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Browsing around the internet after checking Nvidia's (NASDAQ:NVDA) fourth quarter announcement, I came across Intel (NASDAQ:INTC) again and noticed something quite unusual. In fact, for being such a rarity, I'm surprised it hasn't got more press attention and business discussion. Perhaps because it is new; however, the incentive based philosophy Intel disclosed in a letter on February 3, 2014 does a whole lot more than tie "management" to "shareholders' interests." The philosophy change to place the new CEO Brian Krzanich in the 25th percentile, while every other company in the United States continues to place their management team and CEO at least in the 50th percentile is a drastic change. Intel got this step right; they are not paying the new CEO for past success nor are they accepting subpar performance by the CEO's capital allocation strategy. Additionally, they are doing away with stock options, which if one cares to discover how much they destroy shareholder value, let's take a quick look at Cisco (NASDAQ:CSCO).

The "EVIL" of Stock Options:

Cisco just released 2nd quarter fiscal year 2014 earnings, and announced in the press release they spent $4 Billion dollars purchasing 185 million shares of common stock on top of $2 Billion, $1.2 Billion, and $.860 Billion spent purchasing shares in the previous three quarters, respectively. Normally, this would be excellent use of shareholders' cash, especially if one were to look at IBM (NYSE:IBM). IBM has spent $13.9 Billion in gross share repurchases in the full 2013 fiscal year. IBM decreased the diluted shares outstanding at year end by about 75 million shares. Cisco decreased diluted shares outstanding from the end of the three months in January 2013 to January 2014 by only 30 million shares to 5.327 billion shares outstanding. Like last quarter, Cisco stated that the timing of the shares purchased will be delayed to the next quarter to affect the average shares outstanding calculation. Even so, it is quite obvious that stock options are a rampant form of compensation given out to top executives, research engineers and sales employees that causes extreme harm to shareholder value. Not only do these stock options dilute existing shareholders, they continually understate expenses. If one dissects Cisco's announced earnings, they will quickly find huge discrepancies between GAAP and non-GAAP accounting.

An investor should be highly critical of this accounting maneuver for several reasons. Reporting a higher earnings per share number to appease Wall Street does not create long-term shareholder value. Earnings per share is composed of two numbers and can grow by two ways, either increased earnings or decreased shares outstanding. The CEO's job is all about capital allocation. We have seen in the coal sector how terrible financial diligence and capital management can destroy shareholder value and returns. Although Cisco generates significant amounts of cash from operations with minimal capital expenditures, what they do with the cash is a prime example of wasteful shareholders' capital allocation. To bring things into perspective, the same press release states the following:

"As of January 25, 2014, Cisco had repurchased and retired 4.1 billion shares of Cisco common stock at an average price of $20.53 per share for an aggregate purchase price of approximately $84.9 billion since the inception of the stock repurchase program. The remaining authorized amount for stock repurchases as of January 25, 2014 was approximately $12.1 billion with no termination date."

Let's travel back in time to the 2000 10-K on page 27 when Cisco had a high of 7.4 Billion shares outstanding. Since that time they have reduced the share count to today's level around 5.3 Billion shares. Therefore, Cisco spent nearly $40 Billion of shareholders' cash to purchase and retire stock options to prevent excessive dilution. It is safe to say, when you look at a company's non-GAAP figures that exclude share-based compensation, they are indeed using shareholders' cash to compensate their management team and employees at the expense of the shareholders.

IBM in 2008 had about 1.387 Billion shares outstanding, a decrease of about 300 million shares to today's count of around 1.080 Billion shares outstanding. They decreased the shares outstanding by 22% in five years spending nearly $74.3 Billion from 2008 to 2013. It took Cisco 13 years to decrease the share count 28%. One can imagine how much more value they could have created if they didn't spend nearly $40 Billion buying stock options to prevent further shareholder dilution.

Eliminating "EVIL" Creates Shareholder value:

I believe the first step in creating shareholder value is doing away with stock options and moving along the path of IBM, which Intel is now focused on doing. This is why Intel's announcement should garner more attention by investors and the business community. By eliminating stock options and realigning performance pay throughout the organization, Intel is motivating employees through incentives that align operational goals to direct output that affect the bottom and top line growth of Intel, which will be awarded with increased returns of invested capital and growth in earnings per share. Eventually, a combination of little steps throughout the organization with this new incentive structure will reap benefits for shareholders well into the future.

