ADVANCING EXEMPLARY BOARD LEADERSHIP

The Age of Alignment Part II: Getting Strategy-Driven Performance Measurement Right Compensation Series

March 12, 2015

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Meet The Presenters

Michael Ng is a consultant in the Boston office of Pearl Meyer & Partners

with more than 12 years of experience in strategy, human capital and

executive compensation consulting

Greg Lau (moderator), is managing director of the board of directors practice

for RSR Partners, a member of the board of the National Association of

Corporate Directors (NACD) and an NACD Board Leadership Fellow.

Matt Turner is a Managing Director in the Chicago office of Pearl Meyer &

Partners, specializing in executive compensation strategy, incentive plan

design, tailoring of performance measures and assisting Compensation

Committees in setting shareholder-focused performance targets.

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Housekeeping

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Housekeeping

Click below for a copy of the slides

Slides are also available at

pearlmeyer.com/AgeofAlignmentPartIIMeasurement

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You will automatically receive 1 NACD skill-specific

credit for your participation.

Credit may be applied to NACD Fellowship

programs. Contact Fellowships@NACDonline.org

for more details.

The replay and slides will also be available early

next week at NACDonline.org/webinars and

pearlmeyer.com

Housekeeping

Today’s Discussion

• Review of the key takeaways from December

• Identifying strategy-driven performance measures

• Mapping those measures to incentive plans

• Practical concerns with performance measurement

• Setting performance goals

• Questions

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Developing Strategically Aligned Pay Programs

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• Business and leadership strategy drive program design

• External practices and views inform program design

External Perspectives and Optics

Pay / Performance

Alignment

Market Practices

Business Strategy

Leadership Strategy

Compensation Philosophy &

Strategy

Compensation Program Design

Implementation and

Communication

Business Results

Understand Key Drivers

Understand Context

Concept in Practice

•Conscious deviation from market norms

•Drive competitive advantage

•Create value proposition differentiation

Hallmarks of Strategically-Aligned Pay

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1. Balances Driver and Outcome metrics

• Driver or “Lead”: strategic imperatives

• Outcome or “Lag”: financial results

2. Balances Alignment and Accountability

• Alignment: line of sight; ability to influence

• Accountability: absolute; relative

3. Considers both “What” and “How”

• What are the results (measurable)

• How the results were attained (discretion)

Metrics

Goals

Performance Measures are a Critical Link Between a Stated Business Strategy and Management Execution

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• Maximize shareholder value

• Company-specific path to value-

creation taking into account

– Market economic; competitive

position

– Company strengths, weaknesses,

opportunities and risks

• Specific/relevant financial

measures, balancing growth and

returns

• Operational measures tied to

business strategy

Goal

Centerpiece

Financial Measures

Corporate Processes

Operating Decisions

Incentives Planning &

Resource Allocation Reporting

Strategy

Driver Measures

Understanding How a Company Creates Value Allows Identification of Strategy-Linked Performance Measures

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Revenue

Growth

Value

Creation

Economic

Profit

Market Share

Return on Invested Capital

New Products Cost of Capital

Capital

Efficiency Quality

New Markets

Operating

Margin

Capital

Deployed

Innovation

R&D Distribution

Costs

Working

Capital Pricing

Stock Price vs. Free Cash Flow and EBITDA

($100)

($50)

$0

$50

$100

$150

$200

$250

$300

200620052004200320022001200019991998199719961995

$20

$25

$30

$35

$40

$45

$50

$55

$60

FCF EBITDA Price

Case Example 1: Specialty Chemicals Manufacturer

• Company wishes to implement a LTIP that reinforces business strategy

(replacing a simple mix of stock options and restricted stock)

• Continued market growth at economically profitable return levels,

capitalizing on the Company’s strengths

– Manufacturing excellence and innovation

– Top level, tailored customer service

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ROGA (Cash Returns) vs. M/B Ratio

y = 4.30x + 0.77

R 2 = 0.43

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

0% 5% 10% 15% 20%

Return on Gross Assets

Ma

rke

t to

Bo

ok

RONA vs. M/B Ratio

y = 5.72x + 0.55

R 2 = 0.68

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

0% 5% 10% 15% 20%

Return on Net Assets

Ma

rke

t to

Bo

ok

Once Centerpiece Financial Measures are Identified, “Balance” Them Appropriately Based on Strategy

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• A properly balanced performance

measurement framework will

– Emphasize profitable growth/returns,

consistent with strategy and market economics

– Include a mix of lead and lag measures to

ensure appropriate line-of-sight

– Map measures to the right incentive plans

based on timeframe and participant profile

Growth Profitability ROI Stock Price/TSR

% of Target Individual Top Operating Gross NI Working Absolute Relative

Plan Type Total Pay "MBOs" Line Income Margin Margin ROIC Capital Growth to Peers

Annual Incentive

Plan35% X X X X

Cash Long-term

Incentive Plan15% X X X

Performance-

vested Restricted

Stock

15% X X X

Other 5% X X

Case 2: Retailer

• Current incentive plans had 80%+ based

on sales and gross margin dollars

• Analysis showed that the measures were

highly redundant, both internal to the firm

and among peers

• Focusing on one measure allowed for

increased focus on drivers or “lead”

measures

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Performance Linkage

Bonus Dollars at Target - Merchants and Store Mgrs.

