Another CEO "Pay Cut" That Isn't

I understand that stock options are difficult to understand.  And I understand that some journalists seem to have a keen interest in reporting how "overpaid" CEOs are, and others a similar interest in gleefully reporting that a CEO took a "pay cut."

The problem is, CEOs rarely have their compensation reduced through a direct action by the Compensation Committee of the Board of Directors, just as most employees in most organizations rarely have their compensation reduced. Usually these reported pay cuts are inaccurately reported and, more often than not, represent a pay increase.

The latest misunderstanding comes from The Wrap (which I only noticed because so many major media outlets distributed the story) in reporting that Reed Hastings, CEO of Netflix, received a $1.5 million reduction in his "stock option pay" for 2012 compared to 2011.  It is true that a certain number reported in an 8-K filing in December 2010 was $3 million, and the comparable number in an 8-K filing in December 2011 was $1.5 million, leading to the conclusion that the CEO was "paid" $1.5 million less as a result.

For those interested in the true story, keep reading here.  For those that choose to believe that Mr. Hastings is truly being paid $1.5 million less in 2012 than in 2011, just left-click on that link above, rather than right-click.  I won't get into the long-term multi-year nature of the value of options, or vesting schedules, or the complete reliance on stock price as a basis for what the ultimate "pay" really will be. There's something much simpler and, to me, more interesting here.

Netflix uses a dollar denominated approach to determine stock option awards.  It works like this:  In December 2010 the Compensation Committee of Netflix decided to grant to Mr. Hastings stock options with a "fair value" (i.e., hypothetical value as determined by accountants and actuaries) equal to $3 million.  To do this, the company determines the value of one stock option and then simply calculates how many of those it takes to hit the $3 million target.  This was done at a time when Netflix stock was trading around $184 per share.

They took the same approach this year, but determined Mr. Hastings should receive a grant with a fair value of only $1.5 million.  At a time when the stock was trading around $70 per share.  Aha.

To do the calculation, companies typically take the calculated value of the options and do a straightforward division.  So if Netflix stock trading at $70 produces, under the option pricing model, options worth, say, 50% of that amount, each option would be "worth" $35 and, extending this calculation, they would grant $1,500,000/$35  = 42,857 options.  Whereas last year each option would have been worth 50% of $184, or $92 per share, yielding $3,000,000/$92 = 32,609.  Hmm, this year he would have received around 10,000 more options at a lower strike price. (Illustrative numbers not actual, but close.)

I wish someone would give me a pay cut like that.

But wait, there's more.  Netflix doesn't use their accounting-based option valuation to determine the number of options as I describe above.  They specifically disclose in their 10-K footnotes that they use the binomial model instead of Black-Scholes:

"The Company believes that the lattice-binomial model is more capable of incorporating the features of the Company’s employee stock options than closed-form models such as the Black-Scholes model."

Despite their belief in the binomial-based numbers, they do not use these numbers to determine stock option awards.  Instead of a value of about 50% of the stock price resulting from that model, they use an arbitrary 20%.  The result?  An option award that is 250% the size of an award that most companies would make using the same methodology. "Size" being number of options, not hypothetical fair value.

I have no problem with Netflix or their executive compensation practices.  Despite the criticism Mr. Hastings received this year, my family is a loyal customer. Their service keeps two 7-year old girls riveted to Sesame Street videos each morning and the whole family entertained every Friday for Movie Night.

I do have a problem with journalists who know little or nothing about a topic engaging in so-called journalism - which by definition requires fact-checking and making an effort to understand the topic.  Perhaps worse are journalists who do understand the numbers and choose to misrepresent and distort them to make a point.  That belongs in the Opinion section, not the business section.  But the latter is much more difficult to prove while the former is evidenced in the numbers.

Reed Hastings got a great stock option grant this year which should make him feel better about his now-underwater options granted last year.  I'm just glad I bought their service but not their stock.