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The Flap Over HMOlHealthcare CEO Pay Premiums· Posted on December 11, 1998
Several days ago, we released on our subscriber-only website a CEO Pay Simulator. a piece of software that compares a given CEO's pay package to those of 1,568 CEOs and that produces competitive levels of pay, after taking account of a company's size, its shareholder return performance and the type of industry in which it is engaged.
Yesterday, we were talking with Jim Finkle, a reporter for the Bloomberg News Service, and during our- discussion, we· mentioned that- when it comes to high CE0 pay, the· CEOs in the HMO/Healthcare industry seem to be second to none. That sent all sorts of alarm bells ringing, because, barring a flat EEG tracing, everyone is well aware that healthcare costs are a big item in Washington, almost as big as Monica Lewinsky (no pun intended) .
In studying Total Direct Compensation (TDC-the sum of base salary for 1997: annual bonus earned for 1997 performance; the estimated present value of stock option grants made in 1997, using the Black-Scholes Option Pricing Model; the value at grant during 1997 of shares of restricted stock; payouts made during ·1997 under other 'long-term incentive plans; and, as defined by the SEC, 1997 Other Annual Compensation and 1997 All Other Compensation), we found that we could explain:
35% of the variation in TDC if we knew the size of the company (size being measured here by giving equal weight to 1997 revenues, 1997 year end invested capital [long-term debt plus shareholders' equity] and 1997 total employees)
37% of the variation in TDC if we knew both the size of the company and its total shareholder return performance (i.e., stock price appreciation and reinvested dividends in three different time windows--a three-year time window, a two-year time window and a one-year time window, all ending with the end of the company's 1997 fiscal year)
45% of the variation in IDC if we knew the size of the company, its total shareholder return performance and the type of industry in which it is engaged.
In our study, we assigned each of the 1,568 companies to one of many different industry categories. Of these many categories, 31 contained sufficient numbers of cases so as' to pennit their use in a multiple regression analysis that took account of company size, company performance and type of industry.
Our study showed that seven of the 31 industries paid significantly less than other industries. after taking account of their size and performance levels. And four other industries paid significantly more. The probability of any of these industry findings being fluky was less than one-chance-in-a-hundred.
Turning first to our low-payers. For the same amount of company size and company performance:
CEOs in the food retailing industry receive 63% less TDC
CEOs in the power utility industry receive 51 % less TDC
CEOs in the air transport industry receive 45% less TDC
CEOs in the restaurant industry receive 42% less TDC
CEOs in the transportation industry, excluding air transport companies, receive 33% less TDC
CEOs in the wholesaling industry receive 26% less TDC
CEOs in the retailing industry, other than food retailing companies, receive 20% less TDC.
Now for the high rollers: For the same amount of company size and company performance:
CEOs in the computer and software industry receive 39% more TDC
CEOs in the pharmaceutical/biotech industry also receive 39% more TDC
CEOs in the diversified finance industry (mainly, Wall Street firms) receive 61 % moreTDC
And now for our big winner.........CEOs in the HMO/Healthcare-industry-receive-66%-more TDC.
Not all CEOs in the HM/lHealthcare industry earn 66% more than their counterparts in other industries of course.
There are actually some good buys in that industry. But there also are a 101 of non-good buys, as evidenced by the 66% pay premium.
A cursory analysis of some of the really high-rollers in the HMO/Healthcare industry reveals a disturbing pattern:
Total shareholder return performance in the three time ·windows tested has been quite poor, reflecting the recent trashing of HMO stocks
The company may have responded to the poor performance by cutting the CEO's bonus, not infrequently all the way to zero
But then comes the consolation prize: A mega-option grant.
For a case in point, let's look at Malik M. Hasan. M.D., the former Chairman of Woodland Hills, California (near Los Angeles)-headquarted Foundation Health Systems, a company with $7.1 billion of revenues in 1997. (Dr. Hasan, though no longer CEO, continues in the role of Chairman of the Board.)
