Friday, April 07, 2006

Coke and Corporate Governance Trends

Coca-Cola (KO) recently announced that it would pay its directors a fee only if earnings growth goals were met. If such goals were missed, the directors would receive nada. As well, directors would be subject to risking their stock awards over a three year performance cycle. The initial goal is an 8% compound annual growth rate using 2005 earnings of $2.17 as a base.

This move was broadly applauded by many corporate governance watchers including Warren Buffett himself.

Yet, accounting earnings make a very poor proxy for the profitability of a company. Earnings per share can be rather easily manipulated by the judgments that managements and more importantly, the boards themselves must make. Earnings do reflect estimates and judgments and are subject to considerable manipulation. Imagine an insurance company that has a wide scope to decide on its reserving policy. A conservative policy regarding reserve quality damages near-term earnings and improves long term earnings propsepcts. A liberal policy delays the recognition of the inevitable to later accounting periods. The first choice may ensure receiving a zero directors fee but the second rings up the cash register for potentially $175,000. A tough moral dilemma for a director.

Share buybacks have been used craftily by some companies in the past to hit stock value thresholds. I often drone on about the effectiveness of share buybacks.

Are they being used to simply sop up executive share options or are they being used to reduce the fully diluted shares outstanding? Even more important to me, are these shares being purchased at prices below intrinsic value?

Obviously, massive buys at prices above intrinsic value do nothing but enrich the seller, not the buying corporation and the rest of us remaining shareholders, whose wealth is being handed over!

Though "eating their own cooking" is applaudable in that the reward is purely equity based, does such a policy endorse loose and liberal accounting policy?

The trends toward board and committee independence are becoming well entrenched according to a new ISS study on corporate boards. But concomitant with growing responsibility is growing pay. According to this study, the average pay for a director has increased to $143,807 in 2005, up 14% compared to a 23% increase the year before.

Another positive trend is a move to de-classifying boards. Staggered boards were viewed as a means of takeover avoidance, but corporate activists have been able to penetrate this defence.

Here is a link to this very interesting ISS study.

As an alternative to the earnings growth metric which KO chose, why not a return on invested capital hurdle or some sort of measure of the incremental return on invested capital that has been achieved? The use of economic capital modelling makes it relatively easy to measure the true economic profit of an enterprise over time.

Disclaimer: I and my family but no clients have a current position in KO.


At 7:14 PM, Blogger Jay Walker said...

Something along the lines of return on marginal capital, as you mention, makes a lot of sense to me. It ensures that new monies committed (something the present board would obviously have some control over) goes towards "increasing the moat" as Buffett likes to say.

In turn, that will, over time, increase the earnings and the general quality of the business - something any investor can applaud.

The Confused Capitalist


Post a Comment

<< Home

< ? Market Blogs £ >