Five Elements of Activist Stewardship: Insights from Two Letters

Robert G. Eccles is Visiting Professor of Management Practice at Oxford University Said Business School. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here); and Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System by Leo E. Strine, Jr. (discussed on the Forum here).

Engine No. 1 and Elliott Advisors each invested millions of dollars to do careful and in-depth analyses prior to launching their campaigns to improve the performance of ExxonMobil and GSK, respectively. While Engine No. 1’s campaign has been successfully concluded, Elliott’s is still in its fairly early stages. Nevertheless, some insights can be gained by studying the letters which publicly launched each campaign. They reveal five elements of activist stewardship. They also raise five important questions every board member needs to be asking her or his self.

The proxy contest campaign against the Houston-based oil and gas giant ExxonMobil by the new activist investor Engine No. 1 continues to receive attention and accolades and deservedly so. With a tiny investment of $40 million but with strong support from CalSTRS, followed by CalPERS and Legal & General Investment Management and other major asset owners and asset managers, Engine No. 1 successfully placed three of its four candidates on the board of directors.

From its earliest days, in January Colin Mayer and I were optimistic about its prospects. I wrote about the campaign as it evolved, starting with ExxonMobils’ Magical Mystery Tour for its investors. Not long after I saw A Bad Moon Rising for the company, yet ExxonMobil bravely responded with six cute fables inspired by Aesop it prepared in advance of the annual shareholder meeting on May 26, 2021. The annual meeting itself was a well-choregraphed play in three acts, produced, directed, and starred in by Chairman and CEO Darren Woods. Following the meeting, ExxonMobil’s shareholders cheered Here Comes the Sun!

A more recent campaign, publicly launched on July 1, 2021, is the one by the large and well-established activist Investor Elliott Advisors. It is focused on the London-based global healthcare company GSK, in which it has made a multi-billion-pound investment. As expected, the British press is following the story closely, albeit in dramatically varied tone. “It roars out a fire and brimstone sermon” declared Jim Armitage of the Evening Standard who the next day called it “an excoriating open letter to investors.” Alistair Osborne of The Times was less impressed calling it a “damp squib” and saying with an air of disappointment that “for a hedge fund with a bullying reputation, Elliott’s missive was almost subtle.” These two reactions reveal contrary interpretations of the rhetorical style of Elliott’s letter.

I have written more generally about the different reactions to these two campaigns. Investors and others concerned about climate change have been almost universally positive about the hard-hitting ExxonMobil campaign driven by people with backgrounds as traditional activist investors, investors who are often seen as in pursuit of profit no matter the broader long-term costs to shareholders and other stakeholders. The Elliott/GSK story is still evolving but what is clear is that Elliott is taking a much softer approach, too soft for some, and the outcome is unclear.

Yet both campaigns are examples of activist stewardship, which Kirsty Jenkinson, Aeisha Mastagni, and I have written about before in this forum. These campaigns also suggest that we need to rethink some stereotypes of what are often referred to by many with moral derision as “activist hedge funds”—even when hedging has no role in their investment strategy. The Engine No. 1 campaign is regarded by many as a major contribution to “sustainability.” The Elliott Advisors campaign is being considered by many as a rather muted form of activist investing that lacks the traditional punch, although it falls within the boundaries of making money with no regard for or even at the expense of sustainability.

One only has to dig a little bit deeper into each campaign to see some striking similarities despite the differences in styles. This is revealed by reading the letters sent by Engine No. 1 on December 7, 2020 and by Elliott Advisors on July 1, 2020 to the board of directors of ExxonMobil and GSK, respectively. There are five elements these letters have in common. They point to an emerging model of activist stewardship that is focused on long-term returns and an appreciation of the close relationship between financial performance and sustainability.

Respect for the Past but Concern for the Future

Engine No. 1’s letter opens “No company in the history of oil and gas has been more influential than ExxonMobil Corporation (“ExxonMobil” or the “Company”), which is home to many of the industry’s most talented managers, operators, scientists, engineers, safety professionals, and other employees.”

Elliott states that “GSK is an important company within the U.K. and across the globe…making a positive impact on the lives of billions of patients and their families around the world. Its history dates back more than 300 years, over which GSK has pioneered revolutionary innovations in fields such as vaccines and HIV treatment. At its best, GSK provides lifelines to the world’s most vulnerable populations.”

