Recently, David Winters of the Wintergreen Fund sent a damning letter to both the Coca-Cola (NYSE: KO ) Board of Directors and to is largest investor, Warren Buffett of Berkshire Hathaway. In his letter, Winters sharply criticized Coke's new "2014 Equity Plan," writing:
We can find no reasonable basis for gifting management 14.2% of the share capital of Coca-Cola, worth $24 billion at today's share price. No matter how well a management team performs, it is unfathomable that they would require such astronomical sums of money to provide motivation. As representatives of the shareholders, it is the number one priority of the board to look after the owners' interests. This compensation plan appears to place the economic well-being of management far ahead of the interests of the Company's owners.
In a response to the ensuing outcry over the plan, Coke wrote a piece called "What Lemonade Stands Can Teach Us About Ownership," concluding:
We believe that our proposed equity plan is financially sound and encourages our employees to act like owners by tying their interests to those of everyone who owns a share of The Coca-Cola Company. Our business may be a bit more complex than a corner lemonade stand, but at the end of the day, we want our employees to think and act like owners.
Who has it right? Winters or Coke?
Let's go through The Math, and The Reasoning.
Because Coke and Winters come to different conclusions regarding the potential value being transferred to Coke employees through the plan, let's go through a little math first.
The 2014 Plan, along with the equity units left over from previous plans, proposes to create a pool of 500 million shares from which to compensate 6,400 of Coke's employees – although it seems likely the bulk of the value will end up in the hands of a much smaller group.
What's it worth?
The plan has some interesting specifics. For every stock option granted through the plan, the remaining "pool" for grantable shares is reduced by one share. For every "full value" equity award – restricted stock units or performance stock units – the pool is reduced by a total of five shares. This makes sense; an option to buy stock at the current market price is worth much less than the value of a real share of stock. Thus, the structure of the plan attempts to equalize the two.
The ultimate value of the plan will depend on the mix of options and full-value awards given out. Historically, the ratio has been about 60/40, and Coke has indicated this will likely continue to be the case – so let's base our math on that outcome. (Note that the entire plan is designed to be "performance based," in the sense that the equity awards will be contingent upon Coke meeting certain financial goals.) To get our upper bound, we'll assume Coke hits its numbers and the entire plan is exhausted.
60% of 500 million units is 300 million, our rough estimate of how many options Coke could potentially grant under the plan. Of that 300 million, a certain percentage will likely be forfeited or cancelled by departing employees, but we'll assume for now that they're all issued and exercised.
Because Coke chooses to use the proceeds of exercised stock options to buy back their own stock, we can roughly estimate what those options are going to cost them over time. For example, if Coke issues those 300 million options at an average strike price of $45, and they are exercised, on average, at $65 as Coke's stock price rises over time, Coke will be granting $20 of value to the option holder for every option. Let's use that as our working assumption, in which case the 300 million options are worth $6 billion. (Spread, of course, over many years.)
That leaves 200 million shares in the option pool for "full value" awards. If we again ignore forfeitures, the "5:1" full value share counting method means only 40 million shares can really be issued. Using $45 as our average grant date stock price again, those are worth $1.8 billion.
That puts the total value of the plan, under my estimates, at about $7.8 billion. Any forfeitures or shares that go un-granted will reduce that total value — so think of the $7.8 billion as an approximate upper bound. David Winters, in his letters, puts the value of the plan at $13 billion. Including the 368 million options outstanding under prior plans, he pegs the value of Coke's current equity granting at $24 billion. That seems rather high to me unless you're willing to use drastically different assumptions than I have above.
OK, that doesn't mean the plan is good news. While it may be worth less than Winters wants us to believe, we are still talking rather large numbers. Three hundred and forty million shares, in addition to the nearly 390 million already outstanding for equity awards, will amount to nearly 14% of Coke's outstanding shares, assuming full exercise.
Let's ask why Coke thinks this is reasonable and see if we agree.