During the year ending December 31, 1996, FHS generated a shareholder return of a rninus.,.23%. This compares to a return of plus-22.9% for the S&P 500 Index and a return of a rninus-9.8% for the 16 companies comprising the S&P Midcap Health Services Index. So, FHS performed poorly vis a vis companies generally. And it also performed poorly even when compared to the other poor-performing companies in its own industry. For this poor performance, Dr. Hasan received a niggardly salary increase of only 3% and no bonus at alL But he did receive an option grant that came in three tranches:
An option on 100,000 shares carrying a strike price (i.e., the price that must be paid to exercise the option) of $35.25 per share and a term of 10 years. On the date of grant, the market price per share was the same $35.25 per share
An option on 100,000 shares carrying a strike price of $40.54 per share and a term of 10 years. The strike price was 115% of the $35.25 market price on the date of grant
An option on 100,000 shares carrying a strike price of $44.06 per share and a term of 10 years. The strike price was 125% of the $35.25 market price on the date of grant.
We estimate the present value at grant of these three option tranches to be $3.9 million.
In total, Dr. Hasan's pay package for 1996 was worth $5.7 million.
Now let's roll the cameras forward by one year-to the end of 1997. During the 12-month period ending December 31, 1997, FHS generated a total shareholder return of a minus-l0.l %. During the same one-year period, the return on the S&P 500 Index was plus-33.4% .. But the return on the S&P Midcap Health Services Index was minus-9.1 %. In this case, though FHS lagged the S&P 500 Index badly, it came out about even with its peers in the healthcare industry.
Apparently, reducing your negative return from a minus-23% to a minus-10.1 % is cause for intense jubilation in the Hills of Woodland. It's not that Dr. Hasan scored big in base salary, for his salary increase in 1997 amounted to only 4.9%. And it's not that he scored big in bonus, for his bonus,'for' the- second year in a row, was 'zero. But- now for- the-fun part. During 1997, he received an option on 850,000 shares carrying a strike price of $32.50 per share and a ten-year term. Note here that, in number of shares, this option was almost three times the size of his aggregate option grants one year earlier. Moreover, the gutsiness displayed one year earlier, when Dr. Hasan took one-third of his option on a 15% out-of-the-money basis and another third on a 25% out-of-the-money basis, was totally absent. Perhaps it was totally absent because, when the 850,000-share option was granted on September 4, 1997, all three of his option grants made in February 1996 were underwater.
We estimated that the present value of this new 850,000-share grant was $11.5 million, a figure that was 2.9 times the present value of the grants made to Dr. Hasan one year earlier.
That $11.5 million figure, in turn, caused Dr. Hasan's TDC to rise to $12.5 million, a figure that after calibrating for company size and company performance (but before adding in the HMO/Healthcare 66% pay premium) was 3.1 times higher than the competitive norm.
We have noted in past studies that, in general, there are two classes of CEOs who receive the very largest option grants. In the first category are CEOs with superb past performance, for example, a CEO like Sanford Weill of Citigroup. But in the second category are CEOs with horrible past performance. Paradoxically, these CEOs generally receive much larger grants than other CEOs with normal performance.
In effect, if you have the performance numbers, you get rewarded with a big option grant. But if you come up short, you persuade your board that big option grants are once again required "to hold on to our good people" and "to motivate them in difficult circumstances". So if you get a huge option grant for performing hugely and a huge option grant for screwing up, the circumstances under which you won't get a huge option grant are rather rare.
Dr. Hasan last received a cash bonus for his performance during 1995, when his company's total shareholder return actually went into the plus zone (a plus-5.8%, compared to a plus-30.9% for the S&P 500 Index and a plus-20.0% for the S&P Midcap Health Services Index). The bonus was $800.000.
Although he didn't receive any cash bonus for his performance during 1997, it wouldn't take much of an increase in his company's stock price to make his 850,000-share option worth $800,000. The increase would amount to only $0.94 per share, a mere 2.9% increase in share price (compared to the price "prevailing on the date the option was granted).
Of course, that isn't what happened during 1998. As this article was being written on December 11,1998, FHS' stock price closed at $11.6875 per share. With strike prices for his1997 and 1998 option grants ranging from a low of $32.50 per share to $44.06 per share, one needs a stronger adjective than "underwater" to describe the current status of his option grants. Still, he has until the year 2006-2007 time period to bring those grants above water. And that's a long time away.
We would love to have included with this article a complete line-by-line database covering each company in the HMOlHealthcare industry and-its pay- prernium status. But under our license agreement with Standard & Poors Compustat, which provided the raw data for our analyses, we are not permitted to do so. Nonetheless, subscribers can replicate our analytical findings by downloading and then inputting to our CEO Pay Simulator. This piece of software may be found in our subscriber-only website under the article title, "The Crystal Report CEO Pay Simulator".
