hewlett packard (hpq) equity valuation

7/30/2019 Hewlett Packard (HPQ) Equity Valuation

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Mada Arslan

HP Valuation

A. DCF modelFCFF

Characteristics of HP:

Winding Down company: decliningrevenues and earnings, acquisitions thusgrowing inorganically, divestures

Multinational company: operating in USA,Americas, EMEA, and Asia Pacific.

BUY RECOMMENDATION

Target Price $ 22.75

Market Price $ 20.35

Upside Potential 11.81%

Listed on NYSE

Bloomberg Ticker HPQ:US

Enterprise Value (million) $ 34,358

MV Debt (million) $ 20,453Market Capitalization $ 47,065

Outstanding shares (million) 1,974

Bloomberg Industry Computers

Bloomberg Sector Technology

(20,000)

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

2005 2006 2007 2008 2009 2010 2011 2012

HPQ


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Mada Arslan

Tax rates:

Effective Tax rate = 23.5% (from Q2_2013 report)Marginal Tax rate = 35% (from 10K_2012 report)

Incorporating the fact that HP is a multinational, we can take the highest marginal tax rate acrossthe countries & according to Damodaran: While some would push for an average tax rate,weighted by the income in each country, I think it makes far more sense to use the marginal taxrate of the country the company is domiciled in as a floor.

Damodaran Tax rate

Africa average 29.02%

North America average 33.00%

Asia average 22.89%

Europe average 20.50%

Latin America average 28.30%

Oceania average 28.60%

Middle east average 12.00%

Caribbean average 20.00%Source: emergcompfirm.xlshttp://pages.stern.nyu.edu/~adamodar/

Beta:Regression Beta = 0.97 (v/s Yahoo beta 1.52 & Reuters 1.15)Since its a distressed company, using a bottom-up beta is no longer relevant and we deemed thestart of the crisis in 2001.We regressed HPs result since 2001 against a global index since its a multinational: S&P

Global Tech(http://finance.yahoo.com/q/hp?s=IXN&a=00&b=1&c=2001&d=04&e=22&f=2013&g=w).No debt beta was added since HP is not a junk bond. Minimum bond rating is BBB.
http://pages.stern.nyu.edu/~adamodar/http://pages.stern.nyu.edu/~adamodar/http://pages.stern.nyu.edu/~adamodar/http://finance.yahoo.com/q/hp?s=IXN&a=00&b=1&c=2001&d=04&e=22&f=2013&g=whttp://finance.yahoo.com/q/hp?s=IXN&a=00&b=1&c=2001&d=04&e=22&f=2013&g=whttp://finance.yahoo.com/q/hp?s=IXN&a=00&b=1&c=2001&d=04&e=22&f=2013&g=whttp://finance.yahoo.com/q/hp?s=IXN&a=00&b=1&c=2001&d=04&e=22&f=2013&g=whttp://pages.stern.nyu.edu/~adamodar/


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Mada Arslan

Cost of Equity:

Risk-free: 10 Year Treasury Yield 2.02%

Equity Risk Premium 6.06%

Beta equity: regression 0.97

Country Risk Premium 4.57%

Cost of Equity (Re) 12.44%

The Equity Risk Premium is derived from Damodarans 5.8% that is based on a risk-free rate of

1.76%.

Country Risk Premium is based on regional weighted averages according to GDP as perDamodaran, multiplied by the percentage of revenues earned by HP in the regions:

RevenuesQ2_2013

Weightedregional CRP

WeightedCRP

USA 35% - 0.00%

Canada & Latin America 10% 10.19% 1.02%EMEA: Europe, Middle East, Africa 36% 0.08 3.02%

Asia Pacific, and Japan 19% 2.82% 0.53%

Total Weighted CRP 4.57%

Cost of Debt:Since its not a junk bond, we can take YTM of the latest issued long-term bond:

$1,200 issued at discount to par at a price of 99.863% in September 2011 at6.0%, due September 2041 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,198


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Mada Arslan

Operating Lease:We will capitalize OL.

