Coca Cola Misfires on Share Repurchase Rationale

“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. 

Book Review: Fizz — How Soda Shook Up the World

Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component — usually a plus, sometimes a minus — in the value equation.

— Warren Buffett, Berkshire Hathaway 2000 Chairman’s Letter

A common misconception regarding value investing is that the “cigar butt” approach represents the main path to success.  Such an approach can in fact yield very satisfactory results over time but, in most cases, a “cigar butt” is sold when it nears intrinsic value and must then be replaced with a new opportunity.  Most “cigar butts” are good for one additional puff rather than sustained internal compounding of value over long periods of time.

If an investor has set a high internal “hurdle rate” for compounding wealth, it is usually difficult to find a company that can internally compound intrinsic value rapidly enough.  Furthermore, companies that have already demonstrated an ability to compound intrinsic value rapidly often sell at prices that turn off almost all value investors.

Despite the difficulties involves in so-called “growth investing”, value investors should not simply “punt” when it comes to being on the lookout for companies capable of rapid compounding.  For one thing, being aware of such companies costs nothing more than reading about them and the industries involved can be quite fascinating.  Not every research prospect needs to be one that must be immediately actionable.  A bear market can quickly bring about interesting situations with “fallen angels” and turn a “growth” stock into a “value” stock overnight.

Fizz:  How Soda Shook Up the WorldOne of the more productive ways to get into a “growth” mindset is to study the history of rapidly growing industries.  In Fizz:  How Soda Shook Up the World, Tristan Donovan provides a compelling account of the soda industry from its very early days to recent controversies regarding health concerns.  Following a brief survey of the historical origins and human use of naturally occurring mineral waters, the book quickly shifts toward an account of the industry as it took shape in the late nineteenth century.

The early days of the soda industry predated the technology required to reliably and consistently bottle carbonated beverages and, as a result, nearly all soda consumption took place at soda fountains often found in the drug stores in towns and cities of all sizes.  Fortunes were made and lost during the early days with a dizzying variety of different brands and concoctions.  A technological paradigm shift took place when bottling technology progressed to the point where soda could be consumed away from the fountains and fortunes were again made and lost often due to the choices entrepreneurs made regarding whether to invest the capital required for bottling plants or to take a more capital light approach of franchising bottling rights and selling syrup to independent bottlers.

The book does not really provide much in the way of detail regarding the economics of the early industry but reveals enough to whet the appetite of readers who may wish to learn more elsewhere.  Mr. Donovan spends more time looking at higher level strategic decisions that were made to build brands over time.

Coca-Cola WWIIThe Coca-Cola Company’s decision to aggressively distribute its beverage to all troops serving overseas in World War II for five cents per serving must rank as one of the most brilliant in business history.  Five cents was the going price for a serving of soda for decades prior to the war but sugar rationing upended the economics of the industry.  Rather than seeking higher prices, Coca-Cola sacrificed profits in exchange for the prospect of saturating the military with soda that represented a small piece of America for millions of soldiers far from home.

This move likely created lifelong positive mental associations for millions of returning soldiers who then introduced their children, the baby boom generation, to Coca-Cola.  The short term financial pain of offering cheap soda to the troops paid off enormously over the decades that followed.

Coca-Cola’s experience during World War II brings to mind other aggressive promotional behavior by companies seeking to build brands.  Obviously, not all promotional efforts end up being successful over time.  Is it possible to predict which companies aggressively sacrificing profits today are doing so with a reasonable prospect of building a long term durable moat?  Or are promotional activities actually sacrificing current profits with no prospect of improvement in the future?

For example, there is much controversy today regarding due to the company’s willingness to sacrifice current profitability in order to continue dominating online commerce.  Will this promotional behavior lead to a long term moat that will allow to eventually “flip the switch” and operate for profitability or is this a never ending cycle of intense price competition?  Although online commerce has no obvious relationship to the history of soda, it is valuable to look at how a variety of competitive environments played out in the past in an attempt to understand the present and perhaps have more insight into the future.

Readers of Fizz should not expect any earth shattering revelations when it comes to thinking about investing and business but the book might help to refine some mental models regarding competitive behavior that could be useful when thinking about present day opportunities.  It is also an entertaining and quick read for anyone with an interest in American history.

Coca-Cola Tops Interbrand’s Global Brand Survey for 11th Consecutive Year

Branded products often suffer impairments during times of economic stress as consumers search for cheaper alternatives.  However, the combination of attractive products and intelligent marketing can sustain brands even in a poor economic climate.  Interbrand’s report (pdf) covering the best global brands of 2010 suggests that the most entrenched brands have retained their position reasonably well while up-and-coming brands managed to make significant advances.

Interbrand uses a methodology that attempts to determine a brand’s value based on a brand’s financial performance and an assessment of the intangible power of the brand in delivering earnings power.  Some elements are clearly subjective but the top brands in the listing match what many observers would consider to be successful brands. The report lists individual brands rather than companies (for example, Blackberry is considered a brand rather than Research In Motion).

The top five brands for 2010 include Coca-Cola, IBM, Microsoft, Google, and General Electric.  The top five rising brands in terms of improvement in ranking are Apple, Google, Blackberry, J.P. Morgan, and Allianz.  The five brands with the largest decline in value were Harley Davidson, Toyota, Nokia, Dell, and Citigroup.

Here is a brief except from the report regarding Coca-Cola:

Year after year, Coca-Cola demonstrates its ability to adapt to whatever challenges the marketplace throws its way. The number one brand for the 11th year in a row makes its brand central to its business operations. This year, for example, it oriented business operations around a new philosophy of “consumer engagement,” which yielded benefits such as a more robust social media strategy, continued development of owned media projects like its World of Coca-Cola Museum, smart product placements and ads that stir emotions.

Investors must carefully monitor the economic moats created by powerful brands when evaluating investment opportunities.  The best brands, such as Coca-Cola, consistently generate high levels of profitability on the tangible capital employed in the business.  However, brand values can change over time as society changes.

A change in brand value is likely to be less rapid in the case of low-tech/low cost consumable products like Coca-Cola compared to advanced technology such as Microsoft’s software or Blackberry devices.  Investors who pay a premium to obtain valuable brands should carefully determine whether a brand is entrenched enough to provide a reasonable assurance that the premium will be recovered over time.

The danger of brand erosion is particularly apparent when evaluating Toyota’s steep drop in ranking this year.  We pointed out the potential for brand erosion at Toyota earlier this year during the height of the recall story.  Unfortunately subsequent reports that the acceleration issue was mostly driver related did not receive the same prominence as the stories regarding the initial recall.

Disclosure:  The author owns shares of Microsoft Corporation.  No direct position in Coca-Cola;  indirect position through ownership of Berkshire Hathaway shares.