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 In addition to soothing shareholders, the surprise buyback benefited
the company’s senior executives. It added around two cents to the
company’s annual earnings per share, allowing Humana to surpass its
$7.50 EPS target by a single cent and unlocking higher pay for top
managers under terms of the company’s compensation agreement.
Thanks to Humana hitting that target, Chief Executive Officer Bruce
Broussard earned a $1.68 million bonus for 2014.
Most publicly traded U.S. companies reward top managers for hitting
performance targets, meant to tie the interests of managers and
shareholders together. At many big companies, those interests are
deemed to be best aligned by linking executive performance to
earnings per share, along with measures derived from the company’s
stock price.
But these metrics may not be solely a reflection of a company’s
operating performance. They can be, and often are, influenced
through stock repurchases. In addition to cutting the number of a
company’s shares outstanding, and thus lifting EPS, buybacks also
increase demand for the shares, usually providing a lift to the
share price, which affects other performance markers.
As corporate America engages in an unprecedented buyback binge,
soaring CEO pay tied to short-term performance measures like EPS is
prompting criticism that executives are using stock repurchases to
enrich themselves at the expense of long-term corporate health,
capital investment and employment.
“We’ve accepted a definition of performance that is narrow and quite
possibly inappropriate,” said Rosanna Landis Weaver, program manager
of the executive compensation initiative at As You Sow, a
Washington, D.C., nonprofit that promotes corporate responsibility.
Pay for performance as it is often structured creates “very
troublesome, problematic incentives that can potentially drive very
short-term thinking.”
A Reuters analysis of the companies in the Standard & Poor’s 500
Index found that 255 of those companies reward executives in part by
using EPS, while another 28 use other per-share metrics that can be
influenced by share buybacks.
In addition, 303 also use total shareholder return, essentially a
company’s share price appreciation plus dividends, and 169 companies
use both EPS and total shareholder return to help determine pay.
STANDARD PRACTICE
EPS and share-price metrics underpin much of the compensation of
some of the highest-paid CEOs, including those at Walt Disney Co,
Viacom Inc, 21st Century Fox Inc, Target Corp and Cisco Systems Inc.
Fewer than 20 of the S&P 500 companies disclose in their proxies
whether they exclude the impact of buybacks on per-share metrics
that determine executive pay.
Humana would not say whether it adjusted targets to account for its
buyback last year. In a statement to Reuters, the company said it
sets annual per-share targets for executives that take into account
the company’s “capital allocation strategy,” which includes
buybacks, dividends, acquisitions and investments.
Experts said Humana would not have reached the target without the
$500 million buyback. The company told analysts at the time of the
repurchase announcement in November 2014 that it expected to report
annual earnings per share of between $7.40 and $7.60 for the full
year.
“Given the magnitude of the repurchase, the EPS would have been
below $7.50 had it not been for the repurchase,” said Heitor
Almeida, a professor of finance with the College of Business at the
University of Illinois in Champaign.
As reported in the first article in this series, share buybacks by
U.S. non-financial companies reached a record $520 billion in the
most recent reporting year. A Reuters analysis of 3,300
non-financial companies found that together, buybacks and dividends
have surpassed total capital expenditures and are more than double
research and development spending.
Companies buy back their shares for various reasons. They do it when
they believe their shares are undervalued, or to make use of cash or
cheap debt financing when business conditions don’t justify capital
or R&D spending. They also do it to meet the expectations of
increasingly demanding investors.
Lately, the sheer volume of buybacks has prompted complaints among
academics, politicians and investors that massive stock repurchases
are stifling innovation and hurting U.S. competitiveness - and
contributing to widening income inequality by rewarding executives
with ever higher pay, often divorced from a company’s underlying
performance.
“There’s been an over-focus on buybacks and raising EPS to hit share
option targets, and we know that those are concentrated in the hands
of the few, and that the few is in the top 1 percent,” said James
Montier, a member of the asset allocation team at global investment
firm GMO in London, which manages more than $100 billion in assets.
The introduction of performance targets has been a driver of surging
executive pay, helping to widen the gap between the richest in
America and the rest of the country. Median CEO pay among companies
in the S&P 500 increased to a record $10.3 million last year, up
from $8.6 million in 2010, according to data firm Equilar.
At those levels, CEOs last year were paid 303 times what workers in
their industries earned, compared with a ratio of 59 times in 1989,
according to the Economic Policy Institute, a Washington-based
nonprofit.
SALARY AND A LOT MORE
Today, the bulk of CEO compensation comes from cash and stock
awards, much of it tied to performance metrics. Last year, base
salary accounted for just 8 percent of CEO pay for S&P 500
companies, while cash and stock incentives made up more than 45
percent, according to proxy advisory firm Institutional Shareholder
Services.
