The C-Suite Conspiracy
Income inequality and the widening gap between the rich and poor has become a central theme that will likely dominate the political landscape as we head into the mid-term elections. Both sides of the aisle frame the debate differently and as you might expect there is a lot of finger pointing when the topic comes front and center. The gap between CEO compensation and their employees has long been the center of this debate.
Should the Chief Executive Officer make significantly more than their employees? Should management be judged in the same way as athletes and actors whose talent is in high demand?
Of course they should. However, despite my unequivocal support of capitalism, I believe management with full support of the board at many public institutions, abuse their power and have corrupted the very foundations of a free market society.
The signs are everywhere and seem to get worse with each passing day. Perhaps Gordon Gekko said it best when he turned to Bud Fox in the movie Wall Street and said; “If you’re not inside you’re outside.”
Today, making it inside the C suite is the Mafia equivalent of being made. I’m sure at most public companies, job one is running the firm and guiding future growth. However, number two with a bullet is figuring out just how much wealth you can transfer from shareholders to the pockets of management.
The Gap in Pay Continues to Widen
Last year at this time Bloomberg put out a report claiming the average multiple of CEO compensation to their workers at S&P 500 companies was 204 up 20% from 2009. If I was a betting man I’d take the over guessing where that multiple stands today.
The political divide over income inequality is wide enough to drive a tank through. The left wants higher taxes on the wealthy and the right proposes tax reform. Both ignore one of the largest contributors to the income gap staring them right in the face.
While the public and press continue to focus on headline numbers like Larry Ellison’s $78 Million pay package, they miss the big picture. Most of the compensation is in the form of stock options and other equity based incentives. The board is happy to grant this award knowing that for now, it isn’t real money.
Stock options are the cocaine of Wall Street and one of the principal tools used to pump up executive compensation. To offset the continued dilution from printing all this money management initiates buyback programs to hold the share count in check. The cash used to buy back shares won’t be available for R&D and other capital expenditures. While many firms have stock option programs that include employees outside of the C suite, you can bet the bulk of the compensation is earmarked for those on the inside.
GAAP vs. Non-GAAP
Contributing to the increased use of equity based compensation is the continued focus on Non-GAAP earnings. For those not in the world of finance GAAP stands for Generally Accepted Accounting Principles. All U.S. public companies must report earnings in a GAAP format as required by the SEC. Most firms and in particular those in technology prefer to report adjusted earnings or Non-GAAP. Non-GAAP makes adjustments for one-time items and equity based incentives. As you might expect, it looks a lot better than GAAP.
The difference between GAAP and Non-GAAP can be enormous. Let’s look at one example. When you zero in on the income spreadsheet for Oracle (ORCL) you can see projected GAAP earnings for 2014 come in at $2.43. (Oracle is on a May Fiscal Year) However, management would guide you to the Non-GAAP number of $2.91 almost 20% higher.
It’s true that some one-time items can make it more difficult to judge the true health of a quarter. However, I believe analysts and frankly most investors are smart enough to dig through the noise. Over time it evens out. Today, one-time items seem to occur far too frequently to be considered one time.
Regulation G was adopted as part of the Sarbanes-Oxley Act of 2002 which requires companies to report GAAP earnings in the same document. Corporate America has convinced us to ignore this number and focus on what they want us to see.
To put it bluntly U.S. corporate earnings are over stated. The good news is that the media is starting to bring this issue into the public eye. Earlier this week CNBC anchor Brian Sullivan interviewed Bob Olstein of Olstein funds who gave us an accounting primer pointing to some of these abuses.
Pay for Performance
Popular among boards today is pay for performance compensation packages. Management performance certainly looks a lot better using adjusted earnings. We’ve all seen the CEO who agrees to the $1 per year pay package opting to accept their compensation in stock. Not really much of a risk when you consider the height of the bar can be easily adjusted.
CEO and the Board
I have no problem with a Chief Executive Officer that fights for the highest compensation package he can get. That’s exactly how it should work. However, it’s the responsibility of the board to negotiate that deal on behalf of the shareholders. Today’s Board of Directors seem less an advocate for the shareholder and more like an agent for the CEO.
Often, CEO’s and founders endorse capital structures that insure they won’t be kicked out even if they fail to perform. Google (GOOG) founders Larry Page and Sergey Brin saw the handwriting on the wall. Concerned that as they continued to sell stock to support their lifestyle along with the ongoing dilution from stock options, eventually their stake would fall to levels where they might be vulnerable to an activist proposal.
The Google founders already have Class B shares which have 10 votes per share. Recently they split the stock giving each shareholder one Class A share and one Class C share. The C shares have no vote, so effectively they have cut the public’s vote in half. Pretty good way to rig an election don’t you think.
Get Out the Vote
Shareholders aren’t helpless. While it’s close to impossible to fight some companies like Google (GOOG) and others who have stripped shareholders of their voice, most times your vote counts. Unfortunately, both retail and institutional investors often fail to exercise that privilege and let management and the board push through just about any proposal they care to.
Coca Cola’s executive compensation package recently became headline news. Activist investor David Winters who believes Coke’s plan would ultimately transfer roughly $13 billion to management over the next four years urged Coke’s largest shareholder, Warren Buffet’s Berkshire Hathaway, to vote with him. Management disputes Mr. Winter’s claim and to be fair many investors have sided with them.
The Oracle of Omaha, who often speaks out on populist causes had an opportunity to weigh in on this very important issue. On April 23rd, Coca Cola held its annual meeting and a vote was taken on management’s compensation structure.
During an interview with CNBC’s Becky Quick, Warren said he abstained from the vote even though he believed management’s pay plan was “excessive”. He went on to say “it’s kind of un-American to vote no at a Coke meeting.”
Respectfully Warren, It’s kind of un-American not to vote.