Starbucks Options Plan Puts Dilution on Menu

Some investors may balk at the company's latest stock-grant proposal.
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When it comes to stock options,

Starbucks

(SBUX) - Get Report

is asking shareholders for one last refill.

The coffee chain wants to pour in millions of new shares into the cup of options that it can hand out to employees and managers. If approved by investors, the plan, which the company laid out in its proxy filed last week, would push options-related dilution at the company to greater than 19% of outstanding shares -- far above the level at which many institutional investors might be expected to balk.

By some measures, the plan would essentially double the company's options dilution, noted Kent Hughes, managing director of Egan-Jones Proxy Services, an advisory firm. "This just seems like it's excessive potential dilution," he said.

As might be expected, Starbucks' board argued that shareholders should approve the plan at the company's annual meeting on Feb. 9.

"The board has long believed that employee ownership in the company serves the best interest of all shareholders, by promoting a focus on long-term increase in shareholder value," the directors said in the proxy.

But investors could find themselves in a quandary about how to vote. On one hand, the company has been a top financial and stock performer -- the most important issue for the many growth investors who hold the stock.

On the other hand, its options practices seem to run against prevailing investor opinion on the issue -- and could pose both short-term and long-term problems for the company. As soon as Thursday, for instance, accounting regulators are expected to issue a rule that would require companies such as Starbucks to start recognizing the cost of options in their income statements next June, which could immediately hit the company's reported earnings.

According to a footnote in Starbucks' annual report, its earnings would have been 11.5% lower in its just-completed fiscal year if it had expensed options.

"Will

Starbucks' options practices make me sell the stock right now? No," said Brian Gilmartin, a portfolio manager for Trinity Asset Management and a contributor to

TheStreet.com's

sister site,

Street Insight

. But he added, "It's a valid issue." (Trinity is long Starbucks shares.)

Starbucks' proposal would essentially replace its three current stock options plans with a new one and move 14 million shares it has available to grant under its existing plans to the new plan. On top of those shares, the plan would add another 24 million shares to the company's options pool. All told, the company would have about 38 million shares it could grant as options under the new plan, or the equivalent of about 10% of its current outstanding share count.

The new plan does offer some investor-friendly aspects: The company could not reprice the options issued without getting shareholder approval, and the plan allows the company flexibility to award not just options, but restricted shares and stock-appreciation rights. Both types of share-based compensation have recently gained favor among some institutional investors and corporate watchdogs.

"From a design perspective,

Starbucks is moving toward what is being viewed as a more progressive practice," said Pat McGurn, special counsel at proxy adviser Institutional Shareholder Services.

Still, the plan would push Starbucks' total potential options dilution to some 76 million shares -- about double the number of outstanding, unexercised options at the company, as of Oct. 3.

"I'd want to see what the justification is for that level of options

dilution," said Elliot Schwartz, director of research at the Council of Institutional Investors, which represents public and union pension funds. "Relative to most companies -- even high-growth companies -- that sounds like a high level of dilution."

Indeed, many mutual funds have proxy-voting guidelines requiring them to vote against options plans that would lead to dilution greater than even 10% of outstanding shares.

Perhaps even more troubling for investors is the sheer number of options the company would have available to grant. Over the last three years, Starbucks has awarded an average net grant of about 7 million options a year. At that rate, the new options last more than five years.

But the company proposal doesn't place any limits on the number of options or share awards it could grant in any one year, meaning that it would have the ability to greatly increase the number of options it hands out.

And, assuming regulators do require expensing next year, an uptick in the company's options grant could have "big implications to shareholders," Hughes said.

Starbucks emphasizes that its options plan is a broad-based one; the company gives out options not just to its executives but to many front line-employees as well. Indeed, the company granted options to some 40,000 people last year; Starbucks employed nearly 100,000 people at the end of its fiscal year.

But by any measure, Starbucks' executives have made out well under its options plans.

Last year, Starbucks awarded 2 million options -- or nearly 22% of its total grant -- to its top five executives. By the company's own estimates, those options were worth about $21.25 million.

But that may be understating the windfall that executives could see. Last year, for instance, outgoing CEO Orrin Smith alone saw a $23.6 million gain when he exercised 1 million options.

Still, Starbucks likely will find at least some shareholder support for its plan, particularly from investors focused on its recent results.

In the last year, for instance, the company's stock is up 77%, and the company's fiscal 2004 profit -- excluding stock options costs -- grew 46% on a 29% jump in sales.

"The markets don't seem be too concerned about

Starbucks' options practices right now," said Noah Blackstein, a portfolio manager for Dynamic Mutual Funds. "Starbucks would have much bigger problems if it can't meet its growth targets." (Dynamic doesn't presently have a position in Starbucks' stock.)

Indeed, some investors cheer the company's options practices. By distributing them widely, the company has helped boost morale among its "baristas" and has made its restaurants more customer-friendly environments, they say.

"By asking for more options, they'll be taking care of more employees. I don't have a problem with it at all," said George Novello, chief investment officer of Tokio Marine Asset Management. (Tokio Marine is long Starbucks shares.)

And such investors may get important backing from some proxy analysts, who get paid to study such plans. Glass Lewis, for instance, said it would lean toward approving Starbucks' plan.

Starbucks likely will grant about $200 million worth of options next year, or more than 50% of the company's net income, said Greg Taxin, CEO of Glass Lewis. But its average grants are in line with its peers, he said, as is the average amount realized by the company's employees.

"What they've done in the past, frankly, it seems to be working," Taxin said. "The stock price has performed well."