‘The Shareholder Always Has to Win Before We Win’

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To survive in an out-of-control era, David Moffett, former vice chair and CFO of U.S. Bancorp and a director at CSX and PayPal, outlines a framework to help boards refocus on what’s in their control—capital allocation, compensation, communication—with newfound vigor.

David Moffett has lived his entire professional life getting cozy with risk—the kind that most of us would characterize as sweaty, 3 a.m., stare-at-the-ceiling risk. It started right out of grad school, working at a billion-dollar bank in Tulsa, Oklahoma, using brand-new econometric models to analyze how deregulation would impact capital levels at the bank. By age 24, he was running a department pioneering an emerging concept called asset liability management—the forerunner to risk management.

Bank crises, swings in the economy and radical changes to the financial system itself, Moffett, now 71, has been in the mix through it all—and finding innovative ways to thrive. Starting in 1993, he and two colleagues began rolling Cincinnati-based Star Banc and, later, Firststar into U.S. Bancorp, racking up total shareholder return double that of the commercial bank index over the next 13 years, with strategies that also lowered the bank’s risk profile. He still treasures a handwritten note the bank’s executives got from Warren Buffett—one of their top five shareholders at the time. “Everything you said about operations or acquisitions made 100 percent sense to me,” Buffett wrote. “And better yet, you have the performance to go with it.”

In 2008, when the financial crisis struck, then-Treasury Secretary Hank Paulson tapped Moffett to save imploding Freddie Mac, asking him to come to Washington for a job interview that turned into a CEO slot—and a year focusing on reviving and reshaping the institution. He made that happen, too.

No surprise, he’s a popular guy to have in the boardroom, and has served on boards across industries, including those of eBay, Scripps, CIT, Genworth Financial, Building Materials Corporation and MBIA, and also as an advisor to Carlyle Group and Bridgewater Associates. He’s currently a director at CSX and PayPal. 

In this era, he says, the biggest risks to companies likely stem from externalities—wars, weather, politics, pandemics and the like—way outside a board’s control. The best way to respond? Focus on controlling everything in your control. That may sound simple—and it is, in principle. But getting there can require culture change, long-term discipline and unflinching rigor with capital allocation, compensation, measurement and communication. 

“Responsible companies should support an operating plan that builds excess,” he says. “That means your growth rates are probably not going to achieve your potential because you’ll have to build these frameworks of extra liquidity, redundant systems, cybersecurity systems, and it’s just going to be the cost of doing business. You’ll have to accept that.”

Above all else, Moffett is a big believer in boards growing a business the way shareholders really want it to be grown: through real business activities, not financial engineering.

In a long conversation with Corporate Board Member’s Dan Bigman, Moffett lays out his framework for doing all of this and more—just in time for the next black swan to start snapping at us. The conversation was edited for length and clarity. 

We’re in a moment with a lot of conversation about profitability versus growth. You did both. So, how should we be having that conversation? Are we even having the right conversation in the boardroom these days?

I don’t think we are. But it’s really simple. You need to have a return on capital in excess of your cost of capital. That’s the entry point for moving forward. You’re equal to or greater than your peers. My point is, if you keep trying to increase your profitability when you’re pricing individual products, individual businesses, then you’re basically going to drive the growth of the business down because you’re seeking higher and higher levels of profitability. 

There’s one way to do both, and that’s where you never hear this discussion: If you simply grow the revenue of the company at a faster clip than the expenses of a company, then your margins actually go up. Your return on equity, everything else being the same, goes up. And you accelerate your earnings growth at the same time. It’s a really simple concept.

This is lemonade-stand simple. How do we get away from that? Is this “sophisticated” finance pulling us away from what’s core?

