Exxon Mobil (NYSE:XOM) is big. With an equity value of $430B it holds the second highest market cap among US listed companies. Unlike Apple (NASDAQ:AAPL), which is in first place and is rather notorious for hoarding cash, XOM returns about $30B per year to shareholders through purchasing its own shares and by paying dividends.
It also goes through another $30B in capital expenditures every year. XOM has gotten big by being the largest investor and by getting the best returns on capital amongst its peers. The company uses Return on Average Capital Employed as the performance indicator in this regard. The ratio uses net income as a numerator and sources of capital (equity, loans and notes) as denominator. The ratio can be replicated across other companies to benchmark against peers. The approximately 25% return the company has achieved is better than all others. It is also an unexpectedly high level for a company that sells commodities.
Long-term distributions to shareholders are also higher than comparable oil majors, and suggest a strong management (and board) commitment to shareholder returns over the long term. For the period graphed, it has returned more cash than all three comparable companies combined.
So, how did Exxon Mobil get so efficient at capital allocation and so focused on rewarding shareholders? I believe the answer is not in its superior project execution record (XOM recons its projects are delivered on time and on budget more frequently than those executed by its peers), its best in the industry safety record or its traditional high rate of innovation on exploration and production technology and methods. Of course these all help, but they are the result of something else.
I believe the answer is found by looking at management incentives. People respond to incentives, and Exxon has excelled in the art of aligning executive and shareholder interests in a particularly straightforward manner through its executive compensation program. Approved by the board in 2003 (to replace one from the early 90s, they do not change it often) it is not a typical program, it has several features that are unusual. It helps explain why senior managers have such long tenure with the company, over 30 years, and why the company does not need to use employment contracts to attract talent from outside. Even the company´s CEO, Mr. Tillerson is an "at will" employee.
Following is a summary of what I consider to be the key aspects:
- All executives are all under a common compensation program. This promotes a feeling of collegiality that cannot be replicated in the more typical structure where the CEO and other senior executives need to be brought in with big incentives not available to the rest of managers. This is also indicative of strong career advancement policies in place, as senior managers are promoted from within and not hired from outside. At XOM the compensation structure is the same for all executives. The overall compensation varies with degree of responsibility, of course, but everyone is on the same boat.
- According to the latest proxy statement, Exxon has not awarded a stock option to any employee, CEO included, since 2001. From a shareholder perspective this is great. Initially it can look like option grants are a good thing for shareholders, because both shareholders and option holders benefit from an increase in price. However, options have some important drawbacks. First, Because they are expensed on award date, they tend to have short-term expiration (three years or less), which is shorter than typical stock awards with sale restrictions. Second, the payoff is not symmetrical. To a shareholder, a 50% drop or increase in price subtracts or adds 50% in wealth. To an option holder, the change is skewed. Especially with at-the-money or out-of-the-money options (the most common kind granted due to intended incentive), the maximum loss is the option value itself, while the gain is the difference between the stock price and the strike price of the option at expiration, times the number of shares subject to the option. The resulting incentive from the shorter tenor and skewed payoff is to maximize the stock price as fast as possible. This is not the best incentive and tends to lead to a reduction in earnings quality and sustainability (Remember, US GAAP allows management to express a lot of items using its own estimates). Options also cause divergence in interest derives from the fact that option holders are not rewarded by things like dividend payments; they are actually hurt by dividends, because every $1 that is not retained or reinvested is not able to increase future earnings and stock price. Shareholders, on the other hand are not penalized by receiving dividends. Options are generally not adjusted to account for increased capital base, meaning earnings and thus price can be driven higher by retaining cash.
- Bonuses are set to a certain level, which represents a relatively low percentage of total compensation, and then changes to that level track changes in total shareholder return year over year. This is common to most compensation programs. What is not common about the bonus is the deferral payment threshold to receive half the bonus. The board sets an increasing threshold of EPS (currently $6.15 about $3 five years ago) that the corporation needs to achieve before the second half of the bonus is paid. This reinforces the importance of earnings sustainability.
- Recoupment of bonus is authorized by the board. This is definitely not usual practice. If, for example, earnings need to be restated, the company can call back bonuses already earned on the overstated earnings. The message is clear: the board will not tolerate aggressive earnings recognition and instead promotes conservative accounting.
- Restricted stock grants. Instead of options on stock, the company rewards executives mostly with restricted stock. These restrictions last for 10 years even in the event of retirement. In my opinion, this is the key component for aligning interest. It makes management share the same experience from company performance that a long-term shareholder would experience. This is critical for a company where capex decisions affect returns a decade or so into the future. It turns all executives into de facto risk managers. This is especially true for the most senior of managers, with the highest amount of restricted stock and closer to retirement. They must ensure that the pipeline of projects receiving funding will support the earnings needed ten or more years from now when they will be able to sell their stock.
An additional element, not related to the program but also important to understand the care that goes into aligning interests with shareholders is that company policy does not allow employees to enter into hedging contracts for the stock, or other indirect hedging arrangements through commodities contracts.
The resulting executive group is by design a long-term owner of the company, continuously trying to optimize capital use and minimize risks. I think there is a direct link between the incentive packages described here and the track record of being a great steward of shareholder capital. Perhaps another result of XOM management´s conservative attitude and focus on long-term sustainability of earnings is the conservative balance sheet. It has grown without significant use of leverage, making the company one of only four US listed companies with AAA credit ratings; a significant achievement given its exposure to volatile commodity prices.