One major adjustment The Board of Directors of Intel changed is that equity awards will now have downside risk, which means if the performance of the stock decreases significantly compared to the peer group either by depressed revenues or decreased earnings per share or market conditions, the equity awards will amount to $0. Additionally, stock ownership is going to be required by the top 350 personnel of the company in the next three years to align their interests to the performance of the company. General Motors (NYSE:GM) had a similar strategy in their management pay for salaried employees in the mid-1900s that propelled GM to the top of the automobile market from the 1920s to the 1960s. The incentive based system in place with GM encouraged management to put skin in the game and be rewarded when the business did well and suffered with the shareholders when business conditions faltered. An excellent overview of this decentralized approach and compensation strategy came from Alfred P. Sloan, My Years with General Motors. Incentives are never perfect in the business world, but a truly strong focus on keeping employees focused on what is best for the company overall is key to employees from top to bottom making the best decisions for the company. Although Intel's new compensation strategy will have to prove itself with results in the future, it's the engineers, sales team, and middle managers that decide the fate of the company. The executive management is responsible for the policy, culture, and there to answer the big questions about the company's strategy. Simply put, they should be welding together the brains of the organization to increase the output and improve the throughput of the business.

The NEO (Named Executive Officers) compensation will consist of Equity 65%, Annual Bonus 24%, Base Salary 10%, and Profit Sharing of 1%. 60% of the equity awards will be based on Outperformance Share Units, which are Intel's version of performance stock units that are awarded based on a three year total shareholder return compared to a peer group. 40% will be restricted stock units. A more detailed version of this compensation will be released on the proxy statement for 2014. Importantly, as stated above, management and employees in the program have something to lose if the company's stock performance does not do well; however, there is still the possibility of the stock to do better than actual business conditions due to the natural tendency of the market to be irrational at times.

One of the most important changes in the compensation structure is changing the cash compensation component. Beginning in 2014, Intel will simplify operational goals of the company from 150 to 30-40. Additionally, the compensation structure will consist of 50% from corporate wide net income performance and net income performance vs. peer group, each consisting of half of the total. Importantly, the remaining 50% of the cash compensation is based on operational performance for each individual business segment. Intel believes that this will create a sharper focus on key initiatives, increase visibility into those initiatives, and enhance accountability. I do agree with the assessment by the Board of Directors of Intel. Employees should become more engaged and delegate responsibilities to accomplish the most important and critical tasks to improve business performance to achieve the goals that they are responsible for. Overall, they stand to benefit from the cohesion of the group. If every team in Intel takes steps to improve a product design, eliminate process waste, and implement engineering enhancements, they will drive shareholder returns through by decreasing costs and increasing gross margins and returns on invested capital.

Profit sharing is a delicate topic where some shareholders believe that it is their money while others are fine with compensating employees if the incentives and objectives are correlated correctly. Intel changed the formula for profit sharing to one instead of two formulas and every employee in Intel shares the same pool. The payout will increase frequency to quarterly installments instead of semi-annual installments and should foster a more collaborative and focused employee base on their monthly or quarterly objectives to achieve the goals set out by their management. I believe employees that have operational goals set to the profit sharing compensation will generate benefits for the corporation and well exceed the costs for funding such a program.

The Right Incentives Drive Results:

Intel has taken steps to generate a more accountable and focused culture with the new compensation arrangement and CEO's philosophy. Long-term shareholders of Intel now have executive management and employees throughout the organization more closely aligned to improving the business and making decisions to make the corporation better as a whole. The new compensation arrangement is very much like IBM's and allows Intel to offer superior capital allocation decisions compared to Cisco when buying back shares. Intel is following in IBM's footsteps to eliminate costly and dilutive stock options and better align the company to focus on internal objectives to foster an objective based and process improvement culture. Over the next few years, Intel can deploy the cost savings and excess capital to improve shareholder returns by significantly decreasing the number of shares outstanding and improving earnings through lower expenses. The psychological incentives developed and implemented in making this arrangement work are not perfect; however, it is a strong step forward to a more accountable and focused management team closely aligned to shareholder interests.

Note: Please refer to all relevant shareholder materials published with the SEC for more accurate information about all the companies mentioned in the article. Some figures and numbers may be off slightly; however, they are fairly accurate and suitable for the analysis presented.

Source: Intel's Compensation: A Wake-Up Call For Corporate America