Welcome to Guerdon Associates’ October newsletter. This month's highlights include an explanation why your company’s LTI plan is worth a lot less than it was; and we follow this up with a checklist on how to optimise investor communications for successful non binding votes on remuneration. We conclude with the latest on executive and director remuneration disclosure updates available on the GuerdonData™ on line database.

So You Thought Your Company Was A Generous Payer

New Equity Valuation Methods May Cause a Rethink

What You Thought You Paid

Over time boards and executives have become familiar with thinking of incentive pay as a certain proportion of fixed pay. We know, for instance, that in many large companies, board directors believe that 40% of fixed pay is an appropriate level of long term incentive for certain executive positions.

Why We Need to Rethink our Approach

Along with all the other new things directors have to cope with under CLERP 9, are adjustments to these familiar benchmark standards. The 40% that directors have become used to is not really 40%. It is probably not even 20%. It may be as low as 10% to 15%. Why?

Prior to June 30 last year the most common valuation method for share rights and options was the Black Scholes method. For various reasons too complex to go into here it tended to over value options and share rights. However, the move to new accounting standards that expense share rights and options provided impetus to hone up the valuation methodology. The result is a more valid measure of options and rights fair value.

While Black Scholes is still an acceptable method under the new accounting standards, most companies have discovered that the more rigorous methods also significantly reduce the valuations. These methods are generically known as lattice methods, with the binomial model being the most commonly applied. Couple this with probability assessments for performance hurdles and the valuation tumbles dramatically.

Example

The following example illustrates the effect of changing the valuation method to incorporate all the relevant inputs.

Inputs required for a Black Scholes valuation:

Share price at time of option issue: $10
Exercise price of option: $10
Term of option: 5 years
Risk free interest rate: 5.4%
Dividend yield: 0%
Volatility of share: 35%

Using traditional methodologies, these inputs produce an option value of around $4.00.

Using a binomial lattice method, the following additional variables can be taken into account:
• Vesting periods and early exercise of the option,
• Forfeiture (resignations) and
• Performance hurdles.

A minimum vesting period of 3 years coupled with an assumption that executives would be most likely to exercise when share price is 125% of exercise price would reduce the option value to $3.61.

An annual forfeiture (that is, executive turnover) rate of 10% would reduce the option price by a further 24.6% to $2.63.

A typical performance hurdle used today is to grant 50% of the options if the company reaches the 50th percentile of relative TSR performance, with 2% more vesting for each percentile increase in relative performance thereafter. The full grant is achieved if the relative TSR is at or above the 75th percentile. Incorporating this performance hurdle can further reduce the value of the option by as much as 36.7% to $1.17.

Using this more valid method, the LTI your board has previously approved has dropped in value from 40% of fixed pay to only 12%. This is probably in accord with the intuitive view of many executives.

What Now?

It may be time for the remuneration committee and management to review the LTI framework. We have a lot of ideas for how this could be done. But unfortunately we are running out of space! Look out for future newsletter issues on this subject.

Non-binding votes, remuneration reports and investor communications

The process of submitting the company’s remuneration report for a non-binding shareholder vote requires directors and their companies to develop and maintain an effective investor communications process.

To that end, we have developed a checklist for the board remuneration committee members and other directors to have their companies adapt and employ.

A) The devil you know…
While we think most directors would be knowledgeable about their major shareholders, we suggest more work may be needed to understand their issues and concerns with remuneration in general and your company’s remuneration in particular. Many, like AMP Capital for example, wear their heart on their sleeve, making it known what they want to see in remuneration reports, or what they do not want to see. But this is not always the case. For example, just last week Fidelity Investments used their 15% shareholding of US company Clear Channel Communications to express their displeasure with the company’s renewed severance payments contracted for executives. The first Clear Channel’s board knew of this was when votes were counted! Ensure your company’s investor relations staff seek major investors out and listen to them. Directly address their issues. If what you are proposing is different from their preferred approach, take the time to explain how your approach is better suited to where the company is at the current time, and where it wants to move to. And lastly, don't forget to ask them how they intend to vote!

B) Coordinated effort
With the increased external spotlight on executive pay, remuneration issues are no longer the sole preserve of one company department. Investor relations are being asked increasingly complex remuneration questions from interested shareholders and the media. Corporate finance is being asked questions about the link between pay and performance, and how targets are set. Corporate accounting is being asked about share options and share rights expensing. Corporate treasury is being asked about executive ownership levels and share transactions. Legal counsel has been faced with significant CLERP 9, ASX and other legal and regulatory requirements. Human resources are asked about the comparison group for assessing market levels of pay. As a result, the design and communications process should incorporate input from throughout the organisation. Integration among internal stakeholders can be as challenging as working with external advisers. Ensure your board’s point person is an able integrator and coordinator.

C) Frequent and ongoing communications with shareholders.
Companies that receive high marks for governance policies often incorporate frequent and ongoing investor dialogue into their communications strategy. While Corporations Law and other related regulations limit a company’s ability to communicate specific information and conduct limited solicitation efforts, communication channels should remain active and open throughout the year. Investor discussions can be used to till the soil on key remuneration issues. Feedback on emerging trends or broad policy changes can be received throughout the year. Do not limit communications to the 2 months surrounding the AGM.