Several days ago, we released on our subscriber-only website a CEO Pay Simulator. a piece of software that compares a given CEO's pay package to those of 1,568 CEOs and that produces competitive levels of pay, after taking account of a company's size, its shareholder return performance and the type of industry in which it is engaged.
Yesterday, we were talking with Jim Finkle, a reporter for the Bloomberg News Service, and during our- discussion, we· mentioned that- when it comes to high CE0 pay, the· CEOs in the HMO/Healthcare industry seem to be second to none. That sent all sorts of alarm bells ringing, because, barring a flat EEG tracing, everyone is well aware that healthcare costs are a big item in Washington, almost as big as Monica Lewinsky (no pun intended) .
In studying Total Direct Compensation (TDC-the sum of base salary for 1997: annual bonus earned for 1997 performance; the estimated present value of stock option grants made in 1997, using the Black-Scholes Option Pricing Model; the value at grant during 1997 of shares of restricted stock; payouts made during ·1997 under other 'long-term incentive plans; and, as defined by the SEC, 1997 Other Annual Compensation and 1997 All Other Compensation), we found that we could explain:
35% of the variation in TDC if we knew the size of the company (size being measured here by giving equal weight to 1997 revenues, 1997 year end invested capital [long-term debt plus shareholders' equity] and 1997 total employees)
37% of the variation in TDC if we knew both the size of the company and its total shareholder return performance (i.e., stock price appreciation and reinvested dividends in three different time windows--a three-year time window, a two-year time window and a one-year time window, all ending with the end of the company's 1997 fiscal year)
45% of the variation in IDC if we knew the size of the company, its total shareholder return performance and the type of industry in which it is engaged.
In our study, we assigned each of the 1,568 companies to one of many different industry categories. Of these many categories, 31 contained sufficient numbers of cases so as' to pennit their use in a multiple regression analysis that took account of company size, company performance and type of industry.
Our study showed that seven of the 31 industries paid significantly less than other industries. after taking account of their size and performance levels. And four other industries paid significantly more. The probability of any of these industry findings being fluky was less than one-chance-in-a-hundred.
Turning first to our low-payers. For the same amount of company size and company performance:
CEOs in the food retailing industry receive 63% less TDC
CEOs in the power utility industry receive 51 % less TDC
CEOs in the air transport industry receive 45% less TDC
CEOs in the restaurant industry receive 42% less TDC
CEOs in the transportation industry, excluding air transport companies, receive 33% less TDC
CEOs in the wholesaling industry receive 26% less TDC
CEOs in the retailing industry, other than food retailing companies, receive 20% less TDC.
Now for the high rollers: For the same amount of company size and company performance:
CEOs in the computer and software industry receive 39% more TDC
CEOs in the pharmaceutical/biotech industry also receive 39% more TDC
CEOs in the diversified finance industry (mainly, Wall Street firms) receive 61 % moreTDC
And now for our big winner.........CEOs in the HMO/Healthcare-industry-receive-66%-more TDC.
Not all CEOs in the HM/lHealthcare industry earn 66% more than their counterparts in other industries of course.
There are actually some good buys in that industry. But there also are a 101 of non-good buys, as evidenced by the 66% pay premium.
A cursory analysis of some of the really high-rollers in the HMO/Healthcare industry reveals a disturbing pattern:
Total shareholder return performance in the three time ·windows tested has been quite poor, reflecting the recent trashing of HMO stocks
The company may have responded to the poor performance by cutting the CEO's bonus, not infrequently all the way to zero
But then comes the consolation prize: A mega-option grant.
For a case in point, let's look at Malik M. Hasan. M.D., the former Chairman of Woodland Hills, California (near Los Angeles)-headquarted Foundation Health Systems, a company with $7.1 billion of revenues in 1997. (Dr. Hasan, though no longer CEO, continues in the role of Chairman of the Board.)
