Corporate Directors Forum October 8, 2013 Disclaimer These materials are designed to complement a verbal presentation and do not constitute an offer to sell or a solicitation of an offer to purchase an interest in Relational Investors LLC (“Relational”), or any of its affiliated funds. These materials are also not a solicitation for investment advisory services offered by Relational. This presentation is intended to serve as an example of Relational’s investment process and strategy. It is based on actual investments in target companies’ stock that Relational made for and on behalf of Relational’s clients. Past performance is no guarantee of future returns and investments in securities involve the risk of loss. This presentation has been prepared by Relational for informational and discussion purposes only. This presentation is not intended to serve as the basis for any investment decision. Except as otherwise indicated herein, the information provided is based on matters as they exist as of the date of preparation and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after the date hereof. Certain economic and market information contained herein has been obtained from published sources prepared by other parties. While such sources are believed to be reliable, Relational, and its respective affiliates assume no responsibility for and have not verified, such information and do not represent that such information is accurate or complete. Statements contained in this presentation that are not historical facts are based on current expectations, estimates, projections, opinions and/or beliefs of Relational. Due to various risks and uncertainties, actual events or results may differ materially from those reflected in such opinions. These materials should be read with reference to all footnotes which are provided on certain pages. These materials may not be distributed in any jurisdiction where such distribution would constitute a violation of applicable laws and regulations.
Introduction Relational formed in 1996 First activist investor with institutional monies Started with $200 Million – now $6 Billion Over 100 Projects Principals have been on 24 public company boards including Home Depot, Waste Management, Mattel, HP and Intuit When not on the board, working behind the scenes with management and the board at companies like Pepsi, ITW, Deere and SPX
Introduction con’t. Clients are large public pension funds – generally indexed Historically passive 1976 – KKR founded, leading to an era of LBO’s Sell low/buy high Institutional S/H’s – Largely passive, largely indexed needed a way to “fix” companies while remaining public 1987 – CalPERS starts focus list 1994 – CalPERS effect shows outperformance 1996 – CalPERS funds first activist fund – Relational Investors
Characteristics of an Active Investor Concentrated portfolio – generally less than 20 stocks Invests with an agenda designed to correct undervaluation Galvanizes support of institutional shareholder base around agenda Prepared to seek board representation using short slate rule (1992) if necessary
Average Cumulative Relative Return of Engaged Companies Average Cumulative Relative Return1 vs. the S&P 500 Index2 During RI engagement After RI exit3 Prior to RI engagement 5 Year Relative 3 Year Relative 1 Year Relative Relative Return 1 Year Relative 3 Year Relative 5 Year Relative 1 Average cumulative relative return of the Engaged Companies gross of fees and expenses ((total return of each Engaged Company minus the S&P 500 Index benchmark return for the same period)/number of Engaged Companies for the same period). The average relative returns do not reflect any actual or model performance results for any portfolio managed by Relational. Additionally, past performance is not a guarantee of future returns. Source: FactSet 2 The S&P 500 Index is an unmanaged capitalization-weighted index comprised of 500 companies traded in the U.S. markets and is intended to reflect general stock market performance rather than the particular strategy employed by Relational. Source: IDC. 3 Does not include any company that, as of Relational’s exit date, ceases to exist due to a merger, spin-off or other form of acquisition. Relational, on average, improves stock performance of underperforming companies through active engagement.
1-Year Share Price Underperformance of 54% Note: Peer group is based on companies specified in 2013 proxy: ITT, ROK, CMI, CR, TKR, FLS, PH, DOV, TXT, IR, CSL, DHR, ROP, HSC, PNR, PLL, SNA, ETN, and GLW.
3-Year Share Price Underperformance of 47% Note: Peer group is based on companies specified in 2013 proxy: ITT, ROK, CMI, CR, TKR, FLS, PH, DOV, TXT, IR, CSL, DHR, ROP, HSC, PNR, PLL, SNA, ETN, and GLW.
5-Year Share Price Underperformance of 85% Note: Peer group is based on companies specified in 2013 proxy: ITT, ROK, CMI, CR, TKR, FLS, PH, DOV, TXT, IR, CSL, DHR, ROP, HSC, PNR, PLL, SNA, ETN, and GLW.
3 Most Common Root Causes of Underperformance Capital allocation – balancing growth versus returns Compensation structure Succession planning
Growth at Lower Returns Will Be Value Destructive Valuation vs. Returns 25x 20x 15x P/E Multiple 10x 5x 0x 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 Return on Equity (%) Note: Assumes 9% cost of equity and 5% growth.
Home Depot Chases Growth Opened another 500 stores – most with returns below their cost of capital Expanded into the wholesale business, acquiring their way in with returns of about 8%. Again, below their cost of capital Squeezed profitability from their retail stores by – Reducing staffing Under – investing in distribution and IT
Growth at Lower Returns Will be Value Destructive Valuation vs. Returns 16x Core Retail Business 14x 12x HD Supply Business 10x Implied P/E Multiple 8x New Stores 6x 4x 2x 0 25 23 21 19 17 15 13 11 9 7 5 3 1 Return on Equity (%) Note: Assumes 9% cost of equity and 3% growth.
Capital Allocation Best Practice Forecast Long-term Growth and Return Targets Establish Valuation Based on Business Plan STEP 1 Establish Credit Characteristics and Liquidity Objectives, and Adjust Debt/Cash as Indicated F STEP 2 Fund Maintenance Capex, Pension and Benefit Plans, and Regular Dividend STEP 3 Allocate Excess Capital to Highest Risk-adjusted Return Alternative that Exceeds WACC STEP 4 STEP 5 Repurchase Shares Increase Regular Dividend or Pay Special Organic Growth Initiatives Acquisitions Allocate capital to the most accretive alternative using share repurchase as a benchmark
Components of Executive Compensation Base salary Annual cash bonus – short-term (1 year) metrics Long-term incentive plan – Stock options – time vested Restricted stock – effectively time vested Performance units – payable in cash and/or restricted stock – metrics range from 1 to 3 years; performance measured by growth in revenue, operating income, EPS, ROIC and/or TSR.
Home Depot Example
Conference Board Succession Plan Recommendations Assign responsibility to a standing board committee of independent directors Make succession planning continuous and integral to business strategy and culture Integrate succession planning into the top-executive compensation policy Integrate succession planning into risk management Make succession planning transparent, internally and externally
Hess Board Composition
What can you do to avoid a call from an activist investor? Adopt a sound capital allocation philosophy carefully risk adjusting acquisitions Require a rolling 3-year business plan tied to compensation Include a return metric in L/T comp Tie succession planning to comp Communicate all of the above to your shareholders