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Corporate Finance ProjectResearch on Computer Industry

Corporate FinanceMay 4, 1998

Takeshi AokiRichard A. Gryziak

Koji HikosakaHiroyuki Sato

Yuji TokunagaChristine E. Whitney

Corporate Finance Project - Computer Industry

1

Executive summary

We chose the computer industry for our project. We picked five hardware companies-Compaq, Hewlett Packard, Hitachi, IBM, and Unisys – and one software company-Oracle- for our analysis.

Corporate Governance

According to our analysis, we found that all of our chosen companies, except for Hitachi,have good systems of corporate governance. We have concluded that Hitachi’s corporategovernance is weak, which is a general characteristic of the Japanese style ofmanagement. However, its large debt adds discipline to its management due tomonitoring by its lenders.

We also found some general characteristics in the computer industry. First, the larger thecompany, the more attentive it is to its stockholders. Second, in a fast-growing companysuch as Oracle, it is usual that CEO is one of the founders of the company. This type ofcompany gradually transforms itself into a larger-type firm, such as IBM, and becomesmore attentive to its stockholders as it matures.

Risk and Return

In the risk analysis section, we observed that high-risk companies, such as Unisys, havelarger betas and higher costs of equity. As a result of our calculations, we estimated eachcompany’s hurdle rate as follows:

Compaq HP Hitachi IBM Oracle UnisysCost of Equity 15.55% 15.79% 8.04% 13.88% 12.22% 17.58%Cost of Capital 15.55% 15.16% 5.14% 12.37% 11.94% *12.41%

* Unisys’s cost of capital includes preferred stock.

We then compared each company’s ROE with Cost of Equity and ROC with Cost ofCapital. Compaq, HP, IBM and Oracle have all achieved excess returns in ROE, but onlyCompaq and Oracle have excess returns in ROC. This phenomenon led us to theconclusion that Compaq and Oracle generally chose good projects, while HP and IBMare not always as successful. However, HP and IBM return their excess cash thestockholders by paying stable dividends and stock buybacks.

Optimal Capital Structure

Generally speaking, the debt ratio in the computer industry (12%) is relatively lower thanthat in other industries. Considering our chosen companies, mature ones such as IBMand Unisys have higher debt ratios, while fast-growing companies, such as Oracle andCompaq, have lower ones. After our analysis, we reached the following optimal debtratios and paths to the optimal.


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Compaq HP Hitachi IBM Oracle UnisysCurrent 0.00% 5.68% 42.99% 15.91% 3.99% 37.49%Optimal 20.00% 20.00% 40.00% 30.00% 5.00% 20.00%

Hitachi and Oracle have already realized their optimal financing mix. As for HP andIBM, their debt ratios are lower than the optimal, so they need to increase debt ratios bybuying back their stock, which they did recently. Compaq’s debt ratio is lower than theoptimal, so Compaq needs to issue short-term debt (based on the duration coming fromthe regression analysis) in a mix of currencies, because the structure of debt shouldreflect the mix of the revenues from each country. Compaq’s acquisition of DEC willlead Compaq’s debt ratio to increase, but we believe the company still has some excessdebt capacity. Unisys has to decrease its debt ratio immediately by selling assets andrenegotiating with lenders. The company is in the process of restructuring its businessesand its finances in an effort to come to terms with this situation.

Dividend Policy

In summary, the dividend policies of companies in the computer industry are such thatthey do not generally pay many dividends. In the companies we analyzed, the rule ofthumb is that for growth companies, the policy is to not pay dividends. For more maturecompanies, dividends are one of the ways for returning cash to investors.

We found that growing companies such as Compaq and Oracle do not pay dividends atall because of the need of the financing flexibility they require to take advantage goodinvestment opportunities. It is also the case that stockholders in growing companies donot expect dividends and would prefer cash returned to them in the form of buybacks.More mature companies, such as HP, Hitachi and IBM, do pay dividends.

Valuation

Based on our analysis in each section, we chose the valuation model for each company asfollows. Judging from the low average payout ratio, we should not use the dividenddiscount model because the current dividend payout does not show the real value of thecompanies. Therefore, we chose Free Cash Flow models. Except for Compaq, we usedFCFE models because they do not have plans to change their capital structuresignificantly. Since Hitachi’s current growth rate is low and it is a mature company, a 1-stage FCFE model was chosen. On the other hand, a 2-stage FCFE model is appropriatefor HP, IBM, and Unisys because we believe their lengths of faster growth periods wouldbe 5 years. In addition, we selected a 2-stage FCFF model for Compaq because weconcluded that the company’s capital structure should move from the current debt ratio of0% to the optimal of 20%. Finally, we reached the following result of our valuation.