During the year ending December 31, 1996, FHS generated a shareholder return of a rninus.,.23%. This compares to a return of plus-22.9% for the S&P 500 Index and a return of a rninus-9.8% for the 16 companies comprising the S&P Midcap Health Services Index. So, FHS performed poorly vis a vis companies generally. And it also performed poorly even when compared to the other poor-performing companies in its own industry. For this poor performance, Dr. Hasan received a niggardly salary increase of only 3% and no bonus at alL But he did receive an option grant that came in three tranches:
An option on 100,000 shares carrying a strike price (i.e., the price that must be paid to exercise the option) of $35.25 per share and a term of 10 years. On the date of grant, the market price per share was the same $35.25 per share
An option on 100,000 shares carrying a strike price of $40.54 per share and a term of 10 years. The strike price was 115% of the $35.25 market price on the date of grant
An option on 100,000 shares carrying a strike price of $44.06 per share and a term of 10 years. The strike price was 125% of the $35.25 market price on the date of grant.
We estimate the present value at grant of these three option tranches to be $3.9 million.
In total, Dr. Hasan's pay package for 1996 was worth $5.7 million.
Now let's roll the cameras forward by one year-to the end of 1997. During the 12-month period ending December 31, 1997, FHS generated a total shareholder return of a minus-l0.l %. During the same one-year period, the return on the S&P 500 Index was plus-33.4% .. But the return on the S&P Midcap Health Services Index was minus-9.1 %. In this case, though FHS lagged the S&P 500 Index badly, it came out about even with its peers in the healthcare industry.
Apparently, reducing your negative return from a minus-23% to a minus-10.1 % is cause for intense jubilation in the Hills of Woodland. It's not that Dr. Hasan scored big in base salary, for his salary increase in 1997 amounted to only 4.9%. And it's not that he scored big in bonus, for his bonus,'for' the- second year in a row, was 'zero. But- now for- the-fun part. During 1997, he received an option on 850,000 shares carrying a strike price of $32.50 per share and a ten-year term. Note here that, in number of shares, this option was almost three times the size of his aggregate option grants one year earlier. Moreover, the gutsiness displayed one year earlier, when Dr. Hasan took one-third of his option on a 15% out-of-the-money basis and another third on a 25% out-of-the-money basis, was totally absent. Perhaps it was totally absent because, when the 850,000-share option was granted on September 4, 1997, all three of his option grants made in February 1996 were underwater.
We estimated that the present value of this new 850,000-share grant was $11.5 million, a figure that was 2.9 times the present value of the grants made to Dr. Hasan one year earlier.
That $11.5 million figure, in turn, caused Dr. Hasan's TDC to rise to $12.5 million, a figure that after calibrating for company size and company performance (but before adding in the HMO/Healthcare 66% pay premium) was 3.1 times higher than the competitive norm.
We have noted in past studies that, in general, there are two classes of CEOs who receive the very largest option grants. In the first category are CEOs with superb past performance, for example, a CEO like Sanford Weill of Citigroup. But in the second category are CEOs with horrible past performance. Paradoxically, these CEOs generally receive much larger grants than other CEOs with normal performance.
In effect, if you have the performance numbers, you get rewarded with a big option grant. But if you come up short, you persuade your board that big option grants are once again required "to hold on to our good people" and "to motivate them in difficult circumstances". So if you get a huge option grant for performing hugely and a huge option grant for screwing up, the circumstances under which you won't get a huge option grant are rather rare.
Dr. Hasan last received a cash bonus for his performance during 1995, when his company's total shareholder return actually went into the plus zone (a plus-5.8%, compared to a plus-30.9% for the S&P 500 Index and a plus-20.0% for the S&P Midcap Health Services Index). The bonus was $800.000.
Although he didn't receive any cash bonus for his performance during 1997, it wouldn't take much of an increase in his company's stock price to make his 850,000-share option worth $800,000. The increase would amount to only $0.94 per share, a mere 2.9% increase in share price (compared to the price "prevailing on the date the option was granted).
Of course, that isn't what happened during 1998. As this article was being written on December 11,1998, FHS' stock price closed at $11.6875 per share. With strike prices for his1997 and 1998 option grants ranging from a low of $32.50 per share to $44.06 per share, one needs a stronger adjective than "underwater" to describe the current status of his option grants. Still, he has until the year 2006-2007 time period to bring those grants above water. And that's a long time away.
We would love to have included with this article a complete line-by-line database covering each company in the HMOlHealthcare industry and-its pay- prernium status. But under our license agreement with Standard & Poors Compustat, which provided the raw data for our analyses, we are not permitted to do so. Nonetheless, subscribers can replicate our analytical findings by downloading and then inputting to our CEO Pay Simulator. This piece of software may be found in our subscriber-only website under the article title, "The Crystal Report CEO Pay Simulator".