BUSINESS The Most Overpaid (and Underpaid) Chief Executives in Dallas

THE LONG-HERALDED ’ 90S RECOVERY HAS ARRIVED AT THE TOP- in the CEO’s office. Between 1994 and 1995, the median pay increase for a Dallas-area CEO was a hefty 25.9 percent- compared to a median increase of just 8 percent for CEOs nationally. This more-than-noticeable difference came after several years in which Dallas significantly lagged behind the national average for CEO pay.

Thirty-three Dallas public companies were part of my just-completed study of CEO pay among the 1,000 largest U.S. companies, as judged by the 1995 year-end value of all their shares outstanding. My calculations were based on each CEO’s total pay including salary, bonuses, stock and stock options. Average total pay among all 33 CEOs was $3.6 million, ranging from a paltry $370,000 for Atmos Energy’s Robert F. Stephens to an eye-popping $43.7 million for DSC Communications’ James L. Donald.

To determine direction of total pay, I tracked 19 of the 33 CEOs, all of whom had held their positions since at least the beginning of 1992, Between 1992 and 1993, the median Dallas-area CEO increased his total pay by 9.8 percent. Between 1993 and 1994, the median pay increase dropped to a modest 7.6 percent. But between 1994 and 1995. the median again increased by a hefty 25.9 percent. That figure compares to a national median increase of just 8 percent.

So though Dallas-area CEOs once lagged die national market, they have of late been playing a nice game of compensation catchup. Some, of course, like AMR’s Robert Crandall. haven’t caught up enough, and some, like DSC’s James Donald, have more-way more-than caught up.

Why Robert Crandall Doesn’t Make Enough Money

At one time, the aviation leader’s compensation flew higher than his company’s performance. Now, he should he going to AMR board meetings with tin cup in hand.

ROBERT CRANDALL UNDERPAID? YES, BUT IT HASN’T ALWAYS been so. Back in 1988. Crandall made my Black Hat list, because he received a grant of 355,000 deferred shares of AMR stock. Then at a price of $33.20 per share, the stock was worth $11.8 million. During the next eight years, Crandall was to earn a vested right in the shares.

The stock offer wasn’t that unusual-a lot of companies try to motivate their CEOs by giving them free shares of stock. But what caused me to take notice was a provision guaranteeing that if AMR stock dropped below $33.20 per share, Crandall’s ever-grateful board of directors would make up the difference with a cash payment. Here was a proverbial smoking gun, a “heads I win, tails you lose” deal. I understood that AMR’s board was desperate to keep Crandall from jumping ship and going to United Airlines.

Nonetheless, that grant underscored the lamentable fact that it is hard to get a CEO to take his lumps when performance is poor. The easy part of pay-for-performance is high pay for high performance. But CEOs seem to have a lot of trouble grasping that concept of low pay for low performance.

I will never know whether or not Bob Crandall mended his ways because of what I wrote. But mend his ways he surely did. Since 1988, he has been a paragon of pay virtue. During most of those years, the airline industry was in big trouble. Rather than rationalize that AMR’s poor performance was the result of factors outside his control, Crandall stoically took his lumps. He accepted a frozen base salary, and he didn’t take a bonus. What is more, he didn’t even get a stock option grant-at least until 1995.

The result: In 1995, his pay package of $2.5 million put him 55 percent under the market for a CEO of a company with AMR’s size and performance. And that $2.5 million included a stock option grant with a present value of $ 1.4 million. Take that grant away, which is what happened in 1992, 1993 and 1994, and you have a CEO standing in his compensation underwear.

But now, the airline industry has turned around. AMR’s shareholder return performance ranked at only the 27th percentile during (he three years ending Dec. 31,1995, but its performance during 1995 alone rose to the 63rd percentile.

Herb Kelleher of South-west Airlines is actually more underpaid, relative to company size and performance, than is Robert Crandall-76 percent below market, and 33rd out of 33 on the list, while Crandall is 55 percent under the market, ranking 25th most underpaid, relatively.

