by Will Ashworth | January 5, 2012 6:15 am
CEO compensation should be at the top of any investor’s list of red flags, but sadly, it isn’t. Instead, we focus on things like earnings-per-share growth, return on invested capital and all sorts of other financial metrics.
Excessive CEO compensation is very similar to the effects higher management fees have on mutual fund performance, where higher fees don’t necessarily translate into superior returns.
In an effort to demonstrate how this relates to CEO compensation, I plan to compare companies in the same industry; one company will have above-average CEO compensation, and the other, below-average compensation. Each article will look at whether excessive CEO compensation is wasteful.
To evaluate CEO compensation, I’ll look at the structure of that compensation, whether it be salary, cash bonuses, deferred compensation and stock/option awards and grants. The total compensation package is an important number, but equally important is how the compensation committee arrives at this final number. Then I’ll examine the financial performance and stock returns of both companies to determine the better corporate steward.
First, we will look at two companies in the tobacco industry, where the average compensation in 2010 of four CEOs (S&P 500 companies only) was $18.3 million.
The highest-paid CEO was Altria Group‘s (NYSE:MO) Michael Szymanczyk, who earned a whopping $24 million. In comparison, Lorillard‘s (NYSE:LO) Murray Kessler brought in a relatively measly $3.7 million.
Szymanczyk’s salary ($1.3 million) was just 5.4% of his overall compensation, whereas Kessler’s ($370,000) was 10%. However, Kessler — the former vice chairman of Altria Group — was hired by Lorillard in September 2010. If you factor in Kessler’s full-year salary of $1.2 million, his salary would have represented a hefty 27% of his overall pay (which would have been a total of about $4.5 million).
Only in the C-Suite are people complaining that their salary represents too much of their take-home pay.
The lion’s share of Szymanczyk’s compensation came in the form of annual ($3.3 million) and long-term cash incentive plans ($10.8 million), which accounted for $14 million, or 59% of his overall pay. Altria’s long-term incentive plan runs in three-year performance cycles, with 2010 being the final year. If you factor out the long-term money paid out for 2008 and 2009, Szymanczyk’s non-equity incentive pay in 2010 represented 41% of his overall compensation.
Kessler’s 2011 annual incentive plan target is $1.8 million with a maximum payout of $3.3 million. If Kessler were to maximize his incentive pay in 2011, I’d guess it would represent approximately 55% of his estimated $6 million in overall compensation. Szymanczyk, meanwhile, likely will have to get by on about $12 million in 2011.
A good way to sum up the difference in compensation would be to compare the three-year total compensation of the four named executive officers other than CEO. In 2008-10, Altria paid its four NEOs a total of $77.7 million, compared to $29.4 million for Lorillard. Altria’s a bigger company, I’ll grant you, but it’s still a meaningful difference.
Such a difference in pay might lead one to believe Altria’s financial performance must be substantially superior to Lorillard’s, thus justifying the gap.
At first glance, you’d be correct. In the trailing 12 months, Altria’s gross margin is 53.7% compared to 35.4% for Lorillard. In terms of operating margins, Altria’s is 940 basis points higher at 37.8%.
Margins, however, aren’t everything. Lorillard’s return on assets is 32%, more than three times those of Altria. Put another way, Altria uses $3.76 in debt to generate $1 in earnings compared to $2.42 in debt for Lorillard. If you’re at all concerned with leverage, Lorillard should be at least as attractive as Altria, if not more so.
This is where Lorillard truly shines. Since its separation from Loews Corporation (NYSE:L) in the second quarter of 2008, Lorillard has outperformed Altria where it counts most — in the performance of its stock. LO shares have averaged 33% growth in each of the past three years, more than 400 basis points higher than Altria.
When you factor in that Lorillard has increased its quarterly dividend 41% since 2008 and currently yields 4.5%, I’m not sure there’s an argument against owning its stock other than you believe every smoker on Earth is going to quit smoking menthol cigarettes. I just don’t see this happening anytime soon, which makes its dividend very attractive to income investors.
On the surface, it seems to make sense that the CEO of Altria earns more than the head of Lorillard. After all, Altria’s annual revenues are $16.4 billion, almost three times as large. However, as we can see by Lorillard’s outstanding financial performance and strong investment returns, the pay packet doesn’t need to be astronomical to produce above-average results.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned stocks.
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