2013 2012

Year

Lease (Rent)

Expense in

million

PV of

OLYear

Lease

(Rent)

Expense

in

million

PV of

OL

PV of

OL

1780 736

11,012 955

2665 592

2780 694

3517 434

3665 558

4351 278

4517 409

5218 163

5351 262

thereafter 805 476 6 218 154

Total3,336 2,678

thereafter805 449

Total4,348 3,481 (803)

Refer to excel sheet for details of the calculations.

Research & Development:We will capitalize R&D assuming a 10 year life cycle.


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Mada Arslan

Mergers & Acquisitions:M&A should be smoothed for the last 3-5 years by taking an average & the value of the M&A is

calculated as cash paid or price per share x number of shares offered. The M&As were paid forin cash (includes cash paid for outstanding common stock, convertible bonds, vested-in-the-money stock awards and the estimated fair value of earned unvested stock awards assumed-annual report 2012).

2012$ mill

2011$ mill

2010$ mill

2009$ mill

2008$ mill

Acquisition 141 10,480 8,102 391 11,248

Average 6,072

Return On Capital:ROC = EBIT (1-Tc) / BVCapital

We adjusted EBIT for OL and R&D.We adjusted Book Value of Capital for Cash, Goodwill, PV of OL, unamortized portion ofR&D, and minority interest.

ROC = 5.03% < WACCDestroying Value

FCFF:FCFF = (EBIT + pretax cost of debt*PV of OL) (1-Tc) + R&D expense (current) - Depreciation expense of R&D -

(CAPEX - Depreciation + R&D expense - Depreciation expense of R&D + M&A) - NWC - in PV of OL

Adjusted EBIT 4,371CAPEX, net 279

Depreciation (TTM) 1,548

Current R&D (TTM) 3,372


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Mada Arslan

Terminal Value: Expected Liquidation ValueSince its a distress company we used a liquidation value.

There are 2 ways to estimate ELV:1. Expected Liquidation value = Book Value of AssetsTerm yr(1+ inflation rate)Average life of assets2. Earning Power of the Assets

The limitation of the first approach is that it is based on accounting BV.We estimated the earning power of the assets based on TA2012*TAT2012.

Cash (a):Cash interest income in 2012 was $155 million which is less than 2% but the Daily Treasury

Yield Curve Rates for 1year is 0.12% so we should not discount cash for low returns.

Adjusted Enterprise Value (b):HP falls under Reversible Decline with No or Low Distress since its minimum bonds rating isBBB according to Standard & Poors. Refer to Optimal Enterprise Value Model below fordetails on the calculated value.

Market Value of Debt (c):

Its the market value of interest bearing debt.

Pensions/leases (d):Pension leases are computed as Employee compensation and benefits 4,058 + Pension, post-retirement, and post-employment liabilities 7,780 in other liabilities.

Employee Options (e):We valued the options using the modified Black & Scholes approach. These options are issued inthe US therefore are considered tax deductible. We used time T = 2.5 years since averagematurity of these options is 3 years, but since we are valuing in April 2013 we consider it T=2.5and since those are American options thus they can be exercised anytime T/2=1.25.Rf f 0 2% d t t h th t it f th ti


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Mada Arslan

dividends/y/cs $ 0.50

dividend yields 2.46%C 0.79

Value Options (after tax) 44.63

d1= [ln (S/K) + (rfy + /2) t] / td2= d1 - tC= Se^(-y*t) N(d1)Ke^(-rf*t) N(d2)

Minority Interest (f):No information on number of shares bought in those subsidiaries therefore we used BV.

#Shares (g):We used the basic weighted-average #shares as per the 10K report that was used to compute netearnings per share. There are no different classes of common shares although some employeewere granted restricted shares as stock-based compensations, Restricted stock has the same cashdividend and voting rights as other common stock and is considered to be currently issued and

outstanding.

