$24 Billion Wealth Transfer?!

So David Winters is upset about the "biggest transfer of wealth from shareholders to management" in history.  According to Winters Coke's (KO) new 2014 Equity Plan may cause 14.2% dilution to shareholders over the next four years.

His calculation is that there are 4.4 billion shares outstanding so 14.2% of that is 625 million shares, and at $38/share, that's $24 billion of wealth that will be transferred directly from shareholders to management.

Of course this is ludicrous.  How can this much wealth transfer occur in a company like Coke?

This is where the 14.2% comes from (2014 KO proxy):

Expected Value Transfer and Dilution
The Compensation Committee and the Board also considered the expected shareowner value transfer and potential dilution that would result by adopting the 2014 Plan, including the policies of certain institutional investors and major proxy advisory firms. Potential dilution is calculated as shown below:

		[shares underlying equity awards that may be made under the 2014 Plan] + [shares to be issued on exercise or settlement of
Potential Dilution	=	outstanding equity awards under the Prior Plans] + [Holdback Shares] (collectively, “Total Award Shares”)
		[total number of issued and outstanding shares of Common Stock (excluding treasury shares)] + [Total Award Shares]

Actual dilution will depend on several factors, the most important of which is the type of awards made under the 2014 Plan. This is because the 2014 Plan uses a fungible share pool, under which each share issued pursuant to an option or SAR will reduce the number of shares available under the 2014 Plan by one share, and each share issued pursuant to awards other than options and SARs will reduce the number of shares available by five shares.

The Company expects to continue to grant a mix of stock options and full value awards, primarily in the form of PSUs, under the 2014 Plan. To illustrate the range of potential dilution, the table below shows potential dilution pursuant to the above formula based on 4,405,893,150 shares of Common Stock issued and outstanding as of February 24, 2014 and assuming that all authorized shares under the 2014 Plan are granted (i) 100% as stock options, (ii) at the current mix of approximately 60% stock options and 40% full value awards and (iii) 100% as full value awards.

Current 60%/40%

Mix of stock

mix of stock

options/full value

100% stock

options and full

100% full value

awards

options

value awards

awards

Potential Dilution

16.8

%

14.2

%

10.0

%

The problem with this comment is that much of this dilution is going to occur via stock options (in terms of number of shares), and a grant of stock options is not a direct transfer of wealth of the entire underlying amount to the employee who receives it.  For example, if the stock is trading at $38 and an option is offered at a $38 exercise price, the cost to KO (which is expensed) would be around $3.8/share granted, not the entire $38/share.

Here are the inputs to value the stock options from the 2013 10-K:

The fair value of our stock option grants is amortized over the vesting period, generally four years. The fair value of each option award is estimated on the grant date using a Black-Scholes-Merton option-pricing model. The weighted-average fair value of options granted during the past three years and the weighted-average assumptions used in the Black-Scholes-Merton option-pricing model for such grants were as follows:

	2013				2012				2011
Fair value of options at grant date	$	3.73			$	3.80			$	4.64
Dividend yield1	2.8		%		2.7		%		2.7		%
Expected volatility2	17.0		%		18.0		%		19.0		%
Risk-free interest rate3	0.9		%		1.0		%		2.3		%
Expected term of the option4	5 years				5 years				5 years

1	The dividend yield is the calculated yield on the Company's stock at the time of the grant.

2	Expected volatility is based on implied volatilities from traded options on the Company's stock, historical volatility of the Company's stock and other factors.

3	The risk-free interest rate for the period matching the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.

4	The expected term of the option represents the period of time that options granted are expected to be outstanding and is derived by analyzing historical exercise behavior.

If you plug the 2013 inputs into an option model, you will get a fair value of less than 10% (of the stock price).

But if the KO stock price goes up over the next five years and the option is exercised, KO will "sell" stock cheap and then buy it back (repurchase) high.  Assuming the stock price goes up 8%/year, which is the EPS growth target (so is a reasonable estimate of stock price appreciation over the long term), then it may actually end up costing KO $18/share.  Some will say the true cost of the option, then, is the difference between the exercise price and the market price at the time of exercise.  Never mind if that's right or not for now.

The 2014 Equity Plan is based on historic trends in equity grants.  They are just reloading the gun, so the 500 million shares doesn't really mean anything in terms of year-to-year grants.

For real dilution or wealth transfer effects, maybe it's better to just look at the historic burn rate for KO which is disclosed here in the proxy:

Historical Equity Award Granting Practices
In setting and recommending to shareowners the number of shares authorized under the 2014 Plan, the Compensation Committee and the Board considered the historical number of equity awards granted under the Prior Plans in the past two full years and the annual equity awards made in February 2014. In 2012, 2013 and year to date through February 20, 2014, the Company used approximately 60 million, 63 million and 73 million, respectively, of the shares authorized under the Prior Plans to make equity awards.

The Compensation Committee and the Board also considered the Company’s three-year average burn rate (2011-2013) of approximately 1.3%, which is lower than the industry thresholds established by certain major proxy advisory firms.

Based on historical granting practices and the recent trading price of the Common Stock, the 2014 Plan is expected to cover awards for approximately four years.

The burn rate is 1.3% for the three-years 2011-2013.  That is very far from a 14.2% dilution over four years that Winters talks about.  The 14.2% includes options already granted and are outstanding from previous years.