D) Be proactive
While many investors have now developed standard policy guidelines for addressing remuneration issues, these policies are simply guidelines. By being proactive companies can specifically address issues, and avoid adverse reactions from surprised shareholders. Contact can clarify inaccurate or misinterpreted information, and directly address compensation concerns.

E) Effective remuneration reports
While it is early days under CLERP 9, we have observed that there is still a long way to go to ensure remuneration reports are an effective communications instrument. Avoid boiler plate reports. If you have to repeat the words “attract, retain and motivate”, specifically address how your remuneration policy does this, and how it does it more effectively than others who have the same mantra. This may mean wresting the report’s initial preparation away from the legal department! Let them do the review work, and not the communications work. Be forthcoming with information. Highlight shareholder friendly provisions of remuneration practices. Accentuate strong governance provisions. Highlight the pay for performance relationship and how it has worked. Include a graph for better illustration. Be open. Investors will develop more trust in you, and as trust increases, so does the premium component of your share price for lower risk!

F) Incorporate company specific issues in remuneration policy rationales
Remuneration is not a one size fits all issue. Most investors will react on a case by case basis, providing information is full and complete. So companies should tailor their equity and other remuneration plans to the circumstances unique to their situation. And all companies do have a unique situation. So if management or your advisers come to you with a boiler plate draft remuneration report, ask the question on how it specifically relates to the company’s current situation and why this is not described in the report.

G) Do not wait until it is too late
After the rush to release final results, remuneration committees may be tempted to defer planning for the next report. Deliver feedback to management on the response to the last report while it is fresh. Insist on change and improvement to better relate remuneration to performance. Ask for a plan, and re-start that dialogue with investors.

Latest GuerdonData™ Updates

Remuneration reports have been coming out thick and fast with the peak of the reporting season.

But our GuerdonData™ technology, aided by our very smart and hard working analysts, have maintained a data analysis, input and quality control process to ensure we continue to meet our standards of data updates within 48 hours of disclosure. This month’s updates to GuerdonData™ include disclosures from the following 59 companies: ABC Learning Centres Limited, Adelaide Bank Limited, Adsteam Marine Limited, ALE Property Group, Amalgamated Holdings Limited, Austal Limited, Australian Gas Light Company (The), Baycorp Advantage Limited, Boral Limited, Bradken Limited, Circadian Technologies Limited, CFS Gandel Retail Trust, Cochlear Limited, Coffey International Limited, Commonwealth Bank Of Australia, Commonwealth Property Office Fund, Crane Group Limited, CSL Limited, Flight Centre Limited, Foster's Group Limited, Futuris Corporation Limited, Globe International Limited, Gwa International Limited, Hardman Resources Limited, Hills Industries Limited, Independence Group NL, Infomedia Limited, Investa Property Group, JB Hi-Fi Limited, Kingsgate Consolidated Limited, Kresta Holdings Limited, Lynas Corporation Limited, Macquarie Infrastructure Group, Maxitrans Industries Limited, Mayne Group Limited, Mosaic Oil NL, Multiplex Group, Orbital Corporation Limited, Origin Energy Limited, Pacific Brands Limited, Paladin Resources Limited, Paperlinx Limited, Perseverance Corporation Limited, Qantas Airways Limited, SAI Global Limited, Skilled Group Limited, Smorgon Steel Group Limited, Suncorp-Metway Limited, Sunland Group Limited, Super Cheap Auto Group Limited, Telecom Corporation Of New Zealand Limited, Telstra Corporation Limited, Toll Holdings Limited, Transurban Group, Valad Property Group, Ventracor Limited, Vision Systems Limited, Wattyl Limited.

Executive and director remuneration data from all ASX 300 companies on GuerdonData™ is available to any subscriber. More information on GuerdonData™ please visit our website.

View our demo of how easily you can find out director and executive pay information by selecting the More button below.

Guerdon Associates in the News

Gettler, L 2005, ‘Directors flat to board but pay rolls in', The Australian, 9 September, p B4.

Weir, M 2005, ’Fat bonuses help bosses reap 40pc pay increases’, The Western Australian, 16 September, p 6.

Ooi, T 2005, ‘Execs zoom past workers in earning race’, The Australian, 16 September, p 21.

'Money grows at top of tree', The Mecury Hobart, 16 September, p 44.

Gettler,H 2005, 'Booming results swell the pay-offs for chief executives', The Age, 16 September, p 3.

'Australia's CEO Salary Growth Outstrips Employee's Pay Growth', Asia Pulse Full, 16 September.

Swift, B 2005, 'Worker, CEO pay divide widens 10 times', The Advertiser, 17 September, p 21.

'CEO's salaries soaring', Sunday Times Perth, 18 September, p 61.

Disclaimer

The information, analysis and opinion in this e-mail and attachments are intended to be for informational purposes only. Analyses are based on information taken from public documents or private surveys, and we do not represent to its accuracy. Guerdon Associates assumes no liability for the use or interpretation of information contained herein. This publication is provided "as is" without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranties of marketability, fitness for a particular purpose, or non-infringement of third party rights.