Price per share- after iteration (h):We have used 3 iterations to get the price per share to converge to S, diluted.Refer to excel sheet for calculations details.


8/10

Mada Arslan

The model:

Y0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 ELV

g 5.11% 4.49% 3.87% 3.26% 2.64% 2.02% 2.02% 2.02% 2.02% 2.02% 2.02%

EBIT 4,371 4,568 4,745 4,899 5,028 5,130 5,234 5,339 5,447 5,557 5,670

t 24% 24% 24% 24% 24% 24% 35% 35% 35% 35% 35%

EBIT (1-t) 3,344 3,494 3,630 3,748 3,847 3,925 3,402 3,471 3,541 3,612 3,685

RR % 101.71 89.41 77.11 64.80 52.50 40.20 40.20 40.20 40.20 40.20 40.20

WACC 9.93% 9.93% 9.93% 9.93% 9.93% 9.93% 9.93% 9.93% 9.93% 9.93% 9.93%

FCFF 370 831 1,319 1,827 2,347 2,034 2,076 2,118 2,160 2,204 115,569

PV of FCFF 337 688 993 1,251 1,462 1,153 1,070 993 921 855 44,837

PV of Operation 54,559

Non-operating assets:

Cash 11,301 a

Loss Carry Forward 9,142Enterprise Value 75,002

Enterprise Value adjusted 76,232 b

Non-equity Claims:

MV of Debt 20,453 c

Pensions/leases 11,838 d

Employee options 45 e

Minority interests 397 f

Equity Value 43,500

#shares 1,974 g

#options 87

Price per share 22.04 BUYPrice per share- after iteration 22.75 BUY h


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Mada Arslan

Optimal Enterprise Value Model:Expected Value = Status Quo Value (probability of no management change) + Optimum Value

(probability of management change)

Status Quo Enterprise Value 75,002

probability of no management change 0.8

Optimum Enterprise Value 81,155

probability of management change 0.2

Enterprise Value adjusted (b) 76,232

We considered the following changes when we computed the optimal value of HP: Operating margins will increase to the industry average of 7.61% (Reteurs) v/s the

current 5.25%

Divesture of assets that have negative EBIT: Corporate Investments segment Capital expenditures: zero. Live off past overinvestment NWC: based on industry current ratio of 1.56 (Reuters) v/s HPs 1.11. We expect this

difference to double as HP improves its current assets by decreasing inventory on handand speeding-up receivables collections

Treat HP in valuing its DCF in the optimal phase as a mature company Probability of management change


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Mada Arslan

Optimal Enterprise Value Model

Y0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10Y11-Going

Concern

g 4.06% 3.85% 3.65% 3.44% 3.24% 3.04% 2.83% 2.63% 2.43% 2.22% 2.20% 2.02%EBIT 6,272 6,514 6,751 6,984 7,210 7,429 7,640 7,841 8,031 8,210 8,391 8,560

t % 23.50 23.50 23.50 23.50 23.50 23.50 23.50 23.50 23.50 23.50 23.50 35.00

EBIT (1-t) 4,798 4,983 5,165 5,343 5,516 5,683 5,844 5,998 6,144 6,280 6,419 5,564

RR % 56.24 53.42 50.60 47.78 44.95 42.13 39.31 36.48 33.66 30.84 30.55 28.01%

r (WACC, ROC) 7.71% 7.71% 7.71% 7.71% 7.71% 7.71% 7.71% 7.71% 7.71% 7.71% 7.71% 7.21%

FCFF 2,321 2,551 2,790 3,036 3,289 3,547 3,810 4,076 4,344 4,458 4,005

PV of FCFF 2,155 2,199 2,233 2,256 2,269 2,272 2,266 2,250 2,227 2,122 38,463

PV of Operation 60,712

Non-operating assets:

Cash 11,301

Loss Carry Forward 9,142Enterprise Value 81,155

hewlett packard (hpq) equity valuation

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