By the way, check this out from Goldman Sachs' equity compensation presentation of 2013:

Of course, it's not a good idea to bring in GS and other banks to defend KO; I can imagine the outcry of some folks (who think bankers are even more overpaid).  But Buffett is a large shareholder of GS and is well aware of this.  I also don't mind this stuff too much at financial firms as I tend to look at BPS growth over time, and all of this is reflected in shareholders' equity.   For example, if JPM has a high looking burn rate of 2.1% but has grown BPS in double digits, that's fine with me.

OK, back to KO.  KO's burn rate is 1.3%.  I don't know that there is anything in the proxy that indicates that the burn rate will be any higher going forward.  

Well, using this comment:

In setting and recommending to shareowners the number of shares authorized under the 2014 Plan, the Compensation Committee and the Board considered the historical number of equity awards granted under the Prior Plans in the past two full years and the annual equity awards made in February 2014. In 2012, 2013 and year to date through February 20, 2014, the Company used approximately 60 million, 63 million and 73 million, respectively, of the shares authorized under the Prior Plans to make equity awards.

We may conclude that the burn rate might rise to 1.5%/year.  But I don't know if that conclusion is correct. Setting up the plan and granting things from year to year are not the same thing; maybe they want to have enough shares to grant just in case.  I just took the 60 million, 63 million and 73 million and averaged them and then divided by 4.4 billion shares (actually, shares outstanding was 4.6 billion in 2012).

So using a 1.5% burn rate (and for simplicity let's just assume it is mostly options granted) and 8%/year increase in stock price over five years, that's 0.75% actual 'cost':  8%/year would make the stock price go up around 50% in five years, so at-the-money options granted will eventually be worth 50% of the stock price.  1.5% of outstanding shares in options are granted every year so that's 0.75% in total cost.  But since KO gets to deduct the difference between the exercise price and market price (at time of option exercise) for tax purposes, the after tax cost would be around 0.5%/year.

With the current stock price at $38/share, that's $0.19/share in total cost or actual 'dilution'.

2013 EPS was $1.90, so it comes to 10% of 2013 earnings.

Accounting treatment now is that the cost of stock options is expensed using an option model but the difference between exercise price and market value at the time of option exercise, although tax deductible, does not show up on the income statement as an expense but does show up in a reduction in shareholders' equity (so is a "wealth transfer" from shareholders to employees).

Anyway, the above is theoretical, using assumptions (1.5% burn rate, all options, 8%/year stock price appreciation etc.)

We can see what the actual cost was in the recent three years by looking at the 2013 10-K:

Stock option activity for all stock option plans for the year ended December 31, 2013, was as follows:

	Shares (In millions)			Weighted-Average Exercise Price				Weighted-Average Remaining Contractual Life		Aggregate Intrinsic Value (In millions)
Outstanding on January 1, 2013	309			$	27.27
Granted	56			37.68
Exercised	(53	)		25.02
Forfeited/expired	(7	)		34.34
Outstanding on December 31, 20131	305			$	29.42			5.82 years		$	3,636
Expected to vest at December 31, 2013	302			$	29.33			5.78 years		$	3,614
Exercisable on December 31, 2013	187			$	25.87			4.25 years		$	2,887

1	Includes 3 million stock option replacement awards in connection with our acquisition of CCE's former North America business in 2010. These options had a weighted-average exercise price of $18.02, and generally vest over 3 years and expire 10 years from the original date of grant.

The total intrinsic value of the options exercised was $815 million, $780 million and $631 million in 2013, 2012 and 2011, respectively. The total shares exercised were 53 million, 61 million and 65 million in 2013, 2012 and 2011, respectively.

The above table shows the intrinsic value of the options exercised in the past three years.  Intrinsic value, of course, is the difference between the exercise price of the option and the market price of the stock at time of exercise.  This is the tax deductible 'expense' (that is not expensed) that occurs when KO has to sell the shares to the option holder for a low price versus a higher market price.

The figure in 2013 was $815 million, which comes to $0.19/share using 4.4 billion shares outstanding, but after tax would come to $0.12/share.  So that's the wealth transfer that has occurred at KO in 2013 (sold shares cheap, bought back high).  That also comes to 0.5% of the market cap.

And by the way, $815 million compares to $46.9 billion of sales (1.7% of sales) and  $10.2 billion of operating income (8% of operating income).

There are 302 million options outstanding already.  Someone might see this as an $11 billion transfer of wealth, but you can see that the instrinsic value of the options is $3.6 billion (as of the end of 2013).  If all options outstanding were exercised at once and KO repurchased shares in the market to offset it (at the year-end price), it would cost KO $3.6 billion, and after tax $2.3 billion.  That's against a current market cap of $167 billion, or 1.4%.  That's a 1.4% transfer of wealth from KO shareholders to employees.

The above excludes full value awards, but since those are expensed one-for-one and the number of shares are a lot lower than those represented by options, I tend not to think that it's that much of an issue.

Conclusion
I understand the frustration with excessive executive compensation, but I really don't think this sort of hyperbole is productive.  To call this equity plan a $24 billion transfer of wealth is very misleading.   Speaking of hyperbole, the recent "market is rigged" comment seems like that too, which may be another post.

I know there have been issues in the past about the treatment of stock options.  I don't have a strong view on that (other than that is should be expensed) and that's really not the point of this post.

David Winters is a BRK-holding value investor and I have a high degree of respect for him but I sort of wish he didn't resort to this kind of soundbite-ism.  I know that's the way of the world now; people won't pay attention unless you can get the message out in 140 character or less or in four words ("the market is rigged"), and that's very unfortunate.