Engine No. 1 then goes on to note (bold in the original) that “It is clear, however, that the industry and the world it operates in are changing and that ExxonMobil must change as well.” Engine No. 1’s concern is that ExxonMobil has failed to recognize the reality of the energy transition already taking place. While the company may be well-managed, it is managing in the past, not for the future. There are many companies in many industries that are not adapting quickly enough to the changing world around them

Elliott observes that “Despite the strengths of its people, its vaccines, and its drugs, GSK has a poor record of execution and value creation” and “Despite possessing strong businesses in attractive markets, GSK has failed to capture business opportunities due to years of under-management.” This is the opposite situation of ExxonMobil. What GSK does fits very well with what the world needs. It’s just not doing it very well. Again, there are many companies in attractive markets that are failing to take advantage of them due to poor execution.

The tone of both letters is polite and professional, yet candid. Neither uses provocative or inflammatory language. For example, Elliott could have said “poorly managed” instead of “under-managed” and Engine No. 1 doesn’t accuse ExxonMobil of being in climate change denial, even though they essentially still are despite their weak rhetoric to the contrary. Both letters are constructive and express the willingness to engage in a dialogue with management in the best long-term interest for the company and its shareholders. Something neither company appears to have done. The heated rhetoric which emerged during the Engine No. 1 campaign is due to the company doing everything in its power to resist, obfuscate, and deny the reality of its situation in hopes of thwarting the campaign. It failed to do so.

Time will tell the result of Elliott’s overture to GSK but has started on a more positive note. Unlike ExxonMobil, the company has already taken steps to address the performance issues by announcing that it will separate the very different pharmaceutical (New GSK) and Consumer Health (CH) businesses. Elliott is supportive of this decision but has suggestions for how this can be done most effectively to create the most value, potentially >45 percent more than the current market cap.

Poor Strategy Leading to Poor Capital Allocation Decisions

ExxonMobil’s strategy has been to continually drill for unneeded oil in the ground with capital expenditure (capex) plans of $180-250 billion from 2020-2025. Engine No. 1 points out that the company lacks “a Long-Term Plan to Enhance and Protect Value” and worries that while “ExxonMobil has a long history of industry-leading innovation” it could end up ceding this ground, “particularly as its iconic status is threatened.”

GSK’s strategy has flip-flopped, like selling its oncology business to Novartis in 2015 then re-entering it three years later through a $5 billion acquisition of Tesaro which resulted in a $10 billion drop in its market cap. GSK has underinvested in R&D, critical in the pharmaceutical business, and overinvested in “its fragmented and inefficient manufacturing base, high SG&A, and other non-R&D cost buckets.”

Both companies have continued to pay dividends they cannot afford due to their dismal financial performance. Elliott noted that “GSK has persistently paid a higher dividend than it could afford.” ExxonMobil’s record high debt levels (from at one point having no debt at all) has resulted in “market skepticism that it can maintain its current dividend.”

A Rigorous Analysis of Poor Financial Performance

The numbers are striking for both companies. In the case of ExxonMobil:

  • Over the past 10 years the company’s total shareholder return, including dividends, has been -20 percent vs. +277 percent for the S&P 500.
  • Return on Capital Employed (ROCE) for Upstream projects (75 percent of capex) has fallen from an average of ~35 percent from 2001-10 to ~six percent from 2015-2019.
  • It has the highest net debt to cash from operations ratio among the oil majors at over 3.0x and the debt has been downgraded twice by S&P since 2016 (and is on negative watch)
  • Goldman Sachs has estimated that from 2020 its return on capital will be the lowest among its proxy peers
  • It owns 60 percent of the oil majors’ lowest margin assets by production due to a dramatic decline in capital productivity

In the case of GSK:

  • Its share price has underperformed every single peer over nearly every conceivable timeframe (see table on p. 2)
  • Its share of total R&D spend has dropped by over 30 percent
  • Its share of total R&D spend of the top 11 pharmaceutical companies has dropped from 12 percent in 2005 to eight percent in 2020
  • Over the last ~15 years it has dropped from being the third-largest pharmaceutical company in the world to the eleventh-largest one

Note that in both cases, the activist investor is looking at the company’s performance over a 10-year period of time. Neither situation is an example of a recent drop in stock price where cost-cutting or some asset sales will result in a quick pop in the stock price even at the expense of long-term returns. Rather, both letters are taking a patient perspective on what the company needs to do to improve its performance over the long-term.

Questions About Company Leadership

The underlying cause of poor financial performance, as is always the case, is people on the board and in executive management. In the case of ExxonMobil, the central issue, and what the proxy contest was all about, is the composition of the board of directors. Engine No. 1 states that (bold in the original) “We believe that for ExxonMobil to avoid the fate of other once-iconic American companies, it must better position itself for long-term sustainable value-creation.” It further acknowledges that this will not be easy and will require a board that has expertise on the evolving trends, technologies, markets, and policies shaping the future of the industry. Yet the fact is (bold in the original) “none of ExxonMobil’s independent directors have any other energy industry expertise.” As throughout, the letter is respectful and makes no criticism of any individual board member, rather noting that each one “is highly accomplished and respected.” The board simply does not have the expertise it needs to guide ExxonMobil through the energy transition.

