses
Cost of Goods Sold
SG&A
EVA
Raw Materials
Labor
Other
Cost of Debt
Cost of Capital
Cost of Equity
Plant & Equipment
Capital Charge
Fixed Capital
Capital Employed
Legend:
 High Impact
 Medium Impact
 Low Impact
Property
Inventory
Working Capital
Receivables
Payables
Other
Good Will
Intangibles
The Challenge: Making long-term incentives work in a
volatile or a protracted down market.
The Prevailing Methods

Design cash-based long-term
incentives to address stock option
deficiencies.

Improved metrics.

Improved implementation.

Focus on controllable,
company-specific value
drivers. Line-of-sight.

Make calibration and targetsetting truly long-term.

Understand corporate culture
and “process.” Help build
value-creation coaches.
The Challenge: Making long-term incentives work in a
volatile or a protracted down market.
The Prevailing Methods

Design cash-based long-term
incentives to address stock option
deficiencies.

Design better stock options.
What would we like to see?




Real capital at risk.
Management rewarded for its
distinctive contribution to share
value.
Meaningful incentives during
downturns.
A strong aversion to repricing.
Design Challenge 1: Measure good management, not good
luck.
Contention: Commodity price movements and stock market activity explain the
vast majority of most companies’ stock price performance.
Example:
The Specialty Chemical Industry
10%
% Change in
S&P 500
20%
% Change in
Methanol Prices
10%
0%
(10%)
% Change in Ethylene Prices (20%)
0%
20%
(20%)
5%
Sample:
Dow Chem Co
Georgia Gulf Corp
Lyondell Petrochemical Co
Olin Corp
Union Carbide Corp
0%
(5%)

(10%)

R2
0.637
 80.0%
(15%)
(10%)
(5%)
0%
5%
% Change in Market Value
10%
15%
Design Challenge 1: Measure good management, not good
luck.
Contention: Commodity price movements and stock market activity explain the
vast majority of most companies’ stock price performance.
Impact:
Less than one-fifth of most industries’ stock market performance can
be traced to contributions by management.
Conclusion:



During downturns, conventional stock and cash-based incentives are
viewed as lottery tickets.
During good times, conventional bonus plans perpetuate the
impression that stockholder returns relate mainly to good
management.
Over time, even sub-par performance will be rewarded.
Design Challenge 2: Eliminate the Perception Gap in
Bear Markets.
Contention: Conventional stock options lose much of their power to motivate if
the stock is under water, despite retaining significant economic value.
$40
Option Value
Exercise Value
$30
Option Value at Grant
Value of
Stock
Option
Perceived
Value at Grant
$20
Option Value Today
$10
$0
Perceived
Value Today
($10)
$40
$50
$60
$70
$80
Underlying Stock Price
$90
$100
Design Challenge 2: Eliminate the Perception Gap in
Bear Markets.
Contention: Conventional stock options lose much of their power to motivate if
the stock is under water, despite retaining significant economic value.
Implication:
1.
There is often a wide gap between management’s perception of a
stock option’s value and its economic substance. This is especially
true for companies beset by industry cycles.
Reason:
2.
Managers focus on exercise or conversion value, not
option value.
During downturns, stockholders receive a severely diluted
motivational return on the high cost of previously granted options.
Design Approach 1:
Tinker with the options themselves...
but don’t confuse this with repricing.
$120
1. Index against industry performance.
Portfolio of 5.6 at-themoney indexed
options is worth just
one out-of-the-money
$80 option, but ...
Option Value
$100
Slope: 5.4
Specifically: Exclude value gains
(or losses) attributable
to the S&P or industry.
Impact:
$60
Slope: 1.0
$40
The difference in upside
(and downside) potential
is enormous, thus greatly
amplifying incentives.
$20
Creates options where
the difference between
option value and
exercise value (and
thus the perception
gap) is small.
$0
$40
$60
$80
$100
$120
$140
Stock Value
Slope: 0.97
($20)
($40)
1 Standard Option
1 Indexed Option
5.6 Indexed Options
Justifies issuing more
options as a
consequence.
Design Approach 1:
Tinker with the options themselves...
Indexing options exploits the perception gap to comparative advantage.
Perception
Reality
$40
Option Value
$30
$40
Indexing means more control
over destiny—thus greater
option value.
Slope: 1.0
$30
$20
High covariance with index means much
closer relationship between option value
and conversion value.
Slope: 1.0
Slope: 1.0 $20
Slope: 1.0
$10
$10
$0
($10)
$40
$50
$60
$70
$80
1 Standard Option
$0
At-the-money option
considerably more valuable
than out-of-the-money option.
($10)
$90
$100
$110
$120
$40
1 Indexed Option
Unchanging strike price
and longer term to maturity
makes conventional option
more valuable than indexed
option, despite higher
starting point..
$50
$60
$70
$80
1 Standard Option
$90
$100
1 Indexed Option
$110
$120
Design Approach 1:
Tinker with the options themselves...
$120
1. Index against industry performance
1 Standard Option
1 Leveraged Option
8.4 Leveraged Options
$100
2. Reward performance, not longevity.
$80

Consider performance
options—options which raise
the exercise price over time.