Thomson Reuters Corp, owner of Reuters News, used EPS to determine
half of the performance awards in the three-year pay cycle ended in
2014 for CEO Jim Smith and other executives. Smith last year took
home $6.6 million in compensation. The company’s three-year
performance awards going forward are based on both EPS and free cash
flow per share. A company spokesman said Thomson Reuters does not
adjust for the impact of stock buybacks on those metrics.
Share repurchases can make the difference in meeting preset targets,
according to a Reuters review of corporate proxies.
At Xerox Corp, revenue, net income and spending on research and
development all declined last year. But the printer and copier
maker’s EPS target of $1.12 was unchanged from the prior year, and
managers hit it exactly after $1.1 billion in share repurchases.
Half of CEO Ursula Burns’s annual bonus target was predicated on
hitting that EPS level; ultimately, she received a bonus of $1.98
million out of a possible $2.2 million. EPS is also a major
determinant of even bigger bonuses for a three-year performance
cycle ending this year.
Xerox repurchased $1.35 billion of its shares in the first three
quarters of this year. The company declined to comment. Its proxy
statement does not indicate whether it adjusts targets to account
for buybacks.
Managers at information technology company EMC Corp hit their EPS
target for 2014 of $1.90 with the help of $3.7 billion in share
repurchases. Based on the share count before the buybacks, EPS last
year would have been only $1.81, little changed from $1.80 a year
earlier, according to a Reuters calculation.
The EPS target accounted for half of CEO Joseph Tucci’s annual $1.01
million bonus. It also is used to determine 45 percent of bonus
share awards for the company’s future three-year targets.
EMC declined to comment. Its proxy statement does not address
whether it makes adjustments to account for buybacks. It has bought
back $3.11 billion in shares so far this year.
Buybacks can boost a company’s share price to benefit executives
whose shares vest over a period of years. Activision Blizzard Inc,
purveyor of “Guitar Hero,” “Call of Duty” and other well-known video
games, signed Chief Executive Robert Kotick to a contract in 2012
that included $56 million in share awards that vest over time,
depending in part on the share price and EPS.
Last year, Kotick ended up getting about $22 million in
performance-based cash and stock awards, about the same as the year
prior, even as net income dropped 17 percent. How? The stock rose
substantially, meeting goals for total shareholder return and
increasing the value of share awards.
Total shareholder return was helped by an $8.2 billion repurchase
made in late 2013 – when the company and a group of investors led by
Kotick and Activision Chairman Brian Kelly bought out a stake held
by then-majority shareholder Vivendi. The company said the deal
allowed Activision to operate with more flexibility.
The shares rose 33 percent from the date of the buyback announcement
in July 2013 through the end of 2014. The share price has continued
to rise this year, making the awards even more valuable.
Activision declined to comment.
In 1992, Congress changed the tax code to curb rising executive pay
and encourage performance-based compensation. It didn’t work.
Instead, the shift is widely blamed for soaring executive pay and a
heavier emphasis on short-term results.
[to top of second column] |
Companies started tying performance pay to “short-term metrics, and
suddenly all the things we don’t want to happen start happening,”
said Lynn Stout, a professor of corporate and business law at
Cornell Law School in Ithaca, New York. “Despite 20 years of trying,
we have still failed to come up with an objective performance metric
that can’t be gamed.”
Shareholder expectations have changed, too. The individuals and
other smaller, mostly passive investors who dominated equity markets
during the postwar decades have given way to large institutional
investors. These institutions tend to want higher returns, sooner,
than their predecessors. Consider that the average time investors
held a particular share has fallen from around eight years in 1960
to a year and a half now, according to New York Stock Exchange data.
“TOO EASY TO MANIPULATE”
Companies like to use EPS as a performance metric because it is the
primary focus of financial analysts when assessing the value of a
stock and of investors when evaluating their return on investment.
But “it is not an appropriate target, it’s too easy to manipulate,”
said Almeida, the University of Illinois finance professor.
In 2011, Amgen Inc CEO Kevin Sharer oversaw $8.32 billion of
buybacks, by far the largest in the pharmaceutical maker’s history.
More than $5 billion of those repurchases came in the fourth quarter
of the year.
Soon after, Amgen reported that net income was lower than it had
been in the three preceding years. At the same time, the buybacks
lifted EPS far above the target level that determined 30 percent of
Sharer’s bonus, doubling the amount he earned for that portion of
his $4.88 million annual bonus. Without the buyouts, EPS would have
fallen below the target level.
Sharer left the company in May 2012 and is now on the faculty of
Harvard Business School. He did not respond to requests for comment.
The Amgen board’s compensation committee removed EPS as a
performance metric the next year. It opted, instead, to begin using
net income, saying in a 2012 proxy statement that doing so would
“align compensation with a measure that more directly correlates
with the underlying performance of our operations.”