Compaq HP Hitachi IBM Oracle UnisysValuation 33.71 51.57 916.08 106.02 32.05 10.83Current Price 28.25 61.63 959.00 104.63 31.08 13.88


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I. Corporate Governance Analysis

A. Management and Stockholders

Balance of Power

As shown above, five of our six companies pay attention to their stockholders. Overall, the board ofdirectors of both Compaq and IBM are ranked as the 3rd and 5th best boards in the U.S., respectively,according to the Business Week annual survey. In these companies, management power is stressed by thefact that there are only a few insider directors and the companies have established a record of goodcorporate governance.

Take the case of Compaq, whose board was recognized for excellence by the Wharton School of theUniversity of Pennsylvania, Business Week and the CEO Report. Only two of the ten directors on theboard are insiders, and the others appear to be independent of the company. The Compaq CorporateGovernance Committee has also played an important role in keeping the good relationship between themanagement and the stockholders. It is clear Compaq’s management is responsive to its stockholders.

When we turn our eyes to the CEOs’ compensations for our companies, the top managers have beencompensated extraordinarily well over the past several years. In fact, it may appear at first glance thatmanagement neglected the stockholders to line their own pockets through misappropriating stockholders'money. However, such compensations clearly come from the recent growth in earnings of the computerindustry.

In the case of Hewlett Packard and Oracle, the management has strong power compared to the othercompanies. HP is a family-owned company, while the CEO of Oracle is a co-founder of the company. It isdoubtful that their corporate governances work as comparatively well here.

On the other hand, only with Hitachi, the largest electrical company in Japan, do we see managementand ownership that are very clearly separated. The board of directors consists of only insiders. Theincumbent management is often observed in Japan, because Japanese companies usually hold their stocksonly in each other’s companies. This is known as “keiretsu”, where management cares only about howthere own companies are run. Like other Japanese companies, Hitachi’s management appears not to beattentive to its stockholders.

From this analysis, there are some general characteristics we can draw from examination of thecomputer industry. Firstly, the larger the company, the more attentive it is to its stockholders. Secondly, ina fast-growing company such as Oracle, it is usual to find that the CEO is generally the founder of the

Stockholders IncumbentManagers

Balance of Power

HitachiUnisysIBM

HPCompaq Oracle


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company. This kind of company gradually moves to the position of the larger firms such as IBM andCompaq, which become more attentive to the stockholders as they mature.

It is concluded that from our examples, the power between stockholders and managers are relativelybalanced, with the one exception being Hitachi.

IndustryAverage

Compaq HP Hitachi IBM Oracle Unisys

CEOName Eckhard Pfeiffer Lewis Platt Tsutomu Kanai Louis Gerstner, Jr. Lawrence Ellison Lawrence Weinbach

How long 7 years 5 years 6 years 5 years 21 years 1 yearCompensation Salary ($ thou) 587 1,250 1,638 N/A 1,500 1,000 1,200 Bonus ($ thou) 415 3,000 184 N/A 4,500 1,331 2,700* Other ($ thou) 1,189 24,796 1,760 N/A 2,200 16,743 2,800 Total ($ thou) 2,192 29,046 3,582 N/A 10,460 19,074 6,725 Ranks in industry Ranks among 800 exec

615

38217

N/AN/A

1451

1026

N/AN/A

Stock owned % total 0.19 0.02 0.04 N/A 0.03 22.37 Market Value ($ mil) 11.3 3.7 20 N/A 22.4 5,513Board of Directors# of directors 10 14 32 12 8 11# of insider directors 2 3 32 1 3 1# of the directors who are 4 4 0 0 1 4CEOs of other companies

B. Firm and Financial Markets

As reflected above, Compaq, Hewlett Packard, IBM, and Oracle are well-followed firms.According to Zacks, there are more than 20 analysts who follow these companies. While each companyprovides substantial amounts of information in the form of financial statements, many analysts andinvestors actively monitor the movement of these stock prices.

In addition, these stocks trade frequently in these companies. Stock trades for each company

amount to more than $1 million monthly on average. Both facts lead us to expect less bias in the

information that is available about these four firms.

