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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

Oct 23

Written by: Jack Ciesielski
10/23/2009 10:48 AM 

... is stock compensation. And it's about to become bigger, as "pay czar" Kenneth Feinberg moved yesterday to restrict pay on managers at bailed-out banks and automakers. As Joe Nocera points out in the New York Times, retention bonuses are out; guaranteed bonuses are out. But pay for performance is going to be "in," at least among those beneficiaries of government aid. It probably won't stay isolated to just those corporate wards of the state, either. There's a lot of copycat behavior present in pay practices; they always seem to infect companies faster than the flu infects kids in an elementary school.

Suddenly, it's 1993 all over again. That was when the tax code was revised to punish companies executives making more than $1 million; tax-deductibility of the compensation was eliminated unless it was "performance-based." Option-laden plans fulfilled this requirement. Add in the fact that they showed no impact on earnings, and the combination was irresistible for Corporate America. Options nearly became a sort of "shadow currency" during the late 1990's and early 2000's.

Maybe not just like 1993. You might be expecting stock compensation to soar like in the 1990's - again at the urging of the federal government - but the truth is that it never really became unpopular. It just went unnoticed. FASB Statement 123R made expense recognition of stock option grants mandatory, and became effective in 2006. When there was zero recognition of the option comp expense, investors used to get themselves in a lather; after the standard put all companies on equal footing, investors went to sleep. The information improved vastly after Statement 123R went into effect, but it never seemed to regularly figure into investor thinking.

Back to how stock compensation never really became unpopular. In our August report, "S&P 500 Stock Compensation: Running Out Of Options," (AAO subscribers only) we showed that while options lost their attraction after getting expense treatment, restricted stock became the hot ticket. In 2005, the year before expense treatment began, the S&P 500 firms granted employee stock options on 3.1 billion shares, worth an estimated $28.0 billion. The number and value of new options granted annually declined nearly every year since then, bottoming at 2.2 billion options covering shares worth an estimated $20.9 billion in 2008. Over the same period, restricted stock grants on 498 million shares worth $18.0 billion in 2005 jumped to 1.4 billion shares worth $43.5 billion in 2008.

Restricted stock is the new coin of the compensation realm. That's not the whole story, though.

What investors miss is that the grants of all equity instruments affect far more than just the top five officers whose pay goes on display once a year. And those grants affect more than just the top 25 officers whose pay Mr. Feinberg is looking over. These grants can be spread far and wide within a firm - and unless you bother to push for the answer, you aren't going to notice how much they're worth. The stock compensation footnote discloses the number of instruments granted in a particular year and the fair value for both restricted stock grants and option grants.  Multiply the price times the quantity, add the two together, and you've got the total value of stock compensation granted for the year, to be recognized in earnings over the period the services are rendered by the employees.

That's not a figure that jumps out of the financial statements but if you put it into context of the whole company, you can get some interesting angles on just how big - or out of whack - a firm's stock compensation program is.

Let's look at Citigroup, one of the companies at the center of the compensation storm. The combined option and restricted stock grants for Citi totaled $3.949 billion in 2008. The company's average market cap for the year was $98.5 billion, so about 4% of the company was turned over to employees as compensation - with the full permission of the shareholders, of course, because they'd approved such compensation plans. The grants to the top five officers were $78 million: a drop in the bucket relative to the total $3.949 billion granted across the board.

That's not to minimize the issue of executive compensation. The point is that there's way more going out the door in icing-on-the-cake equity compensation than you might think. And the popularity of restricted stock should be of some concern too: if it's simply time-vesting until the award date, without a performance hook, it becomes "pay for pulse." Should shareholders be willing to fork over their interests for that? It's hard to see why they should.

That's a lot of equity out the door in the S&P 500. If you want a better idea of how big it is, put it into the context of other factors that drive the company's performance apart from a motivated work force. In the case of Citigroup, that $3.949 billion of equity instruments to be earned by employees is more than than the new equity given for their Nikko acquisition ($3.5 billion); more than their capital expenditures on premises and equipment ($2.541 billion); and more than advertising for the year ($2.292 billion). Shareholders cede their ownership on a grand scale like this, every year. Yet there's never much accountability for it. The amounts they give up are large in comparison to other factors of production, yet, nobody cares much because the grants are transformed into a smooth expense, leaking into income over time. (Incidentally, in comparing the fair value of those grants to those other items - all of them would be expected to benefit more than only 2008, just like the grants would benefit multiple periods. It's not a comparison of apples to oranges.)

That's not to pick on Citi. The point is that investors need to worry about big compensation in bigger terms. There's a sort of mythology that equity pay motivates employees to do big things that get fairly translated into market returns. It may not be that linear of a relationship at all - and it might make more sense to look at stock grants in terms of the things that really drive shareholder returns, like capital expenditures. Or R&D. (For instance, Apple  granted $1.387 billion in equity compensation granted to employees last year - and it spent $1.109 billion in R&D.) Or in the case of firms with impoverished pension plans, contributions to pension plans might look even stingier when they're compared to stock comp grants. (There's more discussion and examples in our report.)

While big compensation is the topic du jour, it's a good time for investors to rethink just what "big compensation" means relative to things that benefit their interest most.