NDI Executive Exchange

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1 NATIONAL DIRECTORS INSTITUTE NDI Executive Exchange ACCOUNTABILITY AND TRANSPARENCY Are Your Corporate Governance Practices Putting You at Risk? Board Oversight of Capital Allocation Strategies CO-SPONSORS IN-KIND SPONSORS

2 NDI M&A Materials.pptx\3 NOV 214\5:8 PM\1 Board Oversight of Capital Allocation Strategies 6 November 214

3 The Boardroom Conundrum Continues From Active to Urgent Year To Date S&P 5 Revenue Growth: +4.2% 214E S&P 5 Revenue Growth: +5.7% S&P Performance: +26.4% S&P Performance: +9.2% (1) S&P Cash Balance: $1.4 Trillion Debt / EBITDA: 2.1x S&P Cash Balance: $1.6 Trillion (2) Debt / EBITDA: 2.1x (2) Excess Firepower More Excess Firepower Equity Investors Demanding ROC and Applauding M&A Demanding ROC or M&A 1-Year UST: 3.3% 1-Year UST: 2.34% (1) Key Industries Evolving Seismic Shifts Emerging Source Bloomberg Notes 1. As of 31 October LTM S&P Cash Balance and Debt / EBITDA 2

4 Markets Continue to Perform as Volatility Abates Why Capital Allocation is More Important Today Than a Few Years Ago Markets Are Up and Volatility is Down S&P 5 and VIX Index (1) 2,1 Mid-27 Current 1 2,18 1,7 S&P , Jan-5 Dec-6 Dec-8 Dec-1 Nov-12 Oct-14 VIX Index S&P 5 Volatility (VIX) 14. Note 1. Market data as of 31 October 214 3

5 Perception of Growth Is Improving S&P 5 Valuation Breakdown Breakdown of Value S&P 5 (1)(2)(3)(4) Growth vs. Earnings % of Share Price for Period 1% 1% 8% 52% 45% 39% 33% 2% 3% 26% 17% 26% 27% 6% 1% 99% 4% 2% 48% 55% 61% 67% 8% 7% 74% 83% 74% 73% % (%) (2%) Current (5) Capitalized Earnings Implied Growth S&P 5 Sources Bloomberg, Capital IQ Notes 1. EPS calculated using forward fiscal year estimates 2. Cost of equity range is between 8.3% 1.3% 3. Capitalized Earnings = NTM Earnings / Cost of Equity; Implied Growth = Share Price Capitalized Earnings 4. Cost of Equity = Risk free rate (1 year UST) + Barra Predicted Beta * Market Risk Premium 5. As of October 3, 214 4

6 NDI M&A Materials.pptx\3 NOV 214\5:8 PM\5 Board Oversight of Capital Allocation Strategies ROIC is a Key Determinant of Stock Price Based on the S&P 5 (1) Aggregate Value/Invested Capital vs. ROIC (LTM) (1) Aggregate Value/Invested Capital x Correlation = 77% Return on Invested Capital (LTM) (%) Consumer Energy Healthcare Industrials P/E (NTM) vs. Long-Term EPS Growth (1) Price/NTM EPS x Long-Term EPS Growth (%) Correlation = 31% Consumer Energy Healthcare Industrials Tech Telecomm Utilities Materials Tech Telecomm Utilities Materials Valuation Metrics Correlation Over Time (1) Correlation % 1 March 2 NASDAQ hits all-time high December 21 Enron Files for Bankruptcy September 28 Lehman Files for Bankruptcy Avg. Since 21: 77% Avg. Since 21: 28% ROIC vs. AV/Invested Capital NTM P/E (x) vs. EPS Long Term Notes 1. As of S&P 5 excluding Financials 5

7 NDI M&A Materials.pptx\3 NOV 214\5:8 PM\6 Sell Side Paying More Attention to ROIC Over Time Morgan Stanley has reviewed sell-side analyst equity research of relevant peers (1) from 2 to 212 References to ROIC in Research (1) Total Reports Mentioning ROIC 1,2 % of Research Reports Mentioning ROIC 4 Each report was analyzed to determine if the company s allocation of capital program was discussed 1, 1,61 1,6 35 Evolution of research includes paying more attention to balance sheets and ROIC Conclusion: Rapid increase in sell-side/investor awareness and concentration on capital allocation programs Total Reports Mentioning ROIC % of Research Reports Mentioning ROIC Sources Capital IQ, Morgan Stanley Analysis Note 1. Companies include BA, COL, DHR, EMR, GE, HON, IR, ITW, LMT, MMM, SIE, TXT, TYC 6