The Firm ExternalSources

Source of Information

Hitachi UnisysIBM

HP CompaqOracle

CompanyMonthly Trading# of AnalyCompaq $ 350 million 34

HP $ 72 million 27

Hitachi N/A N/AIBM $ 210 million 21

Oracle $ 184 million 31Unisys $28 million 10


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In the case of Unisys and Hitachi, there seems to be a little bias in the information available. Unisysis one of the largest software companies, but it has suffered from large operating losses over the past fiveyears. There may be a possibility this company attempted to hide bad news as long as it could. WithHitachi, the management consists of only the inside directors. Considering how relatively unsophisticatedthe stock market is in Japan, it is quite possible that the bias in the information may be even larger thanwhen compared to other US companies. However, biased information is not beneficial for the companiesin the long-term, and both companies are well known to the public. Considered that the companies wish tokeep their corporate images in their respective stock markets, such bias would not be so serious to themarkets.

C. Firms and Society

All companies in our analysis are committed to conducting their businesses in a manner that iscompatible with the environment and protecting the quality of the communities where they operate. Intheir annual reports, we can easily recognize that the management believes that business must work inpartnership with suppliers, government, community, and industry groups in an effort to protect theenvironment. These communities expect their hometown profitable companies to contribute to theirsocieties.

It is also interesting that most of companies in the computer industry contribute to educationalinstitutions such as public libraries and elementary schools. While such contributions increase thecorporate images and benefit the communities, they also appear to be a kind of investment. In the future,as computer use grows, the educational institutions and current students can be potential customers. Wecite some current examples below.

Firstly, Unisys, while being a relatively low-profile company, provides much needed services to alarge number of companies and government organizations. A recent Unisys publication tells of how thecompany improved the voting system of Costa Rica by digitizing voter information and producing tamper-proof voter identification cards. On other fronts, Unisys sponsors the Science Learning Center, a jointproject of Unisys and the National Science Foundation. The SLC provides training to elementary schoolteachers in ways to incorporate Internet and WWW technology into their classes.

Secondly, according to the annual report of Hitachi, its corporate philosophy is to contribute to societythrough the development and application of superior technologies. Hitachi meets its responsibilities as agood corporate citizen through the activities of Hitachi-endowed foundations and programs designed toensure Hitachi contribute to the betterment of the community. For example, it has achieved notable

Very Low Very High

Social Consciousness and Image Factors

All of the 6firms here


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advances in the recycling of products, supported school libraries in Thailand, and provided opportunities toenjoy Japanese art and culture for Americans, etc.

As can be seen from the above examples, social concerns play important roles in each company’sdecision making.


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II. Stockholder Analysis

To analyze the stockholders in each firm, we searched for a stockholder composite as of the end of 1997. Asshown in the above graph, institutional holdings account for about 40% to 60% in each company. In IBM, thestockholders are well diversified, as there are no large stockholders with more than 5% of the shares in IBM.Compaq and Unisys have a few large institutional holders, but are sufficiently diversified, given their shares are notdisproportionately large compared to other funds. Considering the scale of these firms, as well as the average 50.3%and 47.3% institutional holding in the hardware and software industries, respectively, these four companies aresufficiently diversified.

On the other hand, with regard to insider holdings, all four firms (except for Hewlett Packard and Oracle) havefar lower insider holdings than other companies in their peer groups1. In the case of Oracle, the CEO is a co-founderof the company, while at HP, some of its directors are related to the family. So the insider holdings of each firm arenearly the same when compared to the industry average. The trading volume implies that insiders of these firmsmay not have an impact on their respective stock prices.

In summary, marginal investors are clearly institutional. Risk and return models assume that the marginalinvestor is well diversified and that only non-diversifiable risk matters. Here, the marginal investor is theinstitutional investor, so this assumption should work well.

1 In regard to insider holdings, the hardware industry average is 25.4% and the software industry average is 14.2%.

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III. Risk Profile

Overall Risk Profile

The first step in assessing the relative risk of our companies against the market was to run a regression,based upon the CAPM, of each of our company’s stock against the market (in this case, the S&P 500), for the period1993 to 1997. The regressions yielded each company’s beta and intercept, which was used to compute Jensen’sAlpha2. Jensen’s Alpha, when annualized, tells us how each stock performed against expectations. The stocks thatperformed significantly better than expected over this period were HP, Compaq, and Oracle. Only Unisys, with thehighest relative risk among the stocks, performed worse than expected, with a Jensen’s Alpha of –13.5%.

