Street Talk: CEO Paychecks: How They Are Determined

In the September 2006 issue I wrote about the ticklish issue of CEO pay and how shareholder groups, especially the powerful pension and other institutional groups, are growing sick and tired of CEO overpayment and underperformance.

Brian O'Connell

I'm revisiting the subject after news last month that Home Depot paid outgoing chief executive officer Robert L. Nardelli $210 million in cash and stock options on his way out the door. Included in that little gift basket was a $20 million severance package and retirement benefits valued at $32 million. Yet Nardelli had presided over a period where Home Depot had lost significant ground to its chief competitor Lowe's, and had seen its stock price languish. When Nardelli took the reins at Home Depot, on December 5, 2000, shares of the company closed at $40.75. On his last day on the job, six years later, the stock closed at $40.16. During the same time period, Lowe's saw its stock price rise 210%.

Now we're seeing almost similar situations being played out in the life sciences world, where executives are gobbling up big paychecks while leaving meager scraps for company investors.

All Pay, No Hay

Don't get me wrong. A good CEO can make all the difference in the world on a company's stock price. The problem is that performance goes both ways. In last September's column, I pointed to a well-received University of Florida study that showed how a benchmark group of securities analysts usually predict a firm's future performance based not only on its track record but also on how favorably the analysts view the company, which is influenced largely by how charismatic they consider its chief executive officer.

As I said, negative perceptions of a CEO are especially dominant in the life sciences field. If you read the column, you might remember how former long-time Pfizer CEO Henry "Hank" McKinnell left the company significantly poorer straight across the board.

McKinnell's retirement package would make even the most jaded Wall Street investment banker blush—he was given the option of a lump sum of $83 million or an annual pension of $6.5 million. Company shareholders had to wonder if the world had turned upside down. After all, McKinnell's tenure was a Chicago Cubs-like period of underachievement where Pfizer's stock fell 40%. As one trader said of the McKinnell golden parachute, "It's the equivalent of paying a .220 hitter $10 million a year."

MCKINNELL AND PFIZER ARE HARDLY ALONE

Over at Merck, the company's top executives had structured a noble plan to ensure that executive pay would be tied to the company's stock performance. Good idea, bad execution.

In the past five years, the company has lost roughly 40% in stock value. Still, Merck execs made out okay. In fact, former CEO Raymond Gilmartin earned $54 million during that five-year period, including almost $38 million in cashout payments from company stock options. When he stepped down as CEO, Gilmartin received a generous pension of $784,000 annually. What's more, he continued to receive those generous stock options, although somebody needs to explain to me why a former CEO deserves even one stock option.

The question then is: how did Gilmartin earn all of this dough when the company had supposedly crafted a system where executive pay was tied to company stock performance? Merck said in a statement in 2006, after Gilmartin had left the company:

"(We) believe that executive officer compensation for 2005 was consistent with the level of accomplishment and appropriately reflects company performance." But the metrics used to jump to that conclusion have not been released by Merck, so investors have no idea what formula is being used to calculate executive pay-for-performance.

LOWER TARGETS

Still, there is the school of thought that if you are a CEO burdened with the pressure of taking a biopharm company airborne, then you deserve all of the milk and honey you can get. Right now, on average, CEO compensation (as defined by salary and bonuses) isn't as much as you might think, about $600,000.

And for every McKinnell there is a Kevin Sharer, CEO of Amgen, who received an annual bonus package of about $5 million—that's $1.5 million short of McKinnell's annual pension. According to a 2005 BioWorld Survey, there are 27 life sciences executives whose total compensation (salary, bonus, stock options, and other pay) exceeded $2 million in 2004. That year only saw 15 CEOs take home $1 million or more.

Of course, when you add those stock options, CEO pay goes up significantly. According to the BioWorld survey, life sciences CEOs garnered an average of 4.56% of their companies' stock, including a select group of 12 CEOs who enjoy between 15% and 69% of their companies' shares.

That's not so different from other industries like technology or telecommunications. But what makes the biopharm industry unique is that a "pay-for-performance" culture is embedded in the industry's DNA. The pay-for-hay mentality is always going to be more prominent in an industry like life sciences that offers a host of younger companies in an endless search for profitability.

That just makes sense in an industry that has longer production cycle times than other markets. Hence the need for savvy CEOs who can guide a new drug through the pipeline in timely and profitable fashion. And thus the reason for CEO pay packages that offer stock options and other non cash-based incentives to spur CEOs to greater heights. Biopharm boards are also taking more direct links to the pay-for-performance approach, with pay tied to performance benchmarks like clinical trial completions and patent filings.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, 267.880.3144 brian.oco@verizon.net