Whole Foods Bags Its Options Expensing

It seeks to raise options grants. Critics say shareholders will pay.
By Troy Wolverton ,

Corporate reformers may frown on stock options, but that doesn't seem to faze

Whole Foods

( WFMI).

The natural foods grocery chain is asking shareholders to approve a 28% increase in the number of options it can grant under its current stock plan. The proposed increase -- some 5.5 million shares -- is equivalent to about 9% of the company's outstanding shares.

Whole Foods representatives did not return calls seeking comment. But in a proxy statement filed last week, the company's board noted that the options plan was broad-based, with 94% of grants going to nonexecutives. Whole Foods' options plan helps to attract, retain and motivate employees, the board said.

"We believe our plan creates an ownership consciousness among our

employees that aligns the interests of

employees with those of our shareholders," the board said in the proxy statement.

Whole Foods' shareholders will have a chance to vote on the plan at the company's annual meeting in Seattle on March 22.

The company's options proposal comes as governance and accounting experts are focusing on corporations' use of stock options. Corporate governance critics have linked the accounting scandals at

Enron

,

WorldCom

and other companies to their use of options. Critics say options reward short-term movements in a company's stock, encouraging managers to take shortsighted or illegal steps to boost share prices.

Options have "totally distorted the capital markets," said Albert Meyer, general partner of 2nd Opinion Research, an independent research firm. "They've created inflated earnings, which created inflated multiples, which created aggressive management

of earnings releases."

Regardless of whether options contribute to accounting scandals, critics have also charged that companies that don't expense options often give away too much shareholder value to employees or executives. Under current accounting rules, companies can choose whether to include the fair value of options in their income statements. Whole Foods is among many companies that don't expense options -- something accounting regulators are currently considering making mandatory for all public companies beginning next year.

Like other companies that grant options, Whole Foods has benefited from their use -- and not just through improved morale.

Whole Foods' reported per-share income would have shrunk by 15% in its fiscal 2003 if it had expensed options, according to a footnote in its annual report.

Although the company does not expense options on its income statement, it does include options exercises as a compensation expense on its tax returns. In 2003, the company saw a tax benefit of $25.9 million related to deducting employees' options exercises. That amounted to about 9.3% of Whole Foods' operating cash flow last year and about 24.4% of its free cash flow, or the difference between operating cash flow and capital expenditures.

Options exercises are like a continuous public offering for companies. When employees exercise them, they pay the company the strike price for each share. Whole Foods raised about $52.3 million through options exercises last year, which was equivalent to 49% of its free cash flow.

The problem for shareholders is that money isn't free, said Meyer. It either comes hand in hand with dilution of their shares, or companies end up spending that cash buying back shares to prevent dilution.

Over the last three years, Whole Foods employees have exercised an average of 2.3 million shares a year. Assuming that rate continues, and assuming the company's share price remains about the same, Whole Foods would have to spend about $155 million this year to keep its share count stable. That's an exorbitant amount, considering that the company posted just $103.7 million in net income last year.

Although Whole Foods directors have set aside $50 million for share repurchases, the company has not bought back any shares in the last three years.

At the end of the day, companies such as Whole Foods that don't expense stock options end up spending as much money buying back shares to prevent option dilutions as they would have spent on cash-only salaries, Meyer said.

"The cash-flow effect is exactly the same," he said. "When you look at it that way, you can see the deception."

Shareholders Acquiesce

Despite the increasing scrutiny on options, Whole Foods' options proposal last year passed easily, drawing the support of shareholders representing 78% of the company's shares. Moreover, proxy advisor Glass Lewis will likely support the new proposal, said Greg Taxin, CEO of the San Francisco-based firm.

Whole Foods' executive compensation was below that of its peers, while its stock has outperformed its peers, said Taxin. Over the last five years, Whole Foods' stock has risen 337%. In contrast, the stock of rival natural grocery chain

Wild Oats

( OATS) has fallen 24%, and shares of the larger supermarket retailers have fared even worse:

Kroger's

(KR) - Get Report

are down 38% over the same time period, while

Albertson's

(ABS)

have dropped 60%.

But Taxin did note that Whole Foods' option practices do raise some red flags. In five of the last six years, the company's options grant has exceeded 3% of the company's outstanding shares.

"By most shareholders' views, that's excessive, and it does trigger some negative points in our model," Taxin said.

Whole Foods proposes to increase its options pool in its current stock plan from 19.3 million shares to 24.8 million shares. The proposed increase is the sixth the company has sought in the last seven years. It is also the largest, both in terms of overall shares and as a percentage of the company's outstanding shares.

Without the increase, the company will not have enough options available in its pool to meet its target awards for this year, company directors said in the proxy statement.

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