Next, we examined the R2 of the regressions, which explains the risk or variance of each stock attributableto market sources, such as interest rate risk, inflation risk, etc., and the remaining balance which indicates thediversifiable risk that was associated with each company’s own specific risk components. Oracle, which had thelowest relative risk among the pack as measured by its regression beta, also had the smallest portion of risk that wasattributable to market factors compared to the other firms.

We should note, however, that the standard error of the betas for all the regressions was relatively high,with the exception of Hitachi. Hitachi’s beta is close to 1, with a risk that is nearly the same as the market. This isdue to the fact that Hitachi is a huge and diversified conglomerate firm. It is also worth noting that none of the firmsachieved the same level of performance that the hardware and software industries achieved on average, as reflectedby their very high Jensen’s Alphas. This is due to the fact that all of our companies are large and have existed forseveral decades. The industry averages, on the other hand, may be overstated because they include many newentrants that are start up companies, which often times perform better than expected.

Compaq HP Hitachi IBM Oracle Unisys Hard-Ware

Industry

SoftwareIndustry

RegressionBeta

1.55 1.59 1.0 1.33 .65 1.88 1.49 1.02

Jensen’sAlpha

33.4% 39.6% 1.89% 12.58% 28% -13.5% 430% 413.65%

R2 ofRegression

15% 33% 35.82% 25% 4% 18% 45% 44%

StandardError of

Beta

49% 30% 12% 30% 42% 53% -- --

Measuring Bottom-up Betas

Given that nearly all the companies’ regressions yielded high standard errors in the beta estimates, it isworthwhile to check the validity of these betas. Through estimating a bottom-up beta, we looked at each companyand the businesses they operated in, and determined a new beta for the company based on the unlevered betas fromindustry averages, multiplied by the relative divisional weight within each firm.

Below, we present each company’s estimated bottom-up unlevered beta:

CompaqBusiness Estimated

Value (MM)Comparable

FirmsUnlevered

BetaDivision Wt. Wt. * Beta

Computer HW $42,375 Computer HW 1.37 100% 1.37Firm $42,375 100.00% 1.37

2 The monthly risk-free rate that was used was 0.4%, which is the average monthly risk-free rate of return during this period.


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Hewlett PackardBusiness Estimated


FirmsUnlevered


ComputerServices

$99,491.7 ComputerServices

1.49 82.6% 1.23

Test andMeasurement

Products

$12,045 Test andMeasurement

Products

.80 10.0% .08

MedicalElectronicEquipment

$3,493.05 MedicalElectronicEquipment

.95 2.9% .03

ElectronicComponents

$2,770.35 ElectronicComponents

1.17 2.3% .03

ChemicalAnalysis

$2,2649.9 ChemicalAnalysis

.92 2.2% .02

Firm $120,450 100.00% 1.39

HitachiBusiness Estimated

Value (M)Comparable

FirmsUnlevered


Computer HW Y2,611,729 Computer HW 1.37 46.53% 0.6375Electrical

EquipmentY822,304 Electrical

Equipment0.8 14.65% 0.1172

Machinery Y2,178,967 Machinery 0.64 38.82% 0.2484Firm Y6,501,322 100.00% 1.00

IBMBusiness Estimated


FirmsUnlevered


Computer &Peripherals

$49,938.57 Computer HW 1.37 41.46% 0.57

SoftwareServices

$70,511.43 ComputerSoftware

0.98 58.54% 0.57

Firm $120,450 100.00% 1.14

OracleBusiness Estimated


FirmsUnlevered


Computer SW $31,660 Computer SW 0.98 100% 0.98Firm $31,660 100.00% 0.98

UnisysBusiness Estimated


FirmsUnlevered


ComputerSystems

$2,653.16 ComputerSystems

1.37 38% 0.5206

InformationServices

$2,164.42 ComputerSoftware

0.98 31% 0.3038

GlobalCustomerServices

$2,164.42 ComputerServices

1.49 31% 0.4619

Firm $6,982 100.00% 1.29


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Moving toward Levered Betas

Before we can arrive at a new beta estimate, we must look at the relative debt to equity ratios for each ofthe firms. The share price, shares outstanding, market values of debt and equity, and the debt to equity ratios foreach of the firms are presented below:

Compaq HP Hitachi IBM Oracle UnisysShare Price3 $28.25 $61.63 Y959 $104.625 $31.08 $13.88Shares O/S(MM)

