September 1, 2016
Federal contracts lawyer Jim McAleese recently covered the briefing by Phebe Novakovic, CEO of General Dynamics, at the Jefferies Investors Conference on 9 August. His first point: “General Dynamics’ senior team is paid based on ‘earnings and cash,’ which fund robust share repurchases.” That’s clearly a compensation strategy, and as I wrote back in 2013, GD is using all that cash for “something with an incentive behind it.” But more broadly, do the compensation schemes for top management teams in the defense industry incentivize goals that its customers should favor too?

For the moment, let’s restrict the analysis to the CEO at this one company. (Considering her entire top management team, and other teams at other companies, is a promising and longer job for another day.) According to GD’s 14A form filed with the SEC this past March, Novakovic’s compensation in 2015 included $1,583,740 in salary, $4,850,000 in cash bonus, $6,856,781 in stock awards, $6,855,267 in stock option awards, and unspecified compensation worth another $278,306. To most people, $20,424,094 is a lot of money. More remarkably, for CEOs, it comes in multiple forms.

Salary pays the mortgage with assurance, and big houses around Washington DC are expensive. Stock awards incentivize a CEO to work to keep the share price from dropping. Option awards incentivize her to work to increase that price. In determining its compensation policy, any corporate board faces a conundrum. Set the strike prices of the options too low, and the company has handed over money for free. Set them too high, and with much of the compensation tied up in options, some very risky behaviors could emerge. (I worked once for such a company, and the story did not end well.) In 2015, the share price (NYSE:GD) rather languished, but the dividend returned $873 million in cash to shareholders. That was about $2.86 for every share outstanding, for a roughly 2 percent additional return. Through her stock awards, Novakovic will get a share of those in the future too.

The fourth component is that cash bonus, presumably for meeting those goals in “earnings and cash.” Under Novakovic’s management, General Dynamics more than attained the targets the board set for 2015. The company had sought $2.7 billion in ordinary earnings and $1.1 billion in cash flow from operations, but earned $2.965 billion and took in $1.93 billion in cash. (It also had aimed for a 14.1% return on invested capital, but attained 17.4%.) GD thus earned accruals about 10 percent above target, and if earnings alone were the issue, GD’s directors were rewarding Novakovic with 10 percent of the 10 percent better results (about $20 million) she helped the company bring in. There’s a rough consensus amongst researchers in the field that the actions of a CEO can account for about 10 percent of a company, and by that measure, they weren’t paying too much—just barely. But GD also took in cash about 75 percent above target, so there’s another big reason to pay her a big bonus.

Without hiring compensation consultants, this seems a balanced package. Assessing whether the targets and the amounts were right—as described above—would take some more work. But somewhat separate from cash flow is cash-on-hand. The former replenishes the drawer, but only if the rate of outflow is less than the rate of inflow. McAleese continued by observing that the company has been reducing its cash holdings this year, for three reasons. GD has been burning through cash advances from customers in 2014 for developing two new armored vehicles: the Ajax light tank for the British Army, and the LAV 6.0 for the Saudi National Guard. GD has also been increasing the production rate for the Gulfstream 500 business jet, and unlike governments, not all customers pay in advance. GD also has made commitments to shareholders for the future repurchase of up to another 10 million shares. With the price hovering around $150 per share, the full program would consume another $1.5 billion in cash.

These are all good uses of funds, but as a result, McAleese finds, GD has little dry powder for acquiring other companies, or investing in a big R&D program. Novakovic did come into the job complaining about her predecessor’s predilection for M&A. However, for many defense contractors these days, with their still remarkably low rates of independent R&D spending, M&A is the IR&D. Most of GD's product development funding comes straight from the biggest customer, the US Defense Department. To be sure, there are success stories from self-actualizing investment, even in the United States. But by-and-large, federal profit policies render problematic earning commercially attractive returns from one’s own R&D. Until that changes, the compensation incentives may be right for the shareholders, but they won’t be fully working for the customers.

James Hasik is a senior fellow at the Brent Scowcroft Center on International Security.

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