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OPINION

Three strikes and you're out

Three strikes and you're out
January 8, 2016
Three strikes and you're out

It was unfortunate timing. Just a month before this was made public, Mr Rishton had warned of flat revenue and profit in 2014. "We always expected this," he told a surprised media. The last two years of growth had "defied gravity. What we are now seeing is the impact of sequestration in the US and defence spending cuts in the UK."

This, Rolls-Royce's first profit warning for years, did not go down well. The share price slid 14 per cent on the day. If it had been so obvious, analysts asked, why hadn't Mr Rishton mentioned it before? "We always give guidance at this stage, with the full-year results," he said. And as for them being blindsided: "Whether people are happy, sad or indifferent is for them to think about."

They thought about it. The timing of profit warnings is a matter of judgement and leaving it until later had an unintended consequence. If the profit warning had been issued before the performance condition was assessed as at 31 December 2013, Rolls-Royce's share price would have fallen earlier. And that 50 per cent uplift might not have been triggered. Had it not been, his maturing pay award might have been reduced in value by about £1m.

 

Timing is everything

There are two ways of looking at performance-related pay, both to do with timing: the first is what was received during the year and the second is what was awarded. According to the accounts, what Mr Rishton actually received in 2013 (his "single figure of total remuneration") was £6,228,000 but this single figure can be misleading. He received a salary, benefits and a pension, together worth £1,349,000; and a bonus of £824,000 split into cash of £494,400 plus 33,490 shares that had to be held for two years "subject to continuous employment in the group". Past share awards just happened to mature in 2013, when they were worth £4m. What was awarded in 2013 was much less: 108,470 shares, subject to future performance conditions. If, as seems likely, these shares end up being worthless, what he earned in 2013 would be about a third of that single figure: £1,843,400 plus whatever those 33,490 Rolls-Royce shares are worth when he sells them.

Many of the shares maturing in 2013 were awarded by Rolls-Royce to compensate Mr Rishton for ones he forfeited when he resigned from Ahold in 2011. These were on similar terms to the Ahold ones, but in Rolls-Royce shares; Rolls-Royce performance conditions applied to about half of them. On award, the potential cost was about £2.6m; by the time the 2013 single figure was calculated, the share price had almost doubled, so bloating his apparent 2013 pay (and tax liability). Since the share price then fell and Mr Rishton had not sold his shares, this single figure for remuneration arguably overstates the value that he really received.

 

Reward for success or reward for failure?

To be honest, that February 2014 results meeting did not go well. Analysts accused Mr Rishton of being evasive when answering questions. Chief executives can get away with this sort of attitude when things are going well, they said, but not when they're not. He said growth would resume in 2015 and an investors' day in June 2014 helped steady nerves. But then, in October, came a second profit warning. After the third in February 2015, it was time to go. By then low commodity and oil prices were prompting nuclear, energy and mining customers to cut back on orders; defence contracts were being cut and the civil aviation side was seen to have taken a wrong turn.

Even so, when Mr Rishton resigned in April 2015, the company was able to point to substantial increases in orders, revenue and profit during his four-year tenure. The share price was up by 63 per cent, although Rolls-Royce's own share buying was supporting it. During these four years, Mr Rishton had been paid almost £8m in cash and a similar amount in shares. By the end of 2014 he owned, or potentially owned, 492,801 Rolls-Royce shares plus another 354,621 subject to performance conditions.

Long-term businesses decisions can have far-reaching consequences, so how can departing senior executives be held accountable for their legacy? Since Mr Rishton left, two more profit warnings have almost halved the share price. Yet apart from banking, few companies require departing executives to hang on to their company shares for as long as the business cycle. Perhaps more should be required to do so.

 

When a management with a reputation for brilliance...

How much is it worth paying to turn a company around? At first glance, Warren East's starting package at Rolls-Royce appears to illustrate how top pay rises. A salary of £925,000 plus benefits, making a total fixed (guaranteed) pay of £1.3m, is more than double the fixed pay he earned during his last full year at Arm (ARM). But that would be jumping to conclusions.

What determines the pay package of a new chief executive? His predecessor's? After all, if that was the going rate for the role, why change it? Well, market rates might have moved; so why not ask reward consultants to see what competitors are paying? But it's not a precise science. Few competitors are alike and chief executive roles vary, so like-for-like comparisons require the assessment of job sizes and challenges. Consultants often provide ranges rather than precise numbers.

Comparing fixed pay alone is misleading because a substantial part of chief executives' pay is linked to performance. This is where target pay and maximum potential pay figures come in. Arm's policy was to pay lower salaries than others and to reward people more for their performance. In comparison, Rolls-Royce pays higher salaries but lower variable pay. Mr East left Arm at the top of his game. In his last full year as chief executive, performance-linked awards paid him £7m on top of his salary. The previous year, he'd earned even more.

In theory, companies want to pay just enough to avoid chief executives feeling undervalued. Against this is the human factor. Perceptions of value vary at the best of times and can rise every time a headhunter calls. Why should someone, making a success of things where they are and with a good team behind them, consider joining another organisation? The lure of the new, perhaps. The challenge. A plumping of the ego, no doubt. And an attractive package to lure them away. To land Helge Lund as chief executive, for example, BG (BG.) had to guarantee £2m annually plus a further £5.5m each year if he performs as expected; more if he's perceived to excel.

Rolls-Royce's headhunters scoured the world but shareholders ended up with one of their own. Or rather a non-executive director who'd been with the company for just over a year. Mr East's overall package? Near enough the same as Mr Rishton's, his predecessor: in addition to the £1.3m guaranteed each year, up to £3.3m more depends on performance.

But circumstances are different. Mr Rishton took the helm of a successful organisation; Mr East stepped in after three profit warnings. Why does that matter? Because performance targets are often missed in struggling companies - and so is the additional pay that goes with them. Mr Rishton's variable pay depended on cash flow, earnings per share and share price targets; he received no bonus in 2014 and Rolls-Royce's 2014 executive share awards are likely to end up worthless, too. Maybe the targets will be recalibrated for Mr East. We won't know the full details until the 2015 annual report is published.

Rolls-Royce sidestepped another cost by recruiting internally. Companies often hold back pay, which executives forfeit if they resign - they normally won't move unless the new company compensates them. Critics often say that buyouts prove that these sorts of retention payments don't work. The counter view is that we never hear about the ones killed off by the potential cost. We only know about the exceptions: the £2.6m that Rolls-Royce provided to "buy out" Mr Rishton; the £4.6m worth of shares that BG stumped up for Mr Lund. But Mr East had left Arm already, so this issue never arose.

Not only will he be paid significantly less as chief executive of Rolls-Royce than at Arm, he's also had to make other sacrifices. Since leaving Arm, Mr East had become a non-executive director at BT, De La Rue, Dyson, Micron Inc and Digital Capital. He's agreed to give up all but one of these to take up his new challenge.

And challenges abound. The Serious Fraud Office is investigating historic bribery allegations. There's investor pressure to exit marine and energy; criticism for missing out on building engines to power narrow body planes; and a lull until the new Trent 7000 engine comes on stream. Yet Rolls-Royce's heavy investment and long development programmes that are barriers to entry also hamper swift changes of direction. The order book's bulging but so is the delivery backlog. The management works through a fog of opaque accounting; both need simplifying.

Mr East is staking his own reputation in a bid to restore Rolls-Royce's. It will take years - turnarounds are renowned for taking longer than expected. Since Mr East's appointment was announced, Rolls-Royce's market value has dropped by £9bn. His pay might be quoted in millions, but if he can restore Rolls-Royce's fortunes, he could be worth every penny.