1,500 1,041 3,337,000 968.1 977.97 250.47

MV of Eq.(MM)

$42,375 $64,154 Y3,200,000 $101,287 $30,395 $3,477

Est. MVof Debt(MM)4

$0 $3,864 Y2,413,000 $19,163 $1,264.6 $3,505

D/E 0% 6% 75.41% 18.92% 4% 100.81%

While Oracle’s market value of straight debt is $304.2 million, the company has substantial operatingleases on its books. When discounted back at Oracle’s present cost of debt, which is 8%, the present value of thecompany’s operating lease liability is $960.4 million. This addition increases Oracle’s market value of debtsubstantially to $1,264.6 million, as reflected above.

The formula for moving from an unlevered to a levered beta is presented below, along with the results ofeach company’s levered beta.

Levered Beta for Company = Unlevered Beta [ 1 + ( 1-t) (D/E) ]

Levered Beta for Compaq = 1.37 [ 1 + ( 1 - 0.36) (0%) ] = 1.37

Levered Beta for HP = 1.39 [ 1 + ( 1 - 0.30) (6%) ] = 1.45

Levered Beta for Hitachi5 = 1.00 [ 1 + (1 – 0.493) (75.41%) ] = 1.38

Levered Beta for IBM = 1.14 [ 1 + ( 1 - 0.36) (18.92%) ] = 1.28

Levered Beta for Oracle = 0.98 [ 1 + ( 1 - 0.36) (4%) ] = 1.01

Levered Beta for Unisys = 1.29 [ 1 + ( 1 – 0.36) (100.81%) ] = 2.12

Summary of Beta Estimates Used Forward in Analysis

Regression Betas Bottom-up BetasCompaq HP Hitachi Unisys IBM Oracle

BetaEstimate

1.55 1.59 1.0 1.88 1.28 1.01

For purposes of our analysis, we used the new bottom-up beta estimates for only two of our companies,IBM and Oracle. In the case of IBM, the software division has grown at a faster rate than the hardware division, andcorrespondingly, its revenue resources have changed. In the case of Oracle, it had a relatively high standard error inthe beta estimate, its regression beta was well below the software industry average beta (while its bottom-up betawas more in line with industry average), and Oracle had substantially increased its financial leverage in recent years.

3 All share data as of close of each company’s respective fiscal year end.4 Includes market value of $1,420 million of preferred shares for Unisys Corporation.5 Hitachi’s tax rate was estimated through running a regression of 10 years worth of income and tax data, yielding a marginalcorporate tax rate of 49.3%.


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For all other companies, we used what we believe are the more reliable regression beta estimates. In thecase of Hitachi, both its regression beta and its bottom up beta were 1. For HP, it has a high R-squared, its standarderror of the beta estimate is reasonably low, and its regression beta is higher than the industry average. In the caseof Compaq, we used the regression beta for our analysis forward because there has been no substantial change in thebusiness mix or financial leverage of the company. Lastly, for Unisys, it has been in a rather extraordinary positionbecause it has operated at a loss over the last several years. This runs counter to how the industry has performed, sowe believe the regression beta is a more appropriate measure of risk for the company.

From Betas to Costs of Equity

To arrive at a cost of equity from the appropriate beta for each company, we assumed a risk-free rate of6%, the long-term treasury bond rate for the period of our analysis. For the risk premium, we used a geometrichistorical risk premium for stocks over the long-term treasury bond of 6.16%. For our foreign company, Hitachi, weused the Japanese riskfree rate of 1.88% and the same risk premium.

Using the CAPM formula, below we present the costs of equity (expected returns) for each company:

Compaq HP Hitachi IBM Oracle UnisysCost ofEquity

15.55% 15.79% 8.04% 13.88% 12.22% 17.58%

As we can see, the return that investors expect to make on an investment in Unisys, given its comparativelyhigh risk, is the largest among all companies at 17.58%. By comparison, Hitachi’s expected return is the lowest at8.04%. Its risk is the market risk and is based upon the lower Japanese risk-free rate. The return that investorsexpect to make by investing into any company becomes the cost of equity for managers running that company.