First, Coke claims to be "paying for performance" – the shares are only issued if the Compensation Committee of the Board of Directors deems that Coke has met its targets. Coke has even shown the willingness to let some performance shares go un-granted in recent years due to lack of performance. Bravo. But they have also shown the willingness, in the past, to move the goalposts.
The PSU awards are based on something Coke calls "economic profit growth." Projecting a difficult economic environment and a negative impact from currency movements, Coke's "target threshold" of annual economic profit growth in the 2013-2015 period is merely 6.4%, as opposed to 11.7% in the 2011-2013 period, and 10.7% in the 2012-2014 period, neither of which are likely to be met. From the shareholder perspective, this looks a bit like moving the target a little closer to the archer to help ensure a bulls-eye.
In addition, despite the poor performance last year under the definitions of the PSU plan, Coke still managed to grant 73 million total equity units (in the form of options and RSUs) last year – or about 1.6% of shares outstanding. Pay for performance you say? I'm not so sure.
Not only that, but stock options are a fairly poor way of paying for performance. Their ultimate value derives from the opinion the stock market places on the company – which anyone involved in the market knows can vary widely. Hello Mr. Market. That means an employee can easily be wildly overpaid or underpaid for doing the same job with the same performance, depending on the ultimate mood of a stock market over which they have no control.
Why not simply pay them in cash for hitting their stated goals? Wouldn't actually paying for performance be a more straight-forward way of...paying for performance?
Coke's response to this is probably that it is trying to create a "culture of ownership" by using equity-like compensation. The banks wanted to create 'cultures of ownership' too and we saw how that worked out.
The problem is stock options do not make employees act like owners. The difference between real ownership and "option ownership" is that the latter is all carrot and no stick.
The actual owners have put their hard earned capital on the line, with risk of loss, for the potential benefit of participating in Coke's growth. Option holders are granted a sort of lottery ticket on the company's success. The two are similar in certain respects, but not the same.
Lastly, Coke claims it offsets the issuance of options with stock repurchases. And indeed, Coke seems to use the proceeds from stock option exercise to repurchase shares -- $1.3 billion or probably around 33 million shares last year. This is why Coke can claim that dilution is less than 1% per year (which they have) – the repurchase activity offsets some of the dilution.
The problem with this argument is that the two need not be linked. Indeed, their largest shareholder Mr. Buffett has argued this point in the past. Repurchases, by definition, create per-share value when shares are purchased below their intrinsic value; whether the cash being used comes from sales of soda or the exercise of stock options is irrelevant.
Mindlessly buying back shares at any price simply because shares are being bled into the market via options issuance is not smart capital management. (Imagine, if you will, that Coke's stock price was at triple its actual value last year and yet Coke had continued its policy offsetting all options exercise with buybacks. Essentially their entire share repurchase program would have gone to offsetting options exercise, with no net reduction in shares outstanding. Would this have been a wise use of $4.8 billion of shareholder funds?)
Thus, Coke should consider its options program and its buyback program on their own merits. Just because Coke has a (very smart, on the whole) repurchase program does not give them carte blanche to issue equity to their employees.
There are two other problems with options in the case of Coke. The business itself doesn't need capital, so when people pay for their options, giving the company $45 for their shares, now worth $65, the company cannot invest that money at a decent return. Instead, these new funds will likely go into share repurchases. Another problem with options is that they are fixed price and this is by no means unique to Coke. As along as Coke makes money, however, "retained" earnings will enable it to make more money the following year. These options also ignore the carrying cost of capital.
As you can see, the details behind the Coke program, like most compensation programs across Corporate America, are fairly complex. (Compensation consultants don't get paid for simple.) Besides, if you're too simple, shareholders might actually figure out what management is being paid.
Reasonable minds can disagree about its value. But two things do seem somewhat clear: Coke is using somewhat fuzzy thinking to justify generous equity granting practices, and Mr. Winters is using some fuzzy thinking to help rally shareholders to the cause.
I'm a fan of Coke just getting rid of all options and paying people cash. If they want to be owners, they should put their money on the line like shareholders.
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