The reason I’ve singled out Crandall instead of Kelleher is that AMR is a much bigger and more well-known company, to be underpaying their CEO so significantly. Too, I have followed Crandall for many years and, as I described, Crandall was once a sinner and now has become a saint when it comes to pay risk.

If a CEO is going to take on a huge amount of pay risk-risk that translates into way-below-normal pay packages in years when performance is poor-then that CEO is entitled to a huge raise in pay when his company’s performance turns around. So I hope that AMR’s board digs deep in its pockets this year and passes the hat for good old Bob Crandall.

Why James L.Donald Is Worth Less Than He Makes

DSC was hot last year, and has cooled this year- but whatever the temperature, CEO Donald rakes it in.

HOW CAN ANYONE BE WORTH A PAY PACKAGE OF $43.7 MILLION per year-the pay package that DSC Communications’ James L. Donald received for 1995? Well, maybe there’s someone out there who is worth such a pay package, but the way I score it, that person is not Donald.

For openers, his company is only average in size. And as for performance, you can turn Donald into a hero or a dog, just by changing the period of measurement. For example, his performance between January 1991 and December 1995 ranked him higher than all but 2 percent of the 1,000 companies in my study. But his performance between January 1984 and December 1995 placed him at the 22nd percentile of the distribution, at a point where he was outranked by all but 78 percent of the companies. As for 1995 alone, Donald had a decidedly nonvintage year; his performance weighed in at only the 12th percentile.

After taking account of DSC Communications’ size and performance, my analysis suggested that a competitive rate of pay for Donald for 1995 would be $2.4 million. So Donald’s $43.7 million pay package was, to put it mildly, a bit wide of the mark.

The centerpiece of that pay package was two stock option grants covering a total of 2.15 million shares of DSC stock. During the period between 1995 and 2005. Donald will have the right, but not the obligation, to purchase those shares at prices ranging from $33.75 to $35,875 per share-the prices at which his company’s stock was trading on the days when the option grants were made. Those 2.15 million option shares had a present value of $36.9 million. That value, determined from a widely respected option pricing model, is approximately what an outsider, in an arm’s-length transaction, would have offered for those options on the day they were granted, had Donald been free to sell them (he wasn’t).

In defending their huge stock option grants, many CEOs pooh-pooh option pricing models, although their chief financial officer probably uses the very same model to decide whether or not the company ought to purchase some derivative securities. CEOs point to the fact that, if their company’s stock doesn’t increase, they won’t make a cent, much less $36.9 million.

And if they are DSC’s Donald, they are apt to call special attention to the fact that their options contain onerous exercise restrictions, For example, fully 2 million of Donald’s 2.15 million option shares granted in 1995 cannot be exercised until the market price of his company’s stock doubles to $67.50 per share, compared to the $33.75 per share price at which DSC stock was trading when the grant was made. However, such CEOs may forget to call attention to the fact that the option contains an escape clause; it can be exercised nine and a half years after its grant, even though the stock has appreciated by only 25 cents a share.

So just how much can Donald expect to earn from those 2.15 million option shares? Well, I devised a computer model that realistically simulates the possible future prices of DSC Communications’ stock. In my model, I had Donald exercise his stock options as soon during their 10-year terms as his stock price crossed the $67.50 magic line, if it crossed that line at all. I found that, on the average, Donald might expect to earn $58.5 million from his stock option grants, in about the year 2001.

Of course, that average masks a wide range of possible outcomes. DSC Communications’ stock is quite volatile-in fact, its price dropped more than 68 percent during the first three quarters of 1996-and because it is. there is about a 36 percent probability that Donald will not make a penny from his option shares. But, on the other side of that distribution of stock prices, I found that, if Donald were to wait until the last day of his 10-year terms to exercise his options, he would have a chance to earn $2.7 billion or more-albeit only one chance in a hundred.

So CEOs can pooh-pooh stock options all they want. But it sure is a lot better to have an option on 2.15 million shares than on no shares. Come to think of it, I wonder whether Donald would be willing to take, say, $5 per share for each of those 2.15 million shares, for a nice quick $10.8 million profit? Then again, the options have around nine years to go before they expire. Given his past performance in at least some periods, I’d be willing to bet that Donald can pull another rabbit out of the hat.