Estimating Costs of Debt

The current bond ratings for all our companies are presented below, which are factored into obtaining acurrent cost of debt for all companies:

Compaq HP Hitachi IBM Oracle UnisysBond Rating BBB AA Aa2 A+ BBBPre-taxCost ofDebt6

8% 6.7% 2.58% 6.8% 8% 10%

After-taxCost ofDebt

5.12% 4.69% 1.31% 4.35% 5.12% 6.4%

Estimating Costs of Capital

For each company, we computed a cost of capital by taking the cost of equity, estimated from the beta,along with the after-tax cost of debt. The costs of capital for each company are presented below:

Compaq HP Hitachi IBM Oracle UnisysCost ofEquity

15.55% 15.79% 8.04% 13.88% 12.22% 17.58%

E/(D+E) 100% 94.32% 57% 84.09% 96% 49.8%AT Cost ofDebt

5.12% 4.69% 1.31% 4.35% 5.12% 6.4%

D/(D+E) 0% 5.68% 43% 15.91% 4% 29.86%Cost ofCapital

15.55% 15.16% 5.14% 12.37% 11.94% 12.41%

6 We used the long-term treasury bond rate of 6% for all companies (except Hitachi, where we used the long-term treasury bondrate of 1.88%), adding on the appropriate default spread based upon each company’s bond rating.


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Note that, in addition, Unisys has preferred stock outstanding. We calculated the cost of preferred stock as:

Cost of Pref. Stock = Pref. Div./MV Pref. Equity = 120.4/1420.2 = 8.5%

The cost of capital as calculated above for Unisys includes the weighted average cost of preferred stock of8.5% multiplied by the preferred stock ratio of 20.34%, yielding a total weighted average cost of capital of 12.41%.

The cost of capital for each company is the benchmark each company uses to analyze projects on a predebtbasis. In the next section, we will determine how each company has performed based on their respective costs ofequity and costs of capital.


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IV. Investment Return Analysis

Business Project Flow Characteristics Type of Financing/Appropriate Debt

Computer Hardware

Business

• Be short term for personal computers,

medium term for mainframe computers

• Have cash outflows that are primarily

in dollars, but with inflows that are

frequently in foreign currencies due to

large overseas sales

• Be very competitive and volatile

• Short term

• Both in US $ and foreign currency

• Linked to a high-technology index

fund, if possible

Computer Software

Business

• Be short term





• Can be considerably profitable due to

low fixed costs

• Short term

• Both in US $ and foreign currency

• Linked to a high-technology index

fund, if possible

Electrical Equipment • Be medium to long term





• Stable, but can be cyclical

• Mixture of medium and long term

• Both in US$ and foreign currency

Electrical Machinery • Be long term





• Stable

• Sensitive to exogenous factors, such as

politics and macro-economic factors


• Both in US$ and foreign currency

• Linked to the specific country ratings,

if possible

Test & Measurement

Medial Electronic

Equipment, Chemical

Analysis & Service

• Long term


in dollars

• Stable

• High fixed costs


• Mainly in US$


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Measuring Past Returns

We assumed that the current book value of assets and equity of our companies reflected the current capital

and equity invested in existing projects. Using the net income and book value of equity, we computed the return of

equity of each firm as follows:


ROE 22.19% 21.08% 2.72% 29.4% 38.75% -176.29%

ROC 22.87% 16.13% 2.4% 12.77% 36.56% 9.29%

Hitachi’s ROE and ROC are extremely low compared with the US companies. Unisys operates at a loss

and thus, its ROE is negative. Since Compaq and Oracle have little to no debt, their ROCs are not much different

from their ROEs. IBM’s ROE is significantly higher, reflecting its relatively high debt ratio and its active stock

buybacks.

Graphically, these returns appear as follows:

ROE & ROC

-200%

-150%

-100%

-50%

0%

50%


Return onEquityReturn onCapital


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Evaluation of Past Returns

Calculation of Equity EVA

Compaq HP Hitachi IBM Oracle Unisys Industry

Average

ROE 22.19% 21.08% 2.72% 29.4% 38.75% -176.29% 22.4%

Cost of Equity 15.55% 15.79% 8.04% 13.88% 12.22% 17.58% 12.8%

Equity Return Spread 6.64% 5.29% -5.32% 15.52% 26.53% -193.87% 9.6%

Equity EVA

(MM)

