VideoThe ultimate question, however, is whether the use of options might actually prevent the market from moving higher. That depends, of course, on whether companies can continue to fund stock repurchases to mitigate dilution — and if they can do it without adversely affecting their cash flow. Here, however, the issue becomes chicken-and-egg-like. Many high-tech companies point to the effect on cash flow as the basis for their view that the benefits of expenditures on options are worth the cost. Since the grants are necessary to retain the employees that produce the cash flow, the companies argue, the money effectively underwrites enough growth to more than offset any dilution that isn't soaked up by share repurchases. The issue, as Manpower's Van Handel puts it, is, "Can we get value for that?".
And a challenge may soon become more acute, according to a study of repurchase practices by the Federal Reserve. It suggests that when companies have to buy back increasingly high-priced stock to offset the dilution, they may be hard-pressed to grow their cash flow sufficiently to fund further grants. "It seems unlikely that the total payout rate [net outlays for grants and buybacks] can increase much further," says the study, "absent a sizable increase in debt or a cutback in investment and, presumably, future growth."
For companies whose primary asset is people, then, there may be no essential difference between operating results and stock performance. So in their case at least, options linked only to the latter may make just as much sense as those linked to operating goals, assuming the grants don't vest within 10 years no matter what. And until cash flow suffers, grants only loosely linked to performance are unlikely to spark a shareholder revolt at those companies or others, and may simply be too lucrative for management to resist.
Even as harsh a critic as Martyn Redgrave failed to do so when he worked at publicly traded PepsiCo for 14 years prior to joining Carlson. Back then, he freely admits, "I wanted as many stock options as I could get."
Ronald Fink is a senior editor of CFO.
Short-Term Games
With annual bonuses tied to budgets, more than two out of three corporate managers have an incentive to sandbag performance targets. Or so one would conclude from a Towers Perrin survey.
Under this arrangement, managers at the beginning of a year all too often argue that their targets should be lowered because of tough business conditions, when in fact conditions are better than projected. If their arguments are successful, they can easily surpass the targets. And with those budget goals typically expressed in terms of earnings per share, managers nearing year's end are also encouraged to find noncash items to make their numbers look even better.
But because this approach to short-term objectives often results in subpar operating performance, some public companies are shifting gears. Among the latest is Vectren Corp., an Indiana energy company recently created from the merger of two smaller utilities in the state. For starters, its incentives are tied to ROA and Ebitda targets instead of EPS, so its managers will find it more difficult to pad their results. And by setting their objectives well below actual budgets, the company offers managers no incentive to sandbag projections.
Given Vectren's budgeted projections, aren't its performance targets too easy? On the contrary, says CFO Jerry Benkert. Not only are they above industry benchmarks, but they are also precisely what's required to make Vectren's publicly stated objective for annual earnings growth. What's more, the size of the actual bonuses is tied to the amount by which they exceed their targets. "That's the beauty of it," says Benkert. "We think the plan you're following should get you to the answer you want."
But the Towers Perrin data suggests that most other companies are in danger of getting just the opposite. —R.F.
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