Of course. Donald is 64 years old, and he may not be planning to hang around for the next nine years. Still, he does have a six-and-one-half year employment agreement that-get this!-is renewed every day for another six-and-one-half years. (It does, however, expire when Donald reaches age 75). Can you just imagine the clerk who, after attending church on Sundays, has to come into the office that afternoon to renew Donald’s employment agreement for another six-and-one-half years?

HOW THE SYSTEM WORKS

LOOKING AT ALL 1,000 CEOs IN MY study, I found that 40 percent of the variation in CEO pay was attributable to differences in company size (other things being equal, larger companies pay more than smaller companies), And a further 6 percent of the variation in pay was attributable to differences in company performance (other things being equal, higher-performing companies pay more than lower-performing companies).

I started by determining each CEO’s 1995 total pay, including base salary, performance bonus, the value of any free shares of company stock he received; the estimated present value at grant of stock options (using the Black-Scholes option pricing model); payouts received under other types of long-term incentive plans; and miscellaneous compensation (mainly perquisites and special executive benefits).

In calculating company size, I looked at three different measures, each of which was given equal weight: revenues, an income statement measure of size; permanent invested capital (sum of shareholders’ equity and long-term debt), a balance sheet measure of size; and the total number of employees in the company, a human capital measure of size.

As for company performance, I measured the company’s total shareholder returns (i.e., stock price appreciation and reinvested dividends) in three different time windows: For the three years, 1992 through 1995; for the two years, 1993 J through 1995 ; and for the single year 1995. Given the volatility of stock prices, it’s a good idea to look at shareholder return performance in more than one time period. My three readings of shareholder return were weighted in favor of the wider three-year time window and then adjusted further for the risk inherent in the business.

An easy way to determine whether a CEO is overpaid or underpaid would be to measure his actual total pay in relation to the simple average pay for all CEOs. But that approach could be quite distorting, given that there is a systematic relationship between total pay and company size and between total pay and company performance.

A better way to determine who is overpaid or underpaid is to determine, mathematically, what an average-paying company would offer the particular CEO, were the average-paying company to have, not average size, but that company’s size and not average performance, but that company’s performance. Then a useful comparison can be made between the CEO’s actual total pay and the size-adjusted, performance-adjusted level of competitive pay (see the table accompanying this article).

For an illustration, consider Cyrix and Exxon, respectively, the smallest and largest Dallas-area companies whose CEOs were in my study. In size, Cyrix is outranked by 983 of the 1,000 companies in the overall study ; Exxon is outranked by only six other companies. In performance, Cyrix performed at the 26th percentile ( meaning that 74 percent of the 1,000 companies were higher-performing than Cyrix), while Exxon performed at the 63rd percentile. Given those differences in size and performance, wouldn’t it seem reasonable for the job of Exxon’s Lee R, Raymond to be worth far more than the job of Cyrix’ Gerald D. Rogers? Well, a competitive rate of pay for Raymond turns out to be $10 million per year, while that for Rogers is a relatively tiny $716,000.

Also, I have found in previous studies that CEOs who work in the New York City area earn more pay (23 percent more in 1995) than CEOs elsewhere in the country, even after accounting for differences in company size and performance. But CEOs in Dallas? Forget it! There’s no automatic pay promotion here.

CEOs and their compensation consultants claim that the system is being reformed, with companies putting more emphasis on pay-for-performance than ever before. But before victory is proclaimed, one needs to revisit this statistic: Only 6 percent of the variation in CEO pay has anything to do with company performance. Worse than that, the biggest part of the variation in pay-54 percent to be exact-seems not to be explainable by any factor.

That means there’s lots of work to be done-especially by some CEOs who, unlike AMR’s Robert Crandall, persist in paying themselves a ton of money for what turns out to be 10 ounces of performance. If they don’t know who they are, this article ought to show them the light. -G.C.