Engine No. 1 offered up a slate of four people who collectively have the expertise that is needed. Greg Goff was the CEO of Andeavor, a leading petroleum refining and marketing company which during his tenure generated total returns of 1,224 percent versus 55 percent for the energy sector. Kaisa Hietala is an experienced leader in strategic transformation in the energy sector, who played a central role in the transformation of Neste into the world’s largest and most profitable producer of renewable diesel and jet fuel. Alexander Karsner has more than three decades of global conventional and renewable energy experience and is Senior Strategist at X, the innovation lab of Alphabet, Inc. Anders Runevad served as CEO of Vestas Wind Systems, a company with more installed worldwide wine power than any other manufacturer, and in the six years he was CEO he turned around the company for a total return of 480 percent, significantly more than the global energy and industrial sectors. For reasons I don’t pretend to understand, he was the only one not elected to the board.

In the case of GSK, the central issue is at both the board and CEO level. “Elliott calls on the Board to confirm that, prior to the separation from CH, GSK will appoint non-executive directors with deep biopharma and CH expertise, and that the new, fit-for-purpose GSK Board will then run robust processes for selecting the best executive leadership for New GSK and CH, considering both internal and external candidates (bold in original). The company has already acknowledged the need for greater pharmaceutical expertise on the board of New GSK. What Elliott is asking for is that these new board members be added before the split up and a refreshed board conduct a formal process, including both internal and external candidates, for choosing the CEO of each company.

Some have interpreted this as a broadside attack on GSK CEO Emma Walmsley, deservedly or undeservedly. It is not. The fact of the matter is that while Walmsley had a distinguished career at the luxury consumer goods company L’ Oreal before joining GSK’s consumer healthcare business, unlike the CEOs of her major competitors, she does not have a scientific background or deep expertise in the pharmaceutical industry. Thus, is seems reasonable to suggest that a formal search be conducted for such a major restructuring of the company when the CEO of New GSK will be running a pharmaceutical company, not a mini conglomerate. Elliott has not taken a position for or against Walmsley. It is simply asking that a refreshed board determine the appropriate CEO for each business in a process in which Elliott will have no role. The search process may result in Walmsley being the CEO of New GSK, or it may not.

The Need to Change Incentive Compensation

Engine No. 1 points out that despite ExxonMobil’s dismal negative cumulative total shareholder return of -12 percent from 2017 to 2019, total CEO compensation rose almost 35 percent during that period. Exacerbating this problem is the lack of transparency about the metrics used for determining CEO compensation. Furthermore, return-focused metrics are compared to industry averages without reference to the overall market (which Chevron does) or cost of capital (which BP does). “As a result, management may be incentivized to deploy capital to general ‘leading’ industry returns even where shareholders would be better served by increased returns of capital or other investments to strengthen the business over the long-term.”

For Elliott, the issue isn’t which financial metrics are used to determine compensation: “The portion of the compensation plan linked to financial targets should be substantial.” Rather, it is the performance level at which bonuses can be earned. The company’s most recent guidance of a 2021-2026 compound annual growth rate (CAGR) of five percent for revenues and more than 10 percent for operating profit “should be viewed as a floor below which no bonus is earned for that portion of the compensation plan.” Rather, bonuses should be based on more ambitious targets such as eight percent and 15 percent, respectively. Longer-term targets should also be reflected in executive compensation. “For example, a component linked to R&D milestones will directly influence R&D decision-making and performance, which will benefit shareholders in the long run.”

Five Questions Every Board Member Should Ask Themselves

The implications of these five elements of activist stewardship are obvious for boards of directors and can be framed as five questions:

  1. Does the company have the appropriate strategy and capital allocation process to succeed over the long term?
  2. How does the company’s financial performance along the key dimensions compare to peers and relevant sector and market averages?
  3. Does the company have a board and CEO with the requisite skills?
  4. Is executive and board compensation focused on the right metrics, the right time frames, and the right performance level targets?
  5. Is the company, through the board and CEO, properly engaged in a dialogue with its investors to benefit from their feedback?

The natural human reaction of most board members will be to answer, “All is well!” to these questions. This means that board members need to step back and take a hard and objective look at the company, themselves, and the CEO. If they don’t, there’s a good chance an activist investor, supported by a number of investors with large stakes in the company, will provide the necessary discipline through activist stewardship. The Engine No. 1 and Elliott Advisors campaigns are strong signals that activist stewardship will be a growing force in the future.

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