43% 47%

44%

8%

33%

5%

20%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Merchants Store Mgrs.

Comp Sales Gross Margin $ Income Inventory Turns Expenses

XYZ Department Stores

-15%

-10%

-5%

0%

5%

10%

15%

YO

Y C

ha

ng

e

Sales GM$

ABC Department Stores

-40%

-20%

0%

20%

40%

60%

80%

100%

YO

Y C

ha

ng

e

Sales GM$

123 Department Stores

-50%

0%

50%

100%

150%

200%

250%

YO

Y C

ha

ng

e

Sales GM$

Sometimes the Tailoring of Measures is Worth Consideration

Potential Deviations from Standard Definitions

Some Considerations

Operating income vs. all “earnings” (e.g., interest

income, JVs, discontinued ops)

Employee control and influence

Actual vs. standard tax rates (or pretax earnings) Same as above; is management of a deferred tax

asset part of operations?

Non-cash charges (depreciation, amortization, etc.) Unusual period of growth; management inherited

goodwill; distortions to investment decisions

Effects of exchange rates Employee control and influence; financial vs.

operational hedging; distortions to investment

decisions

Inventory valuation Differences from peers for relative performance

comparisons; large swings in actual value of

inventory

Adjustment of balance sheet values (marking to

market; recognizing non-GAAP assets)

Distorting investment decisions; protecting brand

value

Capitalizing R&D or marketing expenses Encouraging investment without undue impact on

short-term financial metrics

Suspending the impact of acquisitions for a period of

time

Acquisition strategy with multi-year integration

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Once Key Performance Measures are Identified, Understand Their Limitations and Plan Accordingly

• Agree ahead of time on how to treat unusual, non-recurring, and

non-operational items.

Acquisitions and divestitures

Unusual swings in commodity prices, exchange rates, interest rates

Settlement of lawsuits or government-related items

Asset write-downs

Share repurchases

Changes in accounting rules

Windfall gains or losses

• Past precedent is instructive. But think through the intent of the

measures, as well as fairness and optics.

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The Goal-setting Process is Changing and Compensation Committees are More Involved Than Ever Before

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• Budget-driven

• Target-focused

• Compensation Committee

involved at the end of the

process

• Multiple performance

perspectives

• Multiple pay/performance

scenarios considered

• Early, active involvement of

the Compensation

Committee

Traditional Approach Today’s Required Approach

Goal-Setting Should Incorporate Multiple Perspectives on Performance Expectations

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Peer/Comparables

Performance

Shareholder

Expectations

Historical Company

Performance

Bottom-up Budget

Company

Financial

Goals

Cost of Capital

Multiple Performance

Scenarios

Historical Perspectives Forward-Looking Perspectives

Analyst Estimates Variance of Results

Five Goal-Setting Pitfalls to Avoid

1. Relying principally on the company budget process (or any single

perspective)

2. Presuming that financial performance relative to peers is as

relevant (or more relevant) that stock price performance relative to

peers

3. Fixating on year-over-year performance or continuous

improvement

4. Not doing a sanity check by modeling the potential outcomes

5. Becoming too anchored to past results or circumstances

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Case 3: Natural Resources Company

• Historical performance

ROIC (and margins and asset turns) = top quartile

Sales growth = close to median

TSR = close to median

• New performance share plan ROIC and sales growth (3-year)

• Company plan modest decline in ROIC; aggressive sales growth

• Shareholder expectations analysis shows that the plan is consistent

with the current share price/market valuation

Leads to a valuable discussion of the trade-offs between growth and returns

specific to the Company’s circumstances

Confirms that the plan numbers are reasonable for incentive goals

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Key Takeaways from Today’s Presentation

• Performance measures can and ought to be explicitly linked to

business strategy and value creation.

• Measures and the measurement framework should be tailored to

each company’s specific circumstances.

• Plan ahead! Avoid surprises with respect to how a measure is

calculated and/or what non-recurring events are included in it.

• Set goals based on a broad, robust set of analytic inputs – let

your Comp Committee members get a good night’s sleep!

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ADVANCING EXEMPLARY BOARD LEADERSHIP

Questions

Don’t Miss Our Upcoming Webinar

Join NACD and Pearl Meyer & Partners for the next program in our Compensation Series

The Age of Alignment Part III: Moving from

Theory to Practice

To register or check out the archives of earlier webinars in this series, visit NACDonline.org/webinars.

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