Friday, February 7, 2014

H-P's Approach to Executive Comp Is a Lot Better Than JP Morgan's Handwaving

We posted recently about the formulaic and uninformative discussion of JP Morgan Chase's executive compensation philosophy and metrics that might justify a $20 million compensation award to CEO Jamie Dimon. 

Today, in HP's proxy we see the kind of approach that is both mandated by SEC guidelines and which gives a shareholder an insight into how the board looks at the task of setting executive compensation.  Their approach stands in stark contrast to that of JP Morgan Chase's board. 

Having sat on both sides of the board table for public company executive compensation discussions, I can tell you that cannot be solely a highly quantitative, black box process, no matter what the consultants say. There is quite a bit of luck in how equity-based compensation can work out. (see Rakesh Khurana's writings on this issue) It is not the magic bullet, but it is an important part of the compensation tool kit. 

There is no perfect structure that can apply to all companies.  That is why the issue of setting out the philosophy and choice of metrics is important.  Shareholders deserve to know, and management needs to understand, how targets are being set and how they are designed to align with shareholder interests.

HP states that their Human Resources Committee, which met eight times during the past fiscal year, reviews their process and structure annually.  Like management, boards can always get better. 

Their institutional audience of 5% owners has remained unchanged from the prior year: Dodge & Cox own 8.1% of the equity, BlackRock own 6.1%, and on behalf of mutual fund owners State Street holds 5.5%. 

Whereas JPM's board uses the boiler plate term "alignment," the HP board shows how they interpret and implement the concept both in executive compensation and in corporate governance.  I think a diligent analyst or shareholder familiar the company's history can glean a lot from this presentation. 



Corporate Governance
The majority of target total direct compensation for executives is performance-based as well as equity-based
We generally do not enter into individual executive compensation agreements
Total direct compensation is targeted at the median of our market
We devote significant time to management succession planning and leadership development efforts
Actual total direct compensation and pay positioning is designed to fluctuate with and be commensurate with actual performance
We maintain a market-aligned severance policy for executives that does not have automatic single-trigger equity vesting upon a change in control
Incentive awards are heavily dependent upon our performance against objective financial metrics which we believe link either directly or indirectly to the creation of value for our stockholders. In addition, 25% of our target annual bonus is contingent upon the achievement of qualitative objectives that we believe will contribute to our long-term success
The HRC Committee utilizes an independent compensation consultant
We balance growth and return objectives, top and bottom line objectives, and short- and long-term objectives to reward for overall performance that does not over-emphasize a singular focus
Our compensation programs do not encourage imprudent risk-taking
A significant portion of our long-term incentives are delivered in the form of performance-contingent stock options ("PCSOs"), which vest only if sustained stock price appreciation is achieved
We disclose our performance goals and achievements relative to these goals
We provide no special or supplemental pension benefits
We conduct a robust stockholder outreach program throughout the year

Instead of talking about reasonable compensation, HP's board talks about targeting direct compensation at the median of its market, or peer group.  The interesting thing is the choice of peer group, which is effectively very close to the top ten or twenty stocks owned by institutional investors who might look to own HP. At least, this is how I interpret the table.  In addition to Microsoft, Cisco, Google and other technology bellwethers, the peer group also includes Pepsi and Johnson & Johnson two high quality growth stocks which often appear in their 5% owners' portfolios.  As a whole, the peer group companies are subject to economic forces, market forces and technology cycles which should make the median comp metric an appropriate measure. 

In fiscal 2013, 75% of the incentive comp targets were made up of quantitative metrics: revenue (25%), corporate net earnings (non-GAAP) also 25%, and corporate FCF as a percent of revenue at 25%. The other 25% were composed of qualitative factors. 

Management delivered revenue of $112.3 billion, short of the target $117.9 billion, attaining a 19.6% incentive payout versus the target 25% available. The actual payout on corporate net earnings fell 5 percentage points short of target, whereas FCF as a percent of revenue was 8.1% versus a target of 6.3%, and the outperfomance on the latter metric, along with some consideration of the total stockholder return of 81 percent put the overall achievement for the quantitative metrics at 2 percentage points above target.

Our objective is not to provide a complete review of this document, but to show that there is plenty of meat for an interested party to consider in their decision whether to own, hold, or sell HP shares.The document gives a clear picture of management's performance and a window into how the board looks at that performance and pays for it. 

By contrast, JPM's discussion of executive compensation reflects poorly on their board and on their governance.  

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