Starbucks Management Pay: Aligned With Your Best Interests?

"Never, ever, think about something else when you should be thinking about the power of incentives."
-- Charlie Munger

We Fools place a lot of emphasis on finding strong management teams as one of the keys to discovering those great businesses that deliver outstanding shareholder returns. Stellar management can mean the difference between a market-thumping leader and an underperforming laggard.

But we're also respectful of the awesome power that incentives play in our lives. Even the most capable managers will tend to underachieve if their pay and rewards aren't aligned with long-term company interests.

With that in mind, today we're taking a look at the compensation package for Starbucks' (SBUX 0.65%) top management team to see just how well their incentives are aligned with your interests as a shareholder.

Skin in the game
Investors want a management team that has substantial stock ownership in their company. We like executives who are owners, too, and have a sharp focus on long-term results. By that measure, Starbucks meets the standard. As a group, its executive directors own 4.1% of the company's common stock. Here's a look at the stock ownership of the company's main executive team:

Source: Starbucks financial filing. NM = not material.

Starbucks' founder and CEO, Howard Schultz, owns close to 28 million shares, amounting to nearly 4% ownership in the company. Schultz is also required to hold at least six times his annual base salary in stock at all times. But his top lieutenants have a fair bit of skin in the game, too. They own about 1 million shares between them. And they each need to keep a minimum of three times their annual base salary as a long-term equity stake of Starbucks' shares.

Together, the executive team clearly stands to benefit along with investors if the stock performs well. And the managers also have a substantial amount of capital at risk, which should give them pause before sacrificing long-term interests at the expense of short-term gains.

Eyes on the target
But the surest way to align executive's interests with company performance is to tie their compensation directly to those metrics. Here, Starbucks passes the test again. The CEO's pay is made up of just 5% base salary, with the other 95% "at risk," and dependent on hitting certain business performance milestones. The same goes for the rest of the executive team. Schultz's deputies can only bank on 15% of their annual salary in the form of a guaranteed base. The other 85% is variable, and depends on company performance.

So what exactly are those target performance metrics?

The executive team gets paid based on its success at hitting these three goals: operating income, earnings, and return on invested capital. The actual targets are set every year by the compensation committee, which aims to stretch the management team but also to consider factors that they can't control. As the committee explained about 2012's goals, "the targets were designed to be challenging while recognizing significant economic uncertainties, including continued consumer spending restraint and volatility of commodities, specifically coffee."

By these measures, management outperformed all of its goals last year. Each officer hit at least 100% of every target. And the biggest overachievements came from the China division, where operating income was 165% of the goal.

Overall, here's a look at how the company has performed on the three target metrics that made up the bulk of managers' pay last year:

SBUX Return on Invested Capital data by YCharts.

And this is how investors in the company's shares have fared over the last five years:

SBUX data by YCharts.

Looking ahead
For 2013, Starbucks' executive compensation will be more closely tied to net revenue and overall operating income, with per-share earnings taking a backseat.  That shift makes sense in a time where Starbucks plans to spend heavily on expanding its footprint both in the U.S. and overseas. You don't want your managers putting off investments in future growth just to boost earnings in any given quarter.

But the bottom line is that Starbucks' executive team owns a big chunk of the company's stock, and has a pay package that's tied to long-term business goals. When a well-targeted compensation plan meets a capable management team, the result is usually strong shareholder returns over time. And Starbucks is a great example of those incentives at work.