I think it is. I’ll give you an example. At U.S. Bancorp, we had an equipment leasing business. It was a massive business. We leased equipment all over the country. I used to sit in in their financial reviews, and they weren’t growing. We started delving down into what’s keeping you from growing. They said, “Well, it doesn’t matter if we’re growing. It’s our profit margins that are important.” They were trained to get higher and higher return on assets or higher margins. I said, “Well, you won’t ever grow if you keep doing that.” It was a mindset in that business that basically led them to believe that. “That’s the way all my peers run it.” When they go to the conferences, they talk about their margins. But they’re not looking at it from the shareholder’s point of view, which is: What drives shareholder returns? It’s earnings growth and dividends. That’s what drives shareholder value. 

So, we’ve got to do everything we can to grow earnings, and the best way to do it is to simply have a mandate—not only at the corporate level but at the business level and, therefore, in the compensation plans—that you just simply grow revenues faster than expenses. Period. 

You’re a big proponent of looking at earnings quality, and you have some very simple rules of thumb around how to make sure you’re tracking on the right trajectory. What do you look at? What do board members need to look at?

I hate to say it, but it’s really simple. At the end of every quarter and year to date and over the years, is the company’s revenue growing faster than its expenses? And, by the way, you would see this in December when the board is presented with a budget. There are some intricacies here that are important. But that one’s really simple. And that can be translated down to every business unit. 

Now, the intricacy at the business unit level: It can only be expenses that they can control. A lot of corporations’ expenses are managed at a very high level, and the business units don’t have it. So, it’s what I call the marginal revenue, marginal cost. Something you learn in economics, microeconomics, back in college.

Margingal revenue has to be measured properly. But every business unit can do that. Then, if you come down the income statement, the operating income—which is the difference between revenue and expense—grows faster than revenue. So, you’re getting what we refer to as operating leverage. Investors love to see companies have consistent ability to hold or increase operating leverage but not at the expense of earnings growth. 

The next thing I’m looking for is that net income grows faster than operating income. The difference is interest and taxes. Good companies are always trying to manage their tax rates. There are lots of different ways to do it but it’s a good lever for companies to use. Also in that line is interest expense. So, the more you lever the company, the greater the burden on your net income growth from the interest. 

Then, another component—which is what a lot of companies totally get wrong—is you want your earnings per share to grow faster than your net income, to a point. There’s a belief among management that investors don’t understand the difference between net income growth and EPS growth, meaning if I grow net income growth 10 percent and I grow EPS 15 percent, aren’t I smart? But what you’re doing in that process is you’re essentially trying to convince the investor that your real growth is 15 percent when all you did was buy back your stock. There  are limits to that. And investors catch on to that real quickly.

They want to see that you’re really growing the business, not just financially engineering things.

Exactly right. Now, you do want some distinction between EPS growth and net income growth. I use the rule of thumb of 2 percent as acceptable. The reason for that is you do want to be buying back shares equal to or greater than the amount of dilution from compensation programs. You want to fully buy that back so that you’re apples to apples. My point there is the fact that your EPS growth rate is more than your net income, but it’s only to a small extent, not a large extent. 

Here’s another popular financial engineering trick: Rates are low. I can issue debt, take the proceeds and buy back my stock and essentially increase EPS. Well, that’s just smoke and mirrors because if you think about it, that means we’ll raise the stock price today, but the debt’s going to have to be paid off five to seven years from now. So, you’re burdening the company long term. You are essentially leveraging the company.

Basically, management is paying for their raises and their bonuses with future shareholder return?

That’s exactly what’s going on. And believe it or not, boards don’t get that. Shareholders don’t think the company is better run because it’s leveraged. So therefore, you leverage your ROI to have a higher ROE. You buy back more shares so you leverage the EPS. The smart investors that I’ve talked to over the years and talk to today, they totally get this and think it’s a quality of earnings issue. They think it’s a real issue because essentially they’re trading off today’s benefit for future debt in one form or fashion. 

The other thing connected to this is the current economic theory that to calculate cost of capital, you combine debt with equity. Now, when you do that, generally it lowers the after-tax cost of capital because the debt component is cheaper than the equity component.

