by David Nelson
Spring means proxy filings by major corporations, leading to an avalanche of coverage about CEO pay packages.
As The WSJ reported last week, the median pay for CEOs of America’s largest companies rose 5.5% in 2013 to $11.4 million, or roughly 257 times the income of the average American worker.
But not all pay packages are created equal, and even in this era of C-suite excess, some plans are more outrageous than others.
Once again, Oracle’s (ORCL) Larry Ellison topped the WSJ's list of highest-paid CEOs with his $78.4 million pay package. Saleforce’s (CRM) Mark Benioff didn't make the Journal's list, likely because the company's fiscal year ended in January. With $31.3 million in the firm’s most recent fiscal year, Benioff would've ranked #8 in the Journal's Top 10 highest-paid CEOs.
Related: CEO pay: An embarrassement of riches
But when you dig deeper into the respective packages, Benioff’s payout is arguably the biggest of all — bigger even than his former mentor Ellison’s — or, at least, representative of a pay culture that's more problematic for shareholders.
As the accompanying chart shows, Salesforce.com pays far and away the greatest percentage of its cash flow in stock-based compensation among companies with the highest-paid CEOs.
Last year Salesforce.Com (CRM) paid out more than $500 million in stock-based compensation, equal to 57% of the company’s cash flow and over 12% of sales. The $500 million was 200% of non-GAAP income so it isn’t surprising on a GAAP basis the company actually lost money. (More on that below).
By comparison, Oracle’s $722 million in total stock-based compensation was only 5.2% of cash flow and less than 2% of sales.
But Salesforce isn’t alone in pushing stock-based compensation to extreme levels.
Facebook (FB) is paying out 11% of sales and over 20% of cash flow in stock-based compensation. Amazon's (AMZN) $1.1 billion in stock-based compensation was 20% of cash flow but only 1.5% of revenue; we forgive them for not making money.
By way of comparison, stock-based compensation averaged about 7% of cash flow and only 1.4% as a percentage of sales at the 300 companies I looked at. So it’s clear the envelope isn’t being pushed as far at every firm. For example, Pfizer’s (PFE) $501 million in stock-based compensation is less than 3% of cash flow and only 1% of revenue.
Executive Pay: There's no free lunch
Executive pay is a major focal point of the income inequality debate in America today. Corporate boards are increasingly being forced to defend outsized pay packages, with activist investors and institutions demanding more accountability.
But here’s why it really matters to investors: Companies are using absurd non-GAAP earnings to justify huge pay packages, and we’ve become sheep by letting them get away with it.
By paying a substantial portion of executive compensation via stock or stock options, public corporations have found a way to boost pay packages without seeming to incur big related expenses. As an added perk, they get to pay taxes on the real bottom line, which is often a lot lower. Sounds too good to be true? Here’s how it works.
By issuing more shares and diluting existing shareholders, the board pays out a significant portion of compensation in restricted stock or stock options. Prior to Sarbanes-Oxley legislation, this wasn’t being accounted for on the income statement. Today it’s right there in black and white, and this compensation hits the bottom line, reducing earnings on a GAAP (Generally Accepted Accounting Principles) basis. This is what is reported to the IRS for tax purposes.
Earnings in a large number of companies don’t look as good when you focus on GAAP, so Wall Street came up with non-GAAP, which doesn’t include stock-based compensation or one-time "extraordinary" items — some of which appear regularly. And yet managements have somehow convinced investors and analysts that those other expenses just don’t matter.
If you keep issuing shares to pay employees, over time the dilution gets so bad that even non-GAAP numbers look terrible. As a result, companies are forced to buy back stock just to keep the share count in check. That uses up cash that could have been used for other corporate purposes, like building a new factory or hiring more workers.
At some companies, the spread between GAAP and non-GAAP earnings is wide enough to drive a truck through. For some it’s the difference between reporting a profit or a loss.
In each of the last three fiscal years, Salesforce reported net profits but lost money on a GAAP basis. In its latest fiscal year, Salesforce.com’s GAAP net income came in at a loss of $232 million vs. the $221 million in reported non-GAAP "profits."
Of course, the market should set the rate CEOs get paid and all executives are entitled to and should fight for the best pay package they can get. However, by putting so much of the package in stock, there are few checks and balances to keep the board from pushing compensation through the roof.
The most common defense from boards is that by paying out a large portion of compensation in stock, they are aligning executive pay with shareholder interests. In many cases highly paid executives can point to staggering returns in their stock and maybe justify eight-figure incomes. However, if we dig a little deeper we quickly find that you don’t have to be a winner to hit the lottery.
Freeport McMoran (FCX) CEO Richard Adkerson has been paid $139 million in the past four years, during which the stock flatlined. And while the materials sector has been hard hit due to the slowing of China’s economy, Freeport disappoints even when compared to the S&P Materials ETF (XLB). As you can see in the accompanying chart, it's hardly a flattering picture. Of that $139 million paid to Adkerson, only $27 million was paid in salary. I doubt the board would have been so generous if they had to pay cold, hard cash for that kind of performance.
In sum, the boards of many Fortune 500 companies are acting less like advocates for the shareholder and more like an agent for the CEO.
Just a few weeks ago, Warren Buffett was in the hot seat for failing to vote his shares against the pay package for Coca Cola’s (KO) executives, even though he told CNBC's Becky Quick he felt the package was excessive. If the "Oracle of Omaha" is taking heat, it's a good bet the debate on executive compensation is only going to get louder as the year unfolds. Supporters, especially those inside corporate boardrooms, will come out to defend the status quo.
The words of Gordon Gekko still ring true. “If you’re not inside, you’re outside.” Which side are you on?
David Nelson is chief investment strategist of Belpointe Asset Management. At time of publication, Belpointe has a long position in Disney and no position, long or short, in other stocks cited in this article.