Tuesday, February 20, 2007

Applied Materials: Connect-the-Dots of CEO Splinter's Pay Package

As an inducement to jump ship, it is now standard for a company looking for new talent to indemnify their just recruited CEO with guaranteed performance compensation for the first twelve-months of service. Never mind any probationary period, for this guaranteed portion of the CEO’s compensation package is grounded in expected performance, rather than upon their actual performance.

CEOs inveigle, too, the goodwill of their victorious ‘March on Rome’ with the payment of an additional sign-on bonus (cash & restricted stock), ‘no-reduction’ in base pay and ‘separation’ clauses, and one added fillip—a final paragraph—or two—detailing how the employer will reimburse the hire for any legal costs.

As for the consequences of failure, forget about it. How often is an executive’s contract voided ‘for cause?’ Unless they’ve been caught in bed—videotaped or with photographs—spending stockholders’ monies on hooker(s), discharge from the so-named company is usually accompanied by the “personal health/spend more time with family” rhetorical release(s).

Proponents of golden glove contracts for CEOs postulate (a) the new hire must receive recompense to mitigate the loss of substantial compensation forfeited by leaving their former employer and/or (b) a qualified candidate represents an investment in ‘human capital’ to the company, such as leadership/knowledge skillsets and social/professional connections, that will ultimately reward all stakeholders with exponential growth—incremental profits—and (predictably) a higher market valuation.

Unfortunately, no academics—to date—can show a casual relationship that higher CEO pay equals superior—to the previous baseline—growth (in terms of financial and stock price performance).

A new twist is the “failure effect.” A recent Booz Allen study found that more than one-third of CEO turnover was performance related. That is, a CEO is vulnerable to ouster if his stock price has lagged behind the S&P 500 by an average of 2 percent since he took the top job. Ergo, a new boss can no longer promulgate his vision of change through new investments in R&D [with a future value payday years down the road].

Granted, it is difficult for a CEO to walk the tightrope, balancing the short-term pressures of Street sales/EPS expectations with what is truly in the long-term best interest of the company. Meeting quarter-quarter guidance through sleight of hand—delaying R&D investment, cutting headcount, or reducing reserves—will only work for so long.

This argument that premium compensation packages are now necessitated by the probability risks of being a CEO ‘has-been’ statistic is flawed in one constituent element: accountability. Chief executives ought to be paid for shepherding their company to organic growth, not because of the risk associated with failing to restart the company. If that means premium pay—in the form of long-term stock options (at staggered higher strike prices than current stock price)—so be it (but not grants at one-cent per share, etc.)

According to its recent proxy filing with the Securities and Exchange Commission last Wednesday, semiconductor equipment maker Applied Materials Inc.'s (AMAT-$19.02) CEO Michael R. Splinter made about $11.4 million (cash/bonus/long-term incentive comp) in 2006. That in of itself is of little interest to us, but it is the connecting of all the dots—in this and Proxy Statements in recent years past—that reveal the hidden costs associated with hiring a chief executive officer.

As his come-on to join AMAT as President and Chief Executive Officer, on April 21, 2003, the Company entered into an agreement with Michael R. Splinter that provided for the following in Mr. Splinter’s first year of employment:

  1. a base salary of $900,000;
  2. a target bonus of 175% of the base salary based on the achievement of certain performance measures (actual cash bonus paid was $5.0 million, or about 555.6% of his 2004 base salary); and,
  3. stock option to purchase 1,200,000 shares (at an exercise price of $15.72 per share);
  4. the 10Q Detective unearthed, too, his “Make Whole” compensation rider. To wit:

    "[The] Company recognizes that you would be foregoing a substantial amount of unvested "in the money" stock option value by leaving your present employer to join Applied Materials. This amount is estimated to be approximately $3,000,000. In an effort to address this issue we will provide you with a Restricted Stock Grant of 300,000 shares of the Company's Common Stock vesting 50% on October 1, 2003 and 50% on October 1, 2004."

Actually, this restricted grant on May 20, 2003, was worth an estimated $4.2 Million (based on the price of AMAT’s stock on that date ($13.76), less the one cent per share Mr. Splinter paid for the shares). Unless we are mistaken the $1.2 million difference between $3.0 million and $4.2 million is worth much more than an ‘approximate.’

“Finish each day and be done with it. You have done what you could. Some blunders and absurdities no doubt crept in, forget them as soon as you can. Tomorrow is a new day, you shall begin it well and serenely...” – Ralph Waldo Emerson (American Poet & Essayist, 1803 – 1882)

If Applied had terminated Mr. Splinter’s employment without cause on in fiscal 2006, Mr. Splinter would have received the following severance benefits under his employment agreement:

  1. a lump sum payment of $2,362,500, consisting of a combination of his annual base salary for fiscal 2006 of $945,000 and 100% of his target bonus for fiscal 2006 of $1,417,500, and
  2. acceleration of the vesting of stock options to purchase an aggregate of 1,101,250 shares of common stock. Based on the difference between the weighted average exercise price of the options and $17.26, the closing price of AMAT’s common stock on October 27, 2006, the net value of these options would be $462,000.

Another lesser-known—but common—perquisite granted to new hires joining the ranks of top management, too, is a ‘home sales assistance’ benefit—which guarantees that the executives will be insulated from the vagaries of real estate valuation cycles.

Pursuant to the terms of his employment contract, Splinter, 56, a twenty-year veteran of Intel, also had written into his contract certain relocation benefits. Specifically, Splinter made the required efforts [undefined] to sell his former residence but could not secure an outside buyer within the 60-day period specified in AMAT’s relocation policy. After this period, Applied purchased Mr. Splinter’s residence for $1,775,000 in November 2005. Four months later, AMAT sold Mr. Splinter’s former residence for $1.5 million and retained all proceeds from the transaction (including the capital loss, too).

What do real estate prices and the performance of semiconductor stocks have in common? Granted, real estate markets exhibit larger amplitude cycles (of 10 – 20 years), but historically, both markets exhibit a cyclic behavior profile, facing predictable booms and busts (inventory gluts) in demand for their respective products.

We bet that investors who paid $25.00 per share for AMAT stock back in November 2003 wish that they could invoke a ‘sales assistance’ clause, too.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

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