So, it gives them essentially the opportunity to do things. When their cost of capital’s lower, they can buy their stock back. So that’s another fallacy.

Sounds more like an Excel trick than an actual business practice.

It is. Now, this is really in the weeds: The goal should be to lower the beta of the calculation for cost of capital. Why? It’s because when you do that, you essentially open up the number of projects that you can do because if you’re evaluating these projects appropriately, you’re comparing them to the cost of capital. 

I’ll make it simple. Let’s say you’re doing an acquisition. One of the calculations you make is, what is the rate of return on the acquisition relative to your cost of capital? If your cost of capital is low, that means you have a competitive advantage in an acquisition. That’s a good thing. But it’s a longer-term thing. And how you drive net income or EPS matters.

A lot of CEOs are convinced, “Well, if I just get the numbers, then it’ll take care of itself.” No, it’s how you get the numbers. And it goes back to the very top. Is your revenue growing faster than your expenses? It’s just no more complicated than that.

Capital allocation is one of the biggest things that directors do. How do you do it? What do you focus on? Give us some key questions to ask.

The questions start with the annual budget and then the three-year plan. How much excess capital are you really generating that’s available for shareholders? Then the next question you’re asking yourself: What’s the highest and best use of that excess capital to grow the future earnings of the company without a lot of risk? Inevitably, that is reinvesting back in the business. The R&D, new plants, you name it. Those are generally the best things that management can do with that excess capital because it generates future earnings.

Related to that is the starting point. Are you over-levered? And related to that question is a financial discussion regarding the capitalization of a company, meaning you could use that excess cash to tend to your debt, to reduce your debt, to buy back your debt—not replace your debt—but essentially lower the leverage of the company. 

The reason that also pays dividends in the future is it reduces your debt capital cost, improves your credit ratings. Therefore, your debt capital cost in the future will be lower to the extent that you need to access the debt markets for purpose of an acquisition, which makes that acquisition cheaper. It’s also a future source of earnings. You’ve heard Warren Buffett say many times, “You have to keep the powder dry in order to act on opportunities.” That’s why in U.S. Bancorp’s case we started with a company that was less than A-rated and we ended up with AA minus because we focused on that.

This is a very disciplined approach. How do you account for moonshots? 

Whenever we allocated capital for capital expenditures or M&A, we actually put that cost into the P&L budgets for the business unit. For moonshots, we took that capital and we put it in the CEO’s cost center. They had to go directly to him. He was accountable. 

It’s one thing to approve a capital expenditure budget—let’s say it’s 25 percent of your free cash flow for the next five years—but you allocate it to the people who persuaded you with the right financials that they’re good for it and they will make sure it becomes accretive to the earnings of the company. But you have to have a very disciplined accounting process and budgeting process to do that. Most companies, once that acquisition’s done, you never see it.

The champions disappear, and it just gets mixed in with other stuff.

That’s why I said that one of the things you have to do to avoid that is take their next three-year plans and add this on top from an accounting point of view so they can’t escape. You came to us. You asked for the money. We gave you the money. You signed on the dotted line and said you were going to get these earnings accretion numbers as a result. And you live with it.

How does this clarify conversations? Did you find a lot of essential acquisitions and capital projects did not become quite as essential?

Oh, yeah. It’s a deterrent. When I was CFO, we had what we called the capital expenditures committee, which I chaired. Only the people who were 100 percent convinced it would work would ever bring [ideas]. They would have to be confident because their bonus would be tied to it, their long-term comp would be tied to it. 

This is the nuts and bolts of where de-risking takes place.

That’s exactly right. You have to have a framework outlined to every business unit, every person in the company. This is what we think it will take to grow the earnings, this is how we’re going to treat M&A, this is how we’re treating capex. It’s all very, very clear. This is the game plan. And this is your segment of the game plan, and here is how you can access that excess capital that the company will grow—but it belongs to the shareholders. It doesn’t belong to you. It belongs to the shareholders. 

