Our CEO of the Year Nominees

I'll grant that Diogenes likely had a tougher time finding his proverbial honest man, but choosing Morningstar's CEO of the Year is always a challenge. CEOs who have truly had a large impact on their organizations over a long period of time are not easy to find, and companies that meet our high standards for corporate stewardship are even more rare.

This year, we have an eclectic group of nominees. Two have carved or strengthened meaningful economic moats in very tough industries, while the other two have literally invented industries from scratch.

One industry that's notably absent from our nominee list this year is financials. Jamie Dimon might have qualified, given the aplomb with which  J.P. Morgan Chase (JPM) has managed through the credit crisis, but we gave him the award for 2002. Buffett got it last year, and it seems prudent to wait until the smoke has cleared before going any further down the management food chain in financials.

Lonnie Smith,  Intuitive Surgical (ISRG)
First on this year's list of nominees is Lonnie Smith, CEO and founder of Intuitive Surgical, which has essentially created the robotic surgery industry from scratch. Intuitive is quite a story--not many companies grow from $10 million in revenue to almost $1 billion in a decade's time. Smith joined Intuitive in 1997 to make a profitable business out of this former remote battlefield surgery project for the Army, and Intuitive's da Vinci tools are now the standard of care for prostatectomy procedures in the U.S.

We're big fans of Intuitive's business model, which consists of installing robotic surgery systems and then selling services and instruments to customers that want to continue performing procedures with those systems. It's a classic "razor-and-blade" model, which has produced very high returns on capital--well north of 50%.

In 2009, the company made several shareholder-friendly moves. First, management resisted pressure from cash-strapped hospital administrators to cut prices on new systems. Doing so would have no doubt generated some short-term sales, but the move would have likely harmed Intuitive's pricing power over the long run.

Second, the company bought back 3.5% of shares outstanding not too far from the stock's trough, and then put on the brakes when the stock swiftly rebounded. This stands in marked contrast to all the companies that were buying back boatloads of stock a couple of years ago but kept their corporate wallets shut tight over the past year.

Corporate stewardship is solid on other fronts as well, with relatively low salaries and bonuses tied clearly to operating income growth. All employees get options, and Smith owns about 1% of the shares outstanding (1.7% including options). While that may not sound like a high percentage, it's certainly large enough in terms of dollars to keep Smith aligned with shareholders.

Mark Miller,  Stericycle (SRCL)
Our second nominee also took the entrepreneurial route to success, stitching together over 100 medical waste disposal firms to create Stericycle, the largest company in this small, but profitable, industry. CEO Mark Miller had a rough start at the company--when he joined in 1992, Stericycle had only 12 customers and was hemorrhaging cash. With only one month's cash balance left, Miller took a 50% pay cut, mortgaged his home, and cashed out his retirement account to make payroll.

To build the company into its current $1 billion in revenue size, Miller bundled traditional medical waste disposal services with expanded offerings like OSHA compliance training, safety product sales, and pharmaceutical recall and retrieval services. Stericycle also shifted its focus from large hospital customers to smaller, higher-margin customers. This approach has paid off in spades, with earnings and revenue compounding at about 30% annually over the past decade, solid returns on capital, and free cash flow currently running at about 15% of sales.

We like Stericycle's approach to corporate stewardship as well. Executives receive a majority of salary in the form of stock and other long-term incentives, and all executives are required to have equity ownership equal to 3-5 times their base salary, dependent on years of service. In fact, Stericycle's compensation structure is so focused on long-term value creation and long-dated incentives that 2008 was the first time in five years that executives received increases in base salaries--and only 3% at that.

 

Hunter Harrison,  Canadian National Railway (CNI)
Moving from two industries that barely existed 20 years ago to one that was a foundation of the Industrial Revolution, Hunter Harrison of Canadian National Railway is our third nominee. Harrison has actually transformed two railroads in his career, forging a new standard of profitability in a century-old industry in the process. Harrison began his career in 1963 as a carman-oiler on the Frisco, then earned increasing responsibilities on the Frisco, the Burlington Northern (1980), and the Illinois Central (1989).

First as COO, then CEO of the Illinois Central, Harrison implemented his vision of a precision, scheduled railroad and improved the rail's profitability by over 30 percentage points to a remarkably high 37% operating margin. Following CN's 1998 acquisition of the Illinois Central, Harrison resumed his COO duties and expanded this culture of discipline and asset utilization across CN's larger network. He further cemented his vision in the CN institution by serving as CEO from 2003 until his retirement at the end of this year.

When Harrison started at CN, its margins were 23%. Under his leadership, margins improved to a record 38% in 2006, and beat the average of other Class I railroads by an astounding 11 percentage points in 2008. This improvement was not the result of any single transformative idea, but rather a large number of seemingly small changes that really add up in an industry that thrives on discipline and efficiency. For example, CN encourages some customers to load and unload cars 24/7 and has asked others to run their factories on Sundays when it's advantageous for CN's schedule.

We approve of most CN corporate-governance policies, particularly the separation of the roles of chief executive and board chairman and CN's majority voting in board elections. Twelve of 14 directors are independent, and shareholders vote for directors annually, as we prefer. We also like the fact that directors are compensated primarily in stock, aligning their interests with those of other shareholders.

Jim Skinner,  McDonald's (MCD)
Our final nominee is from an industry that's even older than railroads, and which is even more brutally competitive. After starting as a restaurant manager trainee almost 40 years ago, Jim Skinner became McDonald's CEO in November 2004. Under Skinner's guidance, the firm has successfully executed its "Plan to Win" strategy (prioritizing menu variety, efficient restaurant operations, convenience, everyday low prices, and restaurant reinvestment), which has driven a significant improvement in return on invested capital.

McDonald's thrived during 2009 while many of its peers faltered, striking an appropriate balance between growth and profitability and avoiding aggressive discounting to drive sales. Although the firm certainly benefited from its considerable purchasing power and advertising muscle, much of this year's 200 basis point improvement in operating margins can be attributed to new menu innovations across all price tiers and excellent cost containment efforts. And while many restaurant operators are in capital-preservation mode and have slowed unit expansion, Skinner recently announced that the firm will accelerate restaurant openings and remodels in 2010 and invest in more efficient point-of-sales systems and drive-thrus. Wise capital investments such as these should keep McDonald's ahead of its peers for many years to come.

In terms of corporate stewardship, we like that Skinner and other top executives are expected to hold a multiple of their individual base salary in company stock, including six times base salary for Skinner. The company has also done a good job of returning capital to shareholders, with $15.8 billion returned through dividends and share repurchases over the past three years as of October, on track for its stated target of $15-$17 billion from 2007 to 2009.

So who will get the award? The 2009 CEO of the Year winner will be announced on Morningstar.com and CNBC's Squawk on the Street at 9:50 a.m. EST/8:50 a.m. CST on Wednesday Jan. 6, 2010.

Note: This article has been corrected since original publication. Please click here for details.