8 Excess capital should be deployed effectively to maximize value creation and to demonstrate management commitment to shareholder value Board Oversight of Capital Allocation Strategies Excess Capital Prioritization Increasingly Important Capital Deployment Framework Reinvest in core business and/or direct capital to new projects / product lines Improve margins and generate higher sales on similar capital base Organic Growth Higher Returns Acquisitions Reduce capital base and enhance pre-tax earnings Estimated WACC = 7.7% Dividend & Share Repurchase Deploy capital into transformational and/or bolt-on acquisitions Generally more costly growth vs. organic Little upside Repay Debt Return excess capital to shareholders, assuming capital redeployed with similar cost financing Keep Excess Cash Lower Returns 7

9 A Look at Activist Activity Broadly August 212 August 214 (Rolling Last Twelve Months) Activist Campaigns (1) # of Campaigns (Market Cap Greater than $1Bn, August 212 August 214 (Rolling Last Twelve Months)) Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Selected Activist Activity (2) Activists Target A Myriad of Companies Across All Industries YTD (3) 113 Campaigns 133 Campaigns 148 Campaigns 183 Campaigns 152 Campaigns Source SharkRepellent Notes 1. Defined as all U.S. publicly disclosed activism excluding 13D filers with no publicly disclosed activism and targets with a market capitalization more than $1Bn; Illustrative annual rolling last twelve months 2. Yearly campaign totals reflect companies with market capitalization greater than $5MM, excludes 13D filers with no publicly disclosed activism 3. As of 1/7/214 8

10 Observations on Shareholder Activism Activism Here to Stay Activist assets under management up from $47Bn in 21 to $93Bn in 213 Long onlys not sitting on the sideline No Company is Immune Size makes no difference (e.g. Dow, Apple, DuPont, and P&G) Absolute share price performance and valuation increasingly less of a defense Multiple Ways to Define Success Broad range of goals Do not need a tender or proxy fight to claim victory Expansion of Activist Toolkit Increased Activity Outside of Proxy Season Consent solicitations (Darden, Commonwealth) Proposals on annual meeting agenda (Transocean, Timken) Valeant / Pershing Square structure Approaching companies privately and publicly outside of traditional proxy season Threat of upcoming director nomination window not needed to influence boards 9

11 Worldwide M&A Activity has Accelerated (1) (2) Dollar Volume Average Transaction Size $Bn 4,5 4, 3,976 $MM 1,5 1,35 3,5 3, 2,5 2, 1,5 1, 5 3, ,172 3,228 3, ,531 2,483 2,286 2,289 2,293 2,27 2, , ,127 1,239 1, , ,518 1, , , ,515 1, , ,443 1, , , A % Change (3) Global (52) (3) (38) (29) 3 (4) (2) 5 1,2 1, U.S. Targets (4) 12 (57) (44) (4) (17) 9 27 (23) European Targets (17) (46) (11) (43) (46) 23 (3) 24 (31) 65 ROW (48) (29) (23) (2) 65 (22) (5) 23 U.S. Targets European Targets ROW Avg. Transaction Size Source Thomson Reuters as of 2 October 214 Notes 1. Includes announced transactions, each with an aggregate value of $1MM or more. Includes transactions with estimated values. Excludes terminated transactions. Future terminations of pending transactions will reduce totals shown 2. Includes transactions announced as of 3 September Percentage increase/decrease year over year 1

12 NDI M&A Materials.pptx\3 NOV 214\5:8 PM\ Has Seen the Return of Transformational M&A Reduction in volatility in 214 has driven corporate boards to look to strategic M&A to increase growth Top 15 Announced Transactions 214 YTD Shareholders are increasingly supportive of large strategically compelling acquisitions $7.7Bn $67.2Bn $56.3Bn $55.Bn $47.9Bn Feb - 14 May-14 Apr-14 Jun-14 Jun-14 $44.5Bn $39.5Bn $26.8Bn $23.3Bn $23.3Bn Advisors on Top 15 Largest Transactions 214 YTD # of Deals 11 Mar - 14 Apr-14 Jul-14 Feb-14 Feb $19.5Bn $17.3Bn $17.1Bn $16.Bn $15.7Bn Feb - 14 Sep-14 Apr-14 Apr-14 Jan-14 MS Competitor Banks As of September

13 Market Receptivity to M&A at an All Time High Strategic M&A is a High Corporate Priority Today Average Acquirer Stock Price Performance (1) (2) Drivers of Share Performance Drivers of Share Performance 17 8 Investors suffering from acute scarcity of growth Buyer Stock Price up in 3 out of 4 Announced Transactions Need to maintain post-213 momentum (+3% S&P5) Diminishing returns of share buybacks Desire to lock-in highly attractive borrowing costs (2) (4) 212 Q4 213 Q1 213 Q2 213 Q3 25th Percentile Median 75th Percentile 213 Q4 214 Q1 Upside from sensibly levered equity returns Source Bloomberg Notes 1. Deals >$5M in TEV by a Public Acquirer with market data available 2. Share Performance defined as 2 days prior to announcement through 5 days post 12

