2006 CEO of the Year Finalists

Every year, Morningstar awards one top corporate manager its CEO of the Year Award, and it's time to unveil the finalists. Our equity analyst staff sifts through our 1,800-stock coverage universe for CEOs who respect their shareholders, create value with smart capital allocations, and aren't afraid to challenge conventional wisdom. We detailed the specific criteria we look for in last year's announcement of the finalists, so let's cut straight to the chase and review this year's list, in alphabetical order.

John Chambers
 Cisco Systems (CSCO)
Chambers and Cisco probably need very little in the way of introduction. Cisco dominates the networking industry, and Chambers has been at the helm of the company since January 1995, overseeing the firm's growth from $1.2 billion in sales to $28.5 billion this year. Although Chambers' irrepressible optimism was a major reason why the company was late in addressing the bursting of the Internet bubble in 2001, Cisco subsequently bit the bullet and restructured more drastically and rapidly than most of its peers, laying off more than one fifth of its staff.

More importantly, Chambers then steered Cisco in new directions to capture growth outside of its core router and switch business, where it has more than 70% market share. Areas such as home networking, security, and video--through the acquisition of Scientific Atlanta--are now the fastest-growing parts of the company, and the overall strategy of moving beyond Cisco's core router business is paying off. Sales growth has accelerated recently while margins have held reasonably steady, and 2007 will likely be Cisco's best year in some time.

While Chambers has done well steering Cisco financially, the firm does have some warts on the corporate governance side. Although Chambers did cut his salary and bonus to $1 in 2002 and 2003, the firm has long been a staunch defender of heavy options issuance and fought hard against the recent accounting rule change that requires option expensing on the income statement. Given that we believe options should be expensed, we weren't fans of that stance.

Ken Chenault
 American Express (AXP)
Amex is another company that needs little introduction, and Chenault's strong focus on the firm's core card business has earned him a spot among our finalists. Thanks to Chenault's strategy, Amex is becoming a general purpose card that serves the needs of everyday high spenders, rather than just business travelers and the wealthy. He has bluntly stated that while returns on equity are important, the average spending of each Amex cardholder is his chief concern, and his job is to do everything possible to make sure that keeps going up. Since the firm's entire business model is dependent on higher-spending customers, we're very pleased to see this kind of focus.

We also like Chenault's long-term focus and excellent capital allocation. Although he began an aggressive cost-cutting program soon after becoming CEO, he didn't take the easy route to short-term success by letting those savings drop to the bottom line. Instead, he reinvested heavily to increase promotions/advertising/rewards expenses, which are long-term investments in the growth and health of the business. Finally, Chenault explicitly targets returning 65% of available cash flows to shareholders through share repurchases and dividends--a very disciplined approach to capital allocation.

Willard D. Oberton
 Fastenal (FAST)
Industrial-distributor Fastenal is not as well known as Amex or Cisco, but it's no less impressive. Over the past decade, returns on invested capital have averaged almost 25%, earnings have compounded at almost 20% (without meaningful acquisitions), and shares have appreciated over 13% annually. Not a bad track record for a firm that operates in the mundane business of distributing fasteners--of every shape, size, and price--to factories and contractors through 1,700 locations across the country.

Oberton took over the leadership of Fastenal from the firm's long-tenured founder in 2002, and has continuously reinvested in the business, adding 13% to 18% more stores every year. Given Fastenal's high incremental returns on capital, we think this is absolutely the right thing to do. He's also not afraid to trade short-term profits for long-term shareholder value. Case in point: Fastenal's shares sold off early in 2006 when the firm initiated a new round of improvements at existing stores designed to spur growth and improve efficiency. Wall Street wasn't happy with the blow these investments dealt to margins, but we think Fastenal has made the right decision for the long term by staying the course.

Finally, Fastenal's corporate governance is exemplary. Directors and officers own almost 17% of the company, executive compensation is very reasonable (if not even frugal), disclosure is excellent, option issuance is parsimonious, and the firm steadfastly refuses to kowtow to Wall Street. The company is a model citizen on this front.

George Roche
 T. Rowe Price Group (TROW)
Our fourth nominee is from an asset-manager that has taken a road often less-traveled by its peers, building value for company shareholders by tending to its fund shareholders. There's often a tension at asset-management firms between the interests of these two groups, since some decisions--such as charging higher fees--are great for stockholders, but less welcomed by fundholders. T. Rowe has outperformed its peers by taking a long-term view; for example, it keeps expenses down in the belief that lower expenses breed stronger investment performance, thereby attracting more fund investors over the long haul. This strategy has paid off well for stockholders; annual returns have averaged 18% since Roche took the reins in 1997, as compared with 12.5% for the firm's money-management peers.

This long-term view is also reflected in T. Rowe's avoidance of acquisitions and trendy new investment products, its focus on a team-oriented system rather than star managers, and its recent heavy investment in the defined contribution market. T. Rowe has become a giant in the defined contribution business, a very promising and defensible segment of the asset-management world, due in part to the heritage of its brand and the overall quality of the T. Rowe investment lineup. This is a business that requires much investment to enter, but one that should have excellent long-run returns.

Corporate governance is very good, but not exceptional. T. Rowe has been a prodigious issuer of options, and it has frequently bought back shares at uneconomical prices to manage options dilution. Disclosure is also on the skimpy side. However, generally speaking, the firm has done right by its stockholders--certainly good enough to earn a spot on our finalist list.

John Thain
 NYSE Group 
Thain is essentially responsible for bringing the New York Stock Exchange into the 21st century and is arguably the driving force behind consolidation in the exchange industry. NYSE's 2005 purchase of Archipelago, an all-electronic stock and options exchange, was the start of his firm's extreme makeover, and the recently announced merger with Euronext will certainly not be Thain's last move. We think these deals make great sense from both a strategic and a cost perspective.

Thain became CEO of the NYSE in early 2004 in the wake of the Dick Grasso compensation debacle. He quickly gained the confidence of the exchange's members and traders as well as market regulators with his low-key style, Goldman Sachs connections, and willingness to limit the size of his bonus. Breaking from more than 200 years of tradition, Thain convinced the exchange that it needed to transition to electronic trading of NYSE-listed stocks. This move is key to the NYSE retaining market share in its listed stocks once new SEC rules go into effect in 2007. More recently, Thain brokered a merger with Euronext, a European exchange that trades futures contracts as well as stocks. This deal globalizes the stock exchange business by offering easier trans-continent investing opportunities and longer trading hours, and we think it will help diversify the NYSE's revenue by adding a wide-moat asset class: futures.

Thain's tenure is the shortest among our finalists, but his achievements have been impressive. On the financial side, the NYSE's return on equity should exceed 20% this year, up from 12% in 2005, and the shares have appreciated by almost 50% since the consummation of the merger with Archipelago. NYSE's corporate governance has a few blemishes connected to its multiple antitakeover provisions, which the firm justifies by a stated desire to protect itself as a national asset.