$555 $783 -Y 172,000 $3,216 $562 - $939 $50.67

Calculation of EVA

Compaq HP Hitachi IBM Oracle Unisys Industry

Average

ROC 22.87% 16.1% 2.4% 12.77% 36.56% 9.29% 25.24%

Cost of Capital 15.55% 15.16% 5.14% 12.37% 11.94% 12.41% 12.31%

Capital Return Spread 7.32% 0.94% -2.74% 0.4% 24.62% -3.12% 12.93%

EVA (MM) $612 $182 -Y 153,000 $183 $560 - $108 $101.45

Compaq and Oracle are well outperforming their respective cost of equity and cost of capital, meaning both

companies are picking up good projects. On the other hand, return spreads of cost of capital for HP and IBM are

close to zero, as compared to their equity return spread of 5.29% (HP) and 15.52% (IBM). This suggests that since

HP and IBM do not have many good projects, they just buy back stocks alternatively. Reflecting its low ROE &

ROC, Hitachi’s return spread is negative, as is its EVA. Hitachi’s ROE and ROC do not match the hurdle rates, thus

its EVAs are negative. Unisys’ projects did not generate necessary return to the company.

The accounting returns certainly give us general information on each company’s performance. However,

accounting returns do not necessarily reflect the company’s real picture, because they are influenced by certain

accounting standards, and do not reflect market value. Since, it is meaningful to use both book value basis returns

and market value returns to get more precise and comprehensive information of the companies in our analysis, we

compared market value based excess return (return on stock – required return) in the following dividend chapter.


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Assessments for the Future

We believe that the computer hardware and software industries have huge opportunities for further growth in the

future based on the following reasons: 1) we expect that the customer base will continue to expand, both

domestically and internationally; and 2) new related businesses, such as network computer and IT solution

consulting business, were created and grew at a rapid pace.

Compaq has been growing rapidly and is likely to continue to do so in the future, given its relatively small

company size. Through acquiring DEC, Compaq is entering into the network business, which is a business of both

high profitability and risk. However, we believe Compaq’s good brand image will make it possible to earn higher

operating margins.

HP’s diversification into relatively low risk businesses, such as electrical manufacturing, medical electronics and

chemical analysis, provides the company with buffers to exposure in its highly risky computer hardware business.

On the other hand, its diversification may limit its opportunities to capture any high growth opportunities in the

computer hardware business. So, together with its big size, we anticipate that HP’s growth will be stable in the

future.

Hitachi should increase its ROE and ROC in order to match the required hurdle rates. Its low ROE and ROC are a

reflection of Hitachi’s power structure between strong incumbent managers and weak stockholders. If stockholders

acted to check the managers, it would be harder for the firm to generate a negative EVA. Thus, we do not foresee

high growth for Hitachi. Given the current bad fundamentals for the Japanese economy, it may grow only modestly.

While focusing on the computer hardware business, IBM transitioned into other areas, such as software services

and consulting, which are relatively less risky than its current stronghold. IBM’s policy to buy back stocks suggests

that the company does not have many good projects to invest. So, we anticipate that IBM will grow at a moderate

rate.

Oracle, on the other hand, is concentrating on the fast-growing software service business. Given that the company

is still relatively small, there is room to grow for the company, although its growth may be volatile.

Unisys is in the process of turning itself around. Since new CEO Larry Weinbach came on board in September

of 1997, Unisys is focussing on the future. Unisys has since contracted out to manufacture desktop computers and

low-end servers, and is now concentrating on its mainframes and high-end servers.

More importantly, Unisys is over 80% of the way towards achieving Weinbach’s goal of reducing debt by $1

billion dollars by the year 2000. This success resulted from the conversion of $616 million in bonds and the


17

retirement of $198 million in additional debt. With this financial restructuring and the streamlining of its

manufacturing operations, we believe that Unisys is poised to make a comeback.


18

VIII. Dividend Policy: The Tradeoff

The way the six companies return cash to stockholders is different and the reasons they return thecash also vary.

The following tables sum up the dividend and stock buyback of the last 5 years.

HewlettPackard

Hitachi

Year 1993 1994 1995 1996 1997 Year 1993 1994 1995 1996 1997Dividends $228 $280 $358 $450 $532 Dividends 37.35 37.10 37.98 36.39 36.63

+ EquityRepurchases

$6 $25 $325 $726 $305 + EquityRepurchases

= Cash toStockholders

$234 $305 $683 $1,176 $837 = Cash toStockholders

Y37.35 Y37.1 Y37.98 Y36.39 Y36.63

Unisys Oracle

Year 1993 1994 1995 1996 1997 Year 1993 1994 1995 1996 1997Dividends Dividends

+ EquityRepurchases

+ EquityRepurchases

$43.63 $81.16 $75.86 $113.09 $528.21


$0.00 $0.00 $0.00 $0.00 $0.00 = Cash toStockholders

$43.63 $81.16 $75.86 $113.09 $528.21

IBM Compaq

Year 1993 1994 1995 1996 1997 Year 1993 1994 1995 1996 1997Dividends $933 $662 $591 $706 $783 Dividends

