Coca-Cola and PepsiCo: Is Your CEO Paid for Mediocrity?

Through the years, Warren Buffett has decried excessive executive compensation and has resolved to only invest in companies where management's interests are aligned with shareholders. As a large Coca-Cola shareholder, Buffett presumably believes that Muhtar Kent is reasonably compensated for his efforts as CEO.

After a rough year in the beverage business, Kent's 2013 compensation declined 16% to $18.2 million. Kent's counterpart at PepsiCo , Indra Nooyi, saw her pay increase 5% after what was arguably a more disappointing year for her company.

As a result of Kent's declining compensation and Nooyi's increasing compensation, one might conclude that Coca-Cola's pay practices are more shareholder friendly than PepsiCo's. However, hedge fund manager David Winters begs to differ.

Coca-Cola compensation: pay for mediocrity?
David Winters, whose Wintergreen Advisors owns shares of Coca-Cola, recently published letters he sent to Coca-Cola shareholders, the board of directors, and Buffett decrying the company's 2014 equity compensation plan as excessively dilutive. Winters complains that the plan will dilute shareholders by 14.2%.

Winters is a respected value investor with a history of strong performance, so Coca-Cola shareholders should not take his criticisms lightly. Winters' argument centers around the potential dilution of the equity compensation plan, as outlined in Coca-Cola's 2014 Proxy Statement. In the proxy, the company discloses that, assuming all authorized shares under the 2014 plan are granted, existing shareholders could be diluted between 10% to 16.8%.

Source: Coca-Cola Company DEF14A

Of course, this worst-case dilution scenario only happens in the best-case business scenario; Coca-Cola must meet its financial targets in order for the stock awards to be granted. For instance, the company must hit the following targets in order for executives to avoid a hit to annual compensation: 3.5% unit case volume growth, 7% operating income growth, and 8% earnings-per-share growth. These 2014 targets are higher than what was achieved in 2013.

Source: Coca-Cola Company DEF14A

Given that 2014 incentive targets are only slightly higher than 2013's disappointing results, shareholders have grounds to question the legitimacy of the compensation structure. However, the company repurchases a large amount of stock each year; it is targeting $2.5 billion to $3 billion in repurchases in 2014 -- or up to 1.8% of shares outstanding.

Moreover, the potential dilution from the 2014 compensation plan takes place over four years, not all at once. If Coca-Cola repurchases close to 2% of its shares outstanding each year, the repurchases will offset the bulk of potential dilution from the executive compensation plan.

However, that is exactly why Winters is throwing a fit. Instead of returning capital to shareholders, Coca-Cola's share repurchases are mopping up dilution from share grants to executives. In 2013, the company touted $4.8 billion in share repurchases, but $1.3 billion went toward offsetting stock issuance. If share issuance remains the same in 2014, almost half of the company's $2.5 billion to $3 billion in planned stock repurchases will go toward offsetting dilution. In other words, it is just a sneaky way to funnel billions of shareholder dollars to employees.

Story is the same at PepsiCo
PepsiCo's compensation practices are similar to those of Coca-Cola. PepsiCo's plan rewards organic revenue growth, earnings-per-share growth, free cash flow, and return on invested capital. As with Coca-Cola, PepsiCo's targets are well within the range of doable; the company outperformed on each of its four key targets even in a disappointing fiscal 2013.

However, as far as executive compensation goes, investors could do worse than hitching their saddles to Coca-Cola and PepsiCo. There are much worse companies with excessive compensation practices that make the soda giants look like angels. Moreover, Coca-Cola and PepsiCo tend to shrink their share counts each year, if ever so slightly, so shareholders are not slowly relieved of their ownership in the companies.

Bottom line
Muhtar Kent and Indra Nooyi are probably overcompensated for their roles in leading two of the best businesses on the planet, but their pay is not excessive to the point of destroying shareholder returns. Any attempt to rein in excessive pay should be cheered by shareholders, but these businesses are so great that it will take more than a generous pay package to eliminate their attractiveness to investors.

3 stocks that could become your next huge winner
The one sure way to get wealthy is to invest in a groundbreaking company that goes on to dominate a multibillion-dollar industry. Our analysts have done it before with other great stocks. And now they think they've done it again with three stock picks that they believe could generate the same type of phenomenal returns. They've revealed these picks in a new free report that you can download instantly by clicking here now.

The article Coca-Cola and PepsiCo: Is Your CEO Paid for Mediocrity? originally appeared on Fool.com.

Ted Cooper owns shares of Coca-Cola. The Motley Fool recommends Coca-Cola and PepsiCo. The Motley Fool owns shares of Coca-Cola and PepsiCo and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.