“Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.”
— Warren Buffett, 2005 Letter to Shareholders
Coca Cola’s Compensation Controversy
The Coca Cola Company is in the midst of a major controversy prompted by shareholder objections to the company’s equity compensation plan which is outlined in the company’s 2014 proxy statement. David Winters, managing member of Wintergreen Advisors which controls 2.5 million shares of Coca Cola, has sent two letters (dated March 21 and March 27) to Coca Cola’s board of directors in which he strongly objects to the design and magnitude of the equity compensation program. Mr. Winters has also posted a YouTube video in which he presents his case against the compensation plan.
Mr. Winters makes some strong points in his presentation regarding the economics of stock based compensation and the magnitude of the proposed grants at Coca Cola in particular. In recent days, there have been a number of news stories and related commentary regarding the merits of stock option plans as well as the question of whether executive compensation is excessive in general.
Even a cursory glance at Coca Cola’s proxy statement shows that the named executive officers are paid extremely well through a variety of cash and equity programs. However, anyone who has been reading proxy statements of Fortune 500 companies knows that Coca Cola is far from unique. While serving as an executive officer for a large enterprise is no doubt a major responsibility, we have reached the point where anyone serving in such a position for more than a few years is assured of an eight figure net worth providing financial independence for life, in most cases regardless of the company’s performance.
The debate over the level of executive pay and the design of compensation packages occurs during proxy season every year and represents a long term problem for American shareholders. However, we will leave that larger debate for another day and instead focus on Coca Cola’s highly problematic response to Mr. Winters. We find the response to be not only patronizing but highly intellectually suspect when it comes to the company’s understanding of capital allocation.
Lemonade Stands and Capital Allocation
Coca Cola’s latest response to Mr. Winters was written by Gloria Bowden who serves as the company’s associate general counsel and secretary. The title of the response is What Lemonade Stands Can Teach Us About Ownership which is an interesting way to begin a response to a concerned long term shareholder who controls approximately $100 million of the company’s stock.
Once one gets over the patronizing tone, it initially appears that Ms. Bowden is simply reiterating the justification for stock compensation plans that have been put forward countless times in the past. However, Ms. Bowden does not stop there. She attempts to justify how shareholders are “protected” by the fact that Coca Cola has a stock repurchase plan in place:
First, we regularly repurchase shares in the stock market. This reduces the amount of shares on the market which offsets the potential dilutive impact. In 2013, we repurchased $4.8 billion of our stock. That far exceeded the $1.3 billion repurchased related to employee stock options exercises.
One can fairly debate the pros and cons of providing management with equity compensation and whether the much hoped for “alignment of incentives” is actually created through grants of stock options and restricted stock. However, the idea that shareholders are “protected” in any way merely because the company has a stock repurchase program that “offsets dilution” makes no sense whatsoever.
Conflating Operating and Capital Allocation Decisions
The act of granting stock options or restricted stock to employees is an operating decision to effectively sell additional pieces of the company to use as currency for compensation rather than using cash. The act of repurchasing stock is a capital allocation decision that is entirely separate from the decision to grant stock based compensation.
If a company is using equity to pay employees, it is obvious that the effects of the decision are magnified to the extent that the shares are undervalued and dampened if the shares are overvalued. In other words, the company’s owners should be less inclined to use equity to pay employees at times when shares are trading below intrinsic value. If the stock is trading well above intrinsic value, the effect of using stock for compensation is less harmful. Effectively, small pieces of the company are being transferred from owners to employees when stock is used as compensation. As with any “sale” of the business, owners should hope to sell at high levels rather than low levels.
The economics of repurchases are exactly the opposite: Shareholders should cheer when repurchases occur below intrinsic value and hold management to account when repurchases occur above intrinsic value. The idea that repurchases at any price will “protect” shareholders from the impact of stock option dilution reveals a complete misunderstanding of capital allocation. Repurchases, whether motivated by reducing the dilution of a stock option program or for other reasons, will only make shareholders richer if executed below intrinsic value.
Coca Cola and all other companies must make a decision regarding how to deploy free cash flow. Cash can be reinvested in the business, used for acquisitions, paid to shareholders as dividends, or used for repurchases. The fact that Coca Cola directed $4.8 billion toward repurchases in 2013 and that this amount more than offset the dilution from equity compensation is completely beside the point. These funds belong to shareholders, not to management, and it is not through some form of corporate benevolence that the shares were retired.
Corporate Governance at Coca Cola
We do not necessarily expect Ms. Bowden, who is presumably trained as a lawyer, to be well versed in the finer points of capital allocation but we hope that Coca Cola’s senior management and board of directors would immediately recognize the fallacy of her logic with respect to repurchases categorically “protecting” shareholders from dilution. It also seems more appropriate for Muhtar Kent, Coca Cola’s Chairman and CEO, to take the responsibility of responding to a major shareholder’s concern rather than delegating the task to a lower level official.
Coca Cola’s Board of Directors is comprised of seventeen members who are paid well in excess of $200,000 per year and most of whom have substantial business experience. Until recently, Warren Buffett was on the board and Howard Buffett currently represents Berkshire Hathaway’s substantial ownership interest in Coca Cola. It is inconceivable that the board of directors fails to recognize the simple economics behind repurchase decisions outlined in this article and it should be an embarrassment to see a corporate general counsel post such an illogical rationale as part of a poorly thought out and tone deaf response to a major shareholder’s concerns. Whatever justification Ms. Bowden provided regarding the alignment of incentives through ownership (or quasi ownership) by management is far overshadowed by flimsy and alarming logic with respect to capital allocation.
Disclosure: Individuals associated with The Rational Walk LLC own shares of The Coca Cola Company directly and indirectly by virtue of ownership of Berkshire Hathaway common stock.4 Comments on Coca Cola Misfires on Share Repurchase Rationale