How to Fix Executive Compensation and CEO Pay in Corporate America
It is all about incentives — and reining in stock buybacks.
The fact is, CEO compensation has gone completely haywire.
Over the past four decades, as executive salaries — adjusted for inflation — have ballooned by nearly 1,000%, the average worker has seen their compensation increase by a relatively meager 11% over the same period.
The resulting imbalance is striking.
In 2015, the country’s top CEOs were paid a staggering 276 times more than the typical American worker, according to the Economic Policy Institute. Are these CEOs being rewarded for top-notch performance? Not really. In fact, some of the highest paid business chiefs are leading companies in massive decline.
Take IBM for instance. At the start of 2016, the board of the embattled Armonk, New York-based tech icon awarded its CEO Ginni Rometty a $4.5 million bonus for her work in 2015 — $900,000 more than her bonus a year prior — bringing her total compensation to $19.5 million. And all that despite the fact that, as Fortune reported at the time, Big Blue’s revenues had tumbled for 15 straight quarters on Rometty’s watch and IBM shares dropped 15% over the course of 2015.
So, of course the question you are asking yourself — or should be asking yourself — is: how?
How did Rometty, the CEO of a tech company with a growing laundry list of sizable problems (many of which I have previously documented) manage to pocket nearly $20 million, despite IBM’s substandard performance in 2015?
The answer: Stock buybacks and screwy incentives for corporate executives.
Multi-million Dollar Carrots
At IBM, net operating earnings account for 70% percent of the senior executives’ performance-based incentives, with the remaining 30% based on free cash flow, according to the company’s proxy statement. This is a juicy, multimillion dollar carrot dangling in front of the top brass at IBM, galvanizing them to focus on boosting earnings per share — for which there is a shortcut: buying back company stock. When a company repurchases its own stock, it is reducing the number of outstanding shares in the market, artificially boosting earnings per share and, in turn, padding executives’ pockets.
But one party arguably loses out in this scenario: Shareholders.
Every $1 injected back into the market for buybacks boosts shareholder risk, because a company is trading a tangible asset (cash) for an intangible asset (stock) and increasing leverage for shareholders in each and every case. But despite this less-than-ideal scenario, corporate executives are pouring billions back into the market to buy back company stock as their salaries bloat.
Let’s return to IBM for a minute. The metrics outside of Rometty’s fat paychecks tell a darker story of the state of IBM, in my view. Facing a dying mainframe business, the erstwhile tech leader is struggling to stay relevant as it cuts jobs and faces flagging revenues and earnings.
Bloomberg reports that in 2014, 40% of Rometty’s $11.4 million compensation was tied to earnings per share — so it is no wonder she and her fellow C-suite members went hog wild over stock buybacks. Since 2005, IBM has only invested $111 billion in capital spending and R&D but spent $125 billion on share repurchases over the same period.
And IBM isn’t the only company to go on rampant buyback sprees.
Pharmaceutical giant Pfizer and 3M have shelled out $139 billion and $48 billion, respectively, on buybacks and dividends over the past decade. And American Airlines, less than five years out of bankruptcy, has spent $9 billion on share purchases over the past two years alone. Meanwhile, the executives at the top have pocketed millions. In 2015, Pfizer C.E.O. Ian Read made $14.4 million; 3M C.E.O. Inge Thulin raked in $15.5 million; and W. Douglas Parker, the head of American Airlines, made $11.4 million.
So How Do We Fix This?
Well, for starters: overhaul executive incentives and demand shareholder votes on all share repurchases. Second, pay executives on the actual performance of the business, correlated to gross profit and revenue.
There is an alignment problem at hand, but to change it, shareholders need to take their rightful place as owners and assert their authority. There are a number of ways to look at it, but it boils down to this: shareholders are getting stepped on, because they are letting themselves get stepped on.
How we do fix this? Overhaul executive incentives and demand shareholder votes on all share repurchases.
As an investor, you are buying a share of a company’s net assets. That is all a stock certificate is — a legal claim on the net assets of a corporation. And when CEOs issue stock buybacks, they are gambling with your property — and in the majority of cases, you have no say. That is preposterous.
Seattle Seahawks owner Paul Allen would never let someone else sell off bits of his NFL team without his consent. So why then are shareholders letting executive boards pour their assets into the stock market without consent?
Shareholders are getting nicked. Over and over. And the problem is the incentive structure. As Bloomberg noted, 11 of the 15 non-financial companies that shelled out the greatest amount of money on share repurchases in 2014 had executive compensation packages tied to earnings per share or total shareholder return. This illustrates the scope of the problem associated with linking executive salaries to an easily manipulated metric.
Executive incentives need to be realigned with shareholder incentives.
At Worm Capital, our objective is to build our pile of assets. It’s as simple as that. And in our view, the best way to incentivize CEOs to focus on building assets is to reward them purely on the basis of a company’s success.
Pay Execs on Business — Not Stock — Performance
Executives should reach their full compensation targets by hitting gross profit and revenue goals — not earnings per share. Why? Executives can’t manipulate and exploit these metrics.
In the case of IBM, revenue and gross profit have been declining for years, but due to the company’s screwy incentives (in my view), management is focused on earnings per share and gotten rich off of it. They say that is what is most important. But I’m saying, no.
It’s not the most important. To protect your business, you have to protect your assets, and you have to protect your value proposition. And you can’t sacrifice those for quarterly earnings per share. The way to fix that is just better design of incentives that more accurately, which means tying them to gross profit and revenue.
Executives should reach their full compensation targets by hitting gross profit and revenue goals — not earnings per share.
In April 2015, Blackrock head Larry Fink wrote a letter to the CEOs of the companies that make up Standard & Poor’s 500 index, wherein he urged the business leaders to push back on pressure from investors seeking short term returns — namely, dividends and greater earnings per share.
“Corporate leaders’ duty of care and loyalty is not to every investor or trader who owns their companies’ shares at any moment in time, but to the company and its long-term owners,” Fink wrote — offering up a piece of advice that still holds true today.
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Arne Alsin and Worm Capital clients own options positions in IBM and stand to benefit if the trading price of IBM decreases.
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