Members of Amgen’s 2011 compensation committee declined to comment.
Some companies, including software developer Citrix Systems Inc and
kidney dialysis company DaVita Inc, say they avoid EPS in pay
calculations because it is too vulnerable to manipulation.
Most companies that use per-share metrics for executive awards,
however, say little about whether they adjust results to account for
buybacks. A select few, including Johnson & Johnson, FedEx, Time
Warner Inc and IBM, do disclose that they strip out the potential
effect of buybacks on performance metrics.
FedEx, in its most recent filing, said it excluded the effect of
buybacks because the positive effect on EPS “did not reflect core
business performance.” Time Warner Inc said it adjusts for buybacks
“so that payouts were not advantaged” if the media company
repurchased more shares than it initially anticipated when setting
performance goals.
Steve Pakela, managing partner at Pay Governance LLC in Pittsburgh,
Pennsylvania, which advises more than 40 S&P 500 companies on
executive pay, said some directors “believe you shouldn’t strip out
the effect” because share buybacks may be the best use of capital.
In addition to EPS, there is total shareholder return, which
typically comprises a company’s share price appreciation plus
dividends over time. Total return, often used to compare performance
among peer companies, has also become a popular performance measure
for executive pay.
By providing a lift to a stock’s price, buybacks can increase total
shareholder return to target levels, resulting in more stock awards
for executives. And of course, the higher stock price lifts the
value of company stock they already own.
“It can goose the price at time when the high price means they earn
performance shares … even if the stock price later goes back down,
they got their shares,” said Michael Dorff, a law professor at the
Southwestern Law School in Los Angeles.
Exxon Corp, the largest repurchaser of shares over the past decade,
has rejected shareholder proposals that it add three-year targets
based on shareholder return to its compensation program. In its most
recent proxy, the energy company said doing so could increase
risk-taking and encourage underinvestment to achieve short-term
results.
The energy giant makes half of its annual executive bonus payments
contingent on meeting longer-term EPS thresholds. Since 2005, the
company has spent more than $200 billion on buybacks.
ADDITIONAL TWEAKS
While performance targets are specific, they aren’t necessarily
fixed. Corporate boards often adjust them or how they are calculated
in ways that lift executive pay.
Humana specifies EPS ranges to determine annual bonuses paid to its
executives. For the past three years, buybacks of more than $500
million a year increased EPS. That wasn’t all, however. For each of
those years, the board altered calculations in ways that also bumped
EPS higher.
For 2012, then-CEO Michael McCallister received a higher bonus than
he otherwise would have -- $1.63 million -- after Humana’s board
removed litigation expenses from its EPS calculation.
He was succeeded as CEO at the start of 2013 by Broussard. For that
year, Broussard’s annual bonus was lifted into the maximum range,
for a payment $2.44 million, after accounting for the cost of
posting additional reserves against long-term insurance policies.
For 2014, Humana discounted from its EPS calculation losses from
paying down some bonds, even as its overall debt levels increased.
That adjustment brought the company just below its EPS target of
$7.50.
The $500 million buyback the company announced late last year, part
of its total $872 million in buybacks in 2014, was an accelerated
share repurchase. In this sort of deal, a company buys all the stock
from an investment bank in a single transaction. That allows it to
book the reduction in shares outstanding immediately, and the bank
then buys the shares on the open market over the ensuing months.
Humana’s accelerated share repurchase lifted EPS to $7.51, just
above the target.
Susan Young, an associate professor of accounting and taxation at
Fordham University in New York, said accelerated buybacks are
commonly used to reach compensation targets. “I can’t think of a
good reason for this form of repurchase,” she said, noting that the
programs restrict a company’s flexibility to reduce or stop buybacks
if shares become too expensive.
Roy Dunbar, a member of the Humana board’s compensation committee,
declined to comment on Humana specifically. He said the benefit of
accelerated repurchases is to, “in a controlled way, buy a
significant slice of available shares early in the program,” before
an announced buyback pushes up the share price and increases the
cost to the company.
He also said an accelerated program allows shareholders to see
immediate action, which is “important to signal a higher degree of
confidence in something shareholders care a great deal about.”
In general, he said, “effective compensation committees are aware of
impact of share repurchases on EPS, particularly when EPS is part of
the equity compensation of management.”
In July, Aetna Inc announced that it would acquire Humana in a deal
that at the time valued Humana at $37 billion. If Broussard leaves
after the deal, he won’t go empty-handed.
Just before the Aetna deal was announced, Broussard’s compensation
agreement was modified to accelerate equity awards and remove
restrictions on exercising some stock options if he leaves or is
terminated within two years of any acquisition, a regulatory filing
shows.
At the end of last year, Broussard held unvested share awards valued
at around $12.8 million, which have since increased in value as
Humana’s share price has climbed 18 percent.
(Edited by John Blanton)
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