One of your big bugaboos is setting expectations on Wall Street. You’re not a fan of putting out a number. Is putting out a number the root of all evil?

They’re playing directly into the hands of the analysts on the sell side who give the impression that they control the thinking of the investors. My argument is, you’re just doing their work for them and it doesn’t really matter what my earnings are for the next quarter. When you outline the plan like I’ve talked about with the investors, it’s no different than you would to the board, no different than you would to the employees. You use the same words, the same framework, and that’s how you avoid this dilemma about focusing on quarterly earnings.

If you talk to them about your thinking on capital allocation, if you tell them how you’re actually running the business and the different business units and how you measure it, that’s all they need. Their job is to figure out what your earnings will be. It’s not my job. By giving them guidance, you’re doing their job for them.

How do you start this shift? Some of it will be around comp—that’s the big lever the board has when it comes to setting culture, setting tone, setting goals, setting expectations. How do you like to do it as a board member? And how do you think that contrasts with how you see it done most of the time?

It’s much simpler than you realize. We’re expected to have an annual plan. And that annual plan should be two measures: net income growth and our ROA for capital-intensive businesses that have to spend money on assets versus other companies, where I would use an operating margin as a substitute for ROA. 

You look at the analysts’ estimates for the next year. What do they think your net income will be in terms of median? And what is the ROA, as an example, in the first year? You start there by targeting net income growth at the median for your peers. That’s why I get into peer selection. It’s really, really important.

You say it’s in the picking of peers where this all goes wrong.

Right. The question is: Who are the peers that you really compete with, and who are the peers you compete with for talent and investors? We have 10 analysts following us. Who do they compare us to? Who is in their peer group? That’s one group. The second group are the indexes because half the market is passive. And all these active managers are trying to beat the indexes. Well, who’s in the commercial bank index, as an example?

Third is: Who are their debt rating peers? They’re looking at it from the risk point of view. So, who does S&P and Moody’s put in my peer group? Where do those all overlap? That to me is a reasonable way to approach the peer group.

Management tries to influence the [comp] consultant. This is just the way it works. Why? Because the bigger the companies in the peer group, the higher the comp. It’s just that simple. 

Also related to this: The comp discussion is in a committee. You’re talking about the framework, the consultants, the peer group selections, and then it’s reported out—not debated—to the full board. You never have a discussion of linking the metrics and the right compensation measures that will drive the company’s performance. You may think that’s ludicrous, but it doesn’t happen. 

Boards have to force this discussion. That’s really the chairman’s job. I’ve served on comp committees, I’ve served on audit committees. Rarely do you have the chairman say, “You know, we need to make sure all these measures are linked and the one’s driving the other.” Because whatever we pay for, we’ll get. There’s no question about that. But do they drive shareholder value? And are they conflicting? 

You were a CFO for your entire career. What should we be asking our CFOs?

The way you always start is, “What truly drives our total shareholder return? Mathematically, tell me all the considerations of our smartest shareholders, the people who know this business and know what good looks like, and tell me what the metrics are that relate total shareholder return to operating metrics.” That’s a mouthful. There’s a lot to ponder. But that’s where I would always start. 

Then, instead of asking the comp consultant, ask the CFO: “Who are our peers? You tell me who our peers are. And prove it.” And then: “Where’s our current performance relative to those peers or relative to the median of those peers? Either we’re above the median or we’re below the median. What’s our roadmap? What things should we be doing to get to the median?”

This is the core of the start of a real strategy conversation?

That’s exactly right. Everything [else] is just activities. The directors need to be engaged. You have a big table. and you start writing these things on boards, and then you start having a real discussion about the linkage between the goals of the company, performance, compensation—because we really do want to make [management] rich. We really do. But only if the shareholder wins first. The shareholder always has to win before we win. 


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