Because performance options
are worth less than conventional
options, managers can be
offered more such options
without diluting the value of
stockholders’ investment.
$60
$40
$20
Slope: 1.0
$0
$40
$60
$80
$120
$140
Slope: 3.7
($20)
Slope: 0.4
($40)
$100
Design Approach 2:
Tinker with capital structure...
1. Make capital structure line-of-sight.


Create equity in the business
units themselves.

Partial public offerings.

Spinoffs and split-ups.

Letter stock.
Restructure business portfolio to
reflect core competencies.
Design Approach 2:
Tinker with capital structure...
28 Large Corporate Split-Ups
1. Make capital structure line-of-sight.
10-Day Gain
De-Conglomeratization
Quaker Oats
Fisher-Price
Cooper Industries
Cooper Cameron
ITT
Hartford
Proactive
De-Integration
AT&T
Lucent,NCR
James River
Marriott
Crown
Marriott Int'l
Dole
Am. Cyanamid
Cytec
Castle & Cooke
Marriott
Roadway
Coors
The Limited
Host
Caliber
ATX
Intibrands
Litton
D&B
Anheuser Busch Western Atlas
Union Carbide
Campbell Taggart
Praxair
General Mills
Darden
Ceridian
Control Data
GM
EDS
Baxter
AHS
Reactive/
Defensive
Kodak
Eastman
Chemical
Am. Express
Lehman
W.R. Grace
Nat'l Medical Sears
Dean Witter
Allegis
Hertz
Negative
100%
50%
5%
25%
Create equity in the business
units themselves.

Partial public offerings.
Morrison
cafeterias,
hospitals

Spinoffs and split-ups.
Eli Lilly
Guidant

Letter stock.

Positive
Hanson PLC

Restructure business portfolio to
reflect core competencies.
Design Approach 2:
Tinker with capital structure...
1. Make capital structure line-of-sight.
17 Large Corporate Split-Ups
365-Day Gain
De-Conglomeratization
Quaker Oats
Fisher-Price
Proactive
Coors
ATX
Litton
Western Atlas
James River
Marriott
Crown
Marriott Int'l
Dole
Castle & Cooke
The Limited
Intibrands
General Mills
Darden
Union Carbide
Praxair
Eli Lilly
Guidant

Positive
Reactive/
Defensive
Kodak
Eastman
Chemical

Cooper Industries
Cooper Cameron
Am. Cyanamid
Cytec
Ceridian
Control Data
De-Integration
Am. Express
Lehman
Sears
Dean Witter
Allegis
Hertz
Negative
100%
5% 50%
25%
Create equity in the business
units themselves.

Partial public offerings.

Spinoffs and split-ups.

Letter stock.
Restructure business portfolio to
reflect core competencies.
Design Approach 2:
Tinker with capital structure...
1. Make capital structure line-of-sight.
2. Make the stock a management play
rather than an industry play.

Issue equity-linked debt—
pegged to the stock price of
competitors.
Design Approach 2:
Tinker with capital structure...
1. Make capital structure line-of-sight.
2. Make the stock a management play
rather than an industry play.
Specifics:
DECS or Prides issued against
competitors.
Hybrid debt instruments whose interest
payments are linked to the
performance of a particular stock—in
this case, a market-weighted or
equally-weighted portfolio of
competitors.
Examples: Lyondell, Enron, NationsBank,
Netscape, Nextel, Telecom Argentina,
plus seven others—each issued for tax
reasons, not business reasons.
Issuance relatively low-cost and
routine.
Design Approach 2:
Tinker with capital structure...
1. Make capital structure line-of-sight.
2. Make the stock a management play
rather than an industry play.

Issue equity-linked debt—
pegged to the stock price of
competitors.

Issue commodity-linked debt—
pegged to the price of raw
materials.
The Common Theme:
Pay for Performance, Not Luck

Inexpensive way for company, and thus its shareholders, to place an extended
bet against the competition while investing long in management.

Lessens industry risk (and thus beta). Effectively hedges a portion of the
equity against all risk except that of lagging behind the industry.

Lowers the cost of capital. Although risk reduction for stockholders would be
offset by increased risk (and reward) for creditors, the transferred return
would be tax deductible.

Improves cash flow. Debt service would decline when the market anticipated
an industry downswing, and would rise in anticipation of an upswing.

Transforms investing in company from an industry play into a management
play without shuffling investors.
Summary: Getting the most out of long-term incentives.

Equity is still the most powerful longterm motivator.

Real long-term incentives require real
at-risk capital.

LTI’s are more effective if made line-ofsight—whether through cash-based
incentives, changes in capital structure,
portfolio management or better analysis
of value drivers.

LTI’s are more effective if they
differentiate management performance
from the economy’s.
Summary: Getting the most out of long-term incentives.
Bottom Line

Long-term incentives are most
effective when part of a
comprehensive financial and
strategic value-based initiative to
make managers think and behave like
diversified owners.