How much an executive gets paid has always been a thorny issue for investors. Are some managers really worth tens of millions a year? How about hundreds of millions?
That’s the current conundrum for Valeant Pharmaceuticals investors. The company’s CEO, Mike Pearson, has earned compensation totaling $3.4 billion since taking the job in 2008. That equates to making the average Canadian’s annual salary ($49,000, according to StatsCan) every 56 minutes. This might also be a conservative estimate. The total amount earned is open to interpretation based on share price, vesting dates, expected share price and hold restrictions.
Besides an annual salary and bonus of $8 million, and executive perks, the bulk of Pearson’s wealth has come from the granting of stock options, restricted share units (RSUs) and performance share units (PSUs).
The company hasn’t granted Pearson any options since 2011, but he currently holds 4.9 million of them. Approximately 4.4 million are exercisable today and would net him $1.3 billion if he cashed in. The RSUs are granted as a form of equity matching. Valeant’s executives are rewarded extra for holding onto their investment in the company. Pearson owns 580,000 RSUs, which are fully vested and worth $177 million as of August 2015. According to the company’s proxy circular, matching RSUs and required hold periods are an effective and motivating retention tool (expensive as it might seem), especially for executives that have been “extraordinarily successful at the company and have built up significant net worth.”
While the value of the options and RSUs are impressive, the majority of other-worldly compensation is actually driven by PSUs, which vest only when certain total shareholder return (TSR) triggers are met. The better the share price performance, the more they vest, sometimes up to 500%. That means five times the number of shares initially granted would be earned if the top growth target for share price is met. For instance, the company issued 450,000 PSUs to its CEO in January 2015, which could turn into 2,250,000 shares if the top TSR target is met over five years. This tranche alone could be worth $3.2 billion. Pearson has also received generous PSU awards under previous employment agreements.
Potential lopsided motivation
The lopsided weighting of the plan toward a single metric (share price) can create questions about executive motives. Increasing EPS is typically an easy route to a higher share price, but there are different ways to boost EPS. It can be done organically, through better core performance, or through financial engineering. For instance, reducing the number of shares without an actual increase in earnings can raise EPS. This can be done by issuing debt and using the proceeds to buy back shares. Likewise, earnings can be bought through acquisitions. If those acquisitions are paid for with debt, EPS will see a boost and, most likely, share price will follow.
Since 2008, Valeant has made more than 20 major acquisitions valued at $30 billion. During that same period, the company has added more than $30 billion in net debt. As a result, Valeant’s leverage has deteriorated. The company has gone from having no debt to supporting a balance sheet that is financed 82% with debt (or 4.6x debt to equity).
Further, that equity portion is tenuously supported by assets that are 84% intangibles and goodwill. Advisors should question whether Valeant’s super-charged executive compensation plan has overemphasized share price return at the expense of mounting debt load. A similar problem exists with the company’s annual bonus structure, which is based on meeting targets for revenue and cash EPS growth. Both are easily achieved through debt-funded acquisitions.
Despite these challenges, the share price is increasing, and that’s often what matters most to investors. As Valeant notes, the goal of the board is to align management pay with long-term share price returns, and to “richly reward” outstanding performance but shell out “significantly less” for below-average performance. In such situations, it’s good to step back from a purely shareholder-focused view to look at the underlying financial health of the company from a different perspective.
The major credit-rating agencies generally regard Valeant’s debt as BB- (three notches below investment grade). The debt side of the balance sheet rarely lies, and the signs are there for advisors to take heed.
Advisors can always cash out
Valeant has enjoyed a huge multi-year run in terms of share price, and advisors can be excused for wanting to take some money off the table. Huge debt loads can be unforgiving if markets turn, and the value of the intangible assets supporting that thin margin of equity becomes questionable.
The company’s CEO, on the other hand, will have a much tougher time cashing out. Most of his current wealth is tied to agreements that prevent him from selling many of his shares until 2020. No one will likely shed a tear, though, if he ends up forfeiting a billion or two.
Originally published in Advisor's Edge Report
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