14 Trends in Return of Capital Unprecedented Return of Capital and Growing Cash Balances 213: 96% of S&P 5 constituents bought stock or paid dividend 13% bought stock only 65% bought stock and paid dividend 18% paid dividend only 4% neither share repurchase nor dividend 212 S&P 5 Stats: 92% of S&P 5 constituents bought stock or paid dividend 13% bought stock only 61% bought stock and paid dividend 18% paid dividend only 8% neither share repurchase nor dividend 1 Over $75Bn was returned to shareholders in 2 with more than $6Bn returned via 213 structured share repurchase Notional ($ Bn) $Bn 1, $6Bn (1) $64 Bn % increase 7 27% % % 43% $3 Bn 3 $35 Bn $36 Bn $36 Bn % 57% 62% 73% and more companies paying dividends than ever before Cons. Staples Cons. Discretionary Repurchase Dividend 214 Repurchase Annualized 214 Dividend Annualized Energy Financials Healthcare Industrials Info Tech Materials $Bn Repurchased 4 Buyback announcements have grown to historical highs Notional ($ Bn) Telecom Utilities Av. S&P Note Notional ($Bn) US-listed, excludes OTC companies 3-Year Monthly Av erage Note 1. Annualization excludes Apple ASR 13

15 Best Practices on Share Buyback Strategy Highlights from our 214 Investor Survey on Return of Capital We surveyed 45 of our top Equity Accounts in May 214 on Return of Capital and some of the conclusions are below Investors confirmed buyback and dividend were not perceived as a signal that growth opportunities are lacking Is the initiation of a large share repurchase program a signal that growth opportunities are lacking? What method of return of capital do you prefer? % of Investors Communication best practices around capital deployment strategy? While they still favor a combination of dividends and share buybacks, investors are now prioritizing buyback over dividend at the margin Size and commitment are the most important factors in a share repurchase announcement Companies should make an effort to provide clear and transparent return and leverage targets when communicating capital allocation strategy Investors favor ASR as a signal of management s commitment to purchase stock at current levels What factors are important to you in a corporate stock repurchase announcement? Timing Specified timeframe Execution Repurchasing following announcement Commitment - History of completing authorizations Size meaningful size What do you see as the primary benefit(s) of accelerated share repurchase programs (ASRs) % of Investors Strong signal from management to purchase stock at current levels Ability of issuer to monetize volatility to achieve a better economic outcome than an open market program Improved EPS impact versus open market repurchase Ability for issuer to tailor economic payoff Other 14

16 Morgan Stanley s Overall Share Repurchase Franchise Recent Open-Market Repurchases, Tender Offers, and ASRs Morgan Stanley has been a notable leader in the share repurchase space across products Selected Publicly Disclosed ASRs and Tender Offers Accelerated Share Repurchase Activity by Banks (1) $MM Notional 5, 1, 15, 2, 25, While it is difficult to estimate the total volume of Accelerated Share Repurchases, as many are not announced publicly, Morgan Stanley s share repurchase franchise has been a leading player in the space MS GS JPM BAML 1 3,5 13, , ,733 BARC 9 4,95 UBS 2 48 Quick Differentiating Stats 4 Distinct Corporate Clients Since Distinct Repurchase Programs YTD ~9MM Shares Repurchased in 213 >3.7Bn Shares Repurchased Since 28 Access to Team of Desk Sector Specialists Dedicated, Responsive Team of Market Experts C CS DB 3 1, , # Transactions Morgan Stanley # Transactions / $MM Notional Market # Transactions / $MM Notional Note 1. Publicly announced competitor transactions and all transactions tracked by Morgan Stanley 15

17 Sell Company Oshkosh Corp. / Carl Icahn BMC Software / Elliott Compuware / Elliott Gardner Denver / ValueAct Merger Consideration Insufficient National Interstate / Alan Spachman Zale Corporation / TIG Advisors AsiaInfo Linkage / Brandes Investment Partners Unsolicited Offer for Company Types of Activist Campaigns ( ) M&A Potential M&A Target Riverbed / Elliott Allergan / Pershing Square / Valeant Pharmaceuticals CVR Energy / Carl Icahn

18 Types of Activist Campaigns ( ) Operational Underperforming Companies Change in Management / Board / Structure Procter & Gamble / Pershing Square Yahoo! / Third Point Forest Labs / Carl Icahn Darden / Starboard Value LP Sotheby s / Third Point Hess / Elliott Change in Operations / Business Strategy Stillwater / Clinton Group Progress Software / Starboard AOL / Starboard Divest or Spin Assets Yahoo / Starboard Value LP Dupont / Trian Partners Dow Chemical / Third Point Oshkosh Corp. / Carl Icahn Cliffs Natural Resources / Casablanca Mondelez International / Trian Partners Darden Restaurants / Barington Capital PepsiCo / Trian Partners Capital Allocation Balance Sheet Capacity / Cash Rich Situations Return Cash to Shareholders Transocean / Carl Icahn Apple / David Einhorn / Carl Icahn Microsoft / ValueAct Capital Juniper Networks / Elliott NetApp / Elliott