Executive Pay Trends in the Capital Goods Industry

We studied CEO and CFO compensation trends for mid-sized Capital Goods companies from 2016-2017 (as reported in 2017 and 2018 proxy disclosures). Sixty-three companies with revenues ranging from $1B to $3.5B served as the study group. We found this industry and size range to be particularly interesting as CEO pay and performance appear to be aligned over the one and three-year period and robust pay increases appeared in line with strong performance. Further, the industry outlook is compelling:

• Strong revenue growth – Analyst estimates indicate strong revenue growth expectations over the next two years. At median, revenue growth for the study group is expected to be near 10% in both 2018 and 2019.
• Higher input costs – Machinery companies are facing higher input costs with international trade volatility that will likely impact the bottom line.
• Other signs remain relatively positive – U.S. growth expectations are particularly robust. For the companies studied, on average, 65% of revenue is generated within the U.S. The AIA Architecture Billings Index, a leading indicator of non-residential construction activity, was positive for Q2 2018. The increase in billings is typically a leading factor for capital goods companies ranging from HVAC makers to water treatment manufacturers and generator manufacturers.

Here is what we found.

Overall Pay Increases

Pay increased substantially for both CEOs and CFOs from 2016 to 2017. Median CEO and CFO pay both increased by approximately 15%. Growth in pay was consistent with robust stock price performance. Median one-year total shareholder return (TSR) performance was 21% which beat the S&P 500 Index over the same time period by nearly 200 basis points. While strong performance was a significant driver of increased annual bonus payouts, the uncertainty in the industry at the end of 2016 and beginning of 2017 created a difficult goal-setting climate. Many companies in our study overachieved from an annual incentive perspective and received substantial bonus payouts.

Compensation Mix Changes

CEOs experienced significant increases in annual bonus payout values. Long-term incentives also increased, especially for performance-contingent equity, which is consistent with long-term trends.

CFOs also experienced significant increases in bonus payout values and LTI. However, performance-contingent equity did not grow at the same rate as for CEOs. Consistent with general industry trends, CEO compensation is typically more focused towards performance-based pay relative to the CFO and all other executives.

Annual Incentive Plans May Feature Individual Metrics

Companies generally emphasize financial metrics in their annual incentive plans. Operating Income/EBIT/DA is the most prevalent financial metric followed by revenue and cash flow. Interestingly, a considerable number (41%) of companies include individual performance as a metric or modifier. Going forward, more companies may introduce more strategic and qualitative metrics due to the elimination of 162(m). Environmental, social, and governance (or “ESG”) metrics may also increase in prevalence as some investors and advisory firms begin to focus on specific corporate behaviors.

Long-Term Incentive Plans Focus on TSR

Consistent with long-term general industry trends, relative TSR is the most prevalent metric. Companies generally measure TSR percentile performance against a peer group or industry index, such as the S&P 400 Capital Goods.

CEO Pay vs. Performance Generally Aligns

Three-year average CEO pay is generally aligned with three-year performance for the companies studied. We analyzed performance in two different ways: (i) three-year TSR and (ii) three-year revenue growth plus a three-year average EBITDA margin “score” which is illustrated in the chart.* Both comparisons reveal approximately 75% of companies have an aligned pay and performance relationship.

*Score is determined by adding three-year revenue growth (CAGR) and three-year average EBITDA margin (e.g., if a company has revenue growth of 10% and an average EBITDA margin of 15%, the score is 25%).

Pay practices continue to converge, especially in long-term incentive plans as companies place great emphasis on performance-contingent equity and often utilize relative TSR as a metric. While advisory firms such as ISS continue to emphasize relative TSR in their pay-for-performance tests, they have expanded to analyzing other relevant financial metrics. Companies should continue to review their annual and long-term incentive plans to ensure they are supporting the company’s overall strategy, even if that means diverging from prevalent market practices.