High spirits
So well done to Diageo (DGE) for topping this year’s league table. This is based on 47 indicators designed to be a barometer of board behaviour and effectiveness. Diageo scores relatively well on gender diversity. Four of its 10 non-executive directors and five of its 13 senior executives are women. It scores particularly highly in stakeholder relations, which includes corporate and social responsibility. And on what the report calls “audit and risk/external accountability”, which counts for half the weighting but where the indicators boil down to having a decent number of non-executives on the audit committee, changing their auditors from time to time and not paying them too much.
Curiously, only three of the 47 indicators are linked to company performance (the proportion of shares in chief executive pay, the link to total shareholder return and return on equity). On two other indicators, low executive pay and low pay as a proportion to market value, Diageo ticks the right boxes too. Ivan Menezes, Diageo’s chief executive since July 2013, was paid £3.4m last year, relatively low compared with other FTSE 100 chief executives, and a modest proportion of £60bn-plus, which is what the market says Diageo is worth.
Strange brew
And at this point we have to slam on the brakes. The reason for Diageo’s low pay/market value ratio was because Mr Menezes’s long-term incentive plan (LTIP) failed to satisfy its performance conditions.
What were these performance conditions? There were three, covering the period from September 2014 to September 2017. The target was to grow net sales by 4.0 per cent a year; but they grew by just 2.3 per cent. And to improve the operating margin by 125 basis points; but only 80 basis points was achieved. Competition is tough. How about the share price? It flatlined for almost two years, but since June 2016 has gone up by over a third. The dividend yield is about 3 per cent too. High hopes then for the third performance condition: total shareholder return. This ranked Diageo’s share price with dividends reinvested against 16 competitors in the global consumer defensive sector. The outcome? Diageo came 16th.
In fact, last year Mr Menezes did receive some performance-related pay – as an annual bonus – but it was paid in cash. This is unusual. Many companies these days require some of the bonus, typically half, to be awarded in shares and held back for a year or two. According to Lord Davies of Abersoch, the former chief executive of Standard Chartered, who now chairs Diageo’s remuneration committee, one reason for not applying this to Mr Menezes is that he is now required to hold at least five times his salary in Diageo shares. His salary is £1.2m, so that equates to £6m-worth of shares. What’s more, until this shareholding requirement is met, executives are no longer permitted to sell more than half of any shares that vest.
This sounds sensible. But by the way, how many Diageo shares has Mr Menezes already accumulated? Answer: £20m-worth, or 17 times his salary. Which, you might be forgiven for thinking, renders Lord Davies’ arguments somewhat redundant.
And in case you are wondering how Mr Menezes has acquired so many shares, you need to look only at this year’s share award. Double his salary perhaps? No, a whacking five times. This is not obvious because, for some reason best known to the directors, Diageo awards both shares and market-based share options. The share award was worth 375 per cent of his salary and the share options had a face value worth the same. Somewhat arbitrarily, Diageo argues that three share options are worth one share, so (375 per cent + 375 per cent/3) = 500 per cent. Oh, and by the way his salary went up by 18 per cent in the year to June 2017 as well, cranking up the size of the share awards with it. Except for one thing: that 18 per cent is in sterling terms, but Mr Menezes is paid in dollars, and in dollar terms his salary increased by just 2 per cent. The difference is due to the devaluation of the pound caused by Brexit.
At this point, Lord Davies would no doubt point to what he terms in the annual report the “level of stretch in the long-term incentive plan” (translation: tough performance conditions). And that’s a fair point: the performance conditions have failed to trigger the options in each of the past three years. As for the shares, they restricted the payout to just one-third in both 2015 and 2016, and to zero in 2017. But you can look at this in two ways. Tough performance conditions, perhaps. Or was it simply because Diageo underperformed? If the latter, the IOD might wish to review its methodology. By giving credit for low executive pay, the IOD risks effectively rewarding a lack of success.
Options lottery
But this begs another question. Why on earth is a mature company in a sector that is supposed to be defensive paying in share options? These are normally associated with growth companies that pay no dividends and have volatile share prices. Mr Menezes’s predecessor hit pay dirt in 2012 (netting £5m of windfall gains) and 2013 (£7.8m) as stock markets recovered from the depths of three years earlier, when his options and share awards had been granted. One reason that other companies dropped share options was their volatility – options are geared to share price rises (and worth little if share prices stay stable). More tellingly, the outcome hardly relies on the input of the executive.
At Diageo, things appear to be looking up. Brokers are forecasting underlying earnings increases of getting on for 10 per cent a year, and this prospect of growth has boosted its share price further by pushing up the forecast price/earnings ratio. But these are forecasts in sterling, and most of Diageo’s earnings come from abroad – a constant-currency comparison would paint a different picture. If the performance conditions trigger the option, Mr Menezes will have to pay the equivalent of £21.13 per share (the options are actually for ADRs, but let’s not complicate things further). At the time of writing, the market has already pushed his 2017 options into the money to the tune of about £1m. A market setback (or a recovery in the pound) and all this notional gain could be wiped out, regardless of Mr Menezes’s performance. This hardly seems a credible way of rewarding him fairly.
Buyback effectiveness
So maybe real organic growth is hard to come by? Profitable investment opportunities seem limited, for Diageo has said it aims to buy back up to £1.5bn of its shares by the end of March 2018. About a third of this has been spent since September (another factor currently supporting the current share price). But instead of following good practice, as exemplified by Lord Wolfson at Next, of having clear criteria to determine when it makes sense to buy back shares and when it would benefit shareholders to pay dividends instead, Diageo has announced that Morgan Stanley “will make its trading decisions independently of, and uninfluenced by, the company”. In other words, the directors have ducked out. Whether or not the buybacks will enhance shareholder value as much as they might have done will remain a moot point, but in the meantime Mr Olisa might wish to consider buyback policies as another indicator of board effectiveness.
Could do better
Which gets us back to the Good Governance Report. From the investor perspective, controls are vital, as shareholders in companies caught up in the diesel-gate and horse meat scandals found to their cost. But until things go wrong, how can we be sure that internal controls are effective?
Since the financial crisis, companies have had to identify the potential risks that they face, what their impact would be if the worst happened, and what the company is doing to prevent this. Diageo, for example, identifies risks under 10 headings. The first is changes in tax on alcohol and “failure to address perceived growth in anti-alcohol sentiment”. The list includes the threat of disruptive competition, reputational risks, cyber threats and poorly managed acquisitions among a host of others. So far, the indicators chosen by the Good Governance Report hardly cover risk. They relate more to audit. Nor do they really indicate whether directors are effective. What they measure is whether boards have the necessary structures in place to make it more likely that they will be effective. That’s a big difference.
The other main responsibility of directors in any company is the strategic direction. Investors expect this to result in growth and wealth creation. There are a number of ways of measuring the quality of companies, some often described by Algy Hall in his Investors Chronicle column. A favourite is the Piotroski F-Score. By looking at nine measures covering profitability trends – borrowing, capital raising and operating efficiency – the F-score is believed not just to review the past but also to flag potential future success.
So far, the indicators used for the Good Governance Report have been confined to only some aspects of control. As such, they are one sided. Running a company responsibly is of course paramount, but controls add to costs and directors have other responsibilities as well. Their effectiveness depends on ensuring not only that risks are anticipated and managed efficiently, but also that their chosen strategy generates wealth – and generates it ethically. To have traction, the report could do with indicators for the quality of these. The good news is that it is still evolving. Maybe next year it will embrace other measures of directors’ effectiveness as well.