+ EquityRepurchases

$10 $5,526 $5,005 $6,251 + EquityRepurchases


$933 $672 $6,117 $5,711 $7,034 = Cash toStockholders

$0.00 $0.00 $0.00 $0.00 $0.00

In the following table we compare the 3 companies of ours that pay dividends to industryaverages:

DividendPayout

DividendYield

IBM 12.85 0.77

HP 17.06 0.83

Hitachi 41.46 0.01

Hardware Ind.Avg.

7.67 0.42

Soft.&ServInd. Avg.

7.25 0.19

Ind. Wt. Avg. 7.45 0.30


19

As shown above, our 3 companies have higher payout ratios and yields than the industryaverages. However, we must view Hitachi as an exception because it is a Japanese company andoperates under different constraints.

To better understand some of the tradeoffs of different dividend policies, we will compare thepolicies of Compaq and IBM, which exemplify two common dividend policies, namely thepolicy of paying dividends and the policy of not paying dividends.

Factor Implication for Compaq Implication for IBMStockholder Tax Preference Considering its history of

no dividends, stockholderschoose it for its capitalgains potential. In thefuture, stockholders wouldprefer buybacks overdividends.

IBM was a typical dividendpaying company before therecession, but 5 years oflow dividends have changedstockholders attitudes sonow they do not expect highdividends

Information Effects andSignaling Incentives

Considering its no-dividendpolicy, it is unlikely thatCompaq would usedividends to signalinformation about futurecash flows.

Its announcement that itwould reduce dividendssent its stock plummeting.

Effect on Flexibility Not paying dividends givesCompaq more flexibility inaccepting projects

Since IBM does not havemany good projects, theytend to return money tostockholders. Therefore,they do not require muchflexibility.

Bond Covenants andRatings Agency Concern

Considering that it has nodebt, this is not a concern

They have many bondholders, so ratings are aconcern and effects theirdividend policy.

As suggested above, when Compaq decides to return money to stockholders it should do so inthe form of buybacks. IBM should continue its current dividend policy.


20

IX. Dividend Policy: A Framework

The following tables sum up our results of what the companies should have returned and whatthey did. It also shows where the companies paid out too much.

Hewlett Packard

Year 1993 1994 1995 1996 1997 Average

Net Income $1,177.00 $1,599.00 $2,433.00 $2,586.00 $3,119.00 $2,182.80

(Cap Ex - Depr) (1-DR) $397.00 $168.00 $318.00 $642.00 $557.00 $416.40

Change in WC * (1-DR) $556.00 $647.00 $721.00 $1,472.00 $1,676.00 $1,014.40

FCFE $224.00 $784.00 $1,394.00 $472.00 $887.00 $752.20

Cash to Shareholders $234.00 $305.00 $683.00 $1,176.00 $837.00 $647.00

Payout Ratio 19.4% 17.5% 14.7% 17.4% 17.1% 17.2%

Cash Paid as % of FCFE 104.5% 38.9% 49.0% 249.2% 94.4% 107.2%

Hitachi

Year 1993 1994 1995 1996 1997 Average

Net Income $77.29 $65.28 $113.91 $141.77 $88.33 $97.32

(Cap Ex - Depr) (1-DR) $91.50 $112.39 $90.87 $112.55 $132.60 $107.98

Change in WC * (1-DR) ($88.96) ($31.75) $37.16 $205.87 ($11.52) $22.16

FCFE $74.75 ($15.36) ($14.12) ($176.64) ($32.75) ($32.82)

Cash to Shareholders $37.35 $37.10 $37.98 $36.39 $36.63 $37.09

Payout Ratio 48.3% 56.8% 33.3% 25.7% 41.5% 41%

Cash Paid as % of FCFE 50.0% -241.5% -269.0% -20.6% -111.8% -119%

Compaq

Year 1993 1994 1995 1996 1997 Average

Net Income $462.00 $867.00 $789.00 $1,318.00 $1,855.00 $1,058.20

(Cap Ex - Depr) (1-DR) ($11.00) $188.00 $177.00 $1.00 $184.00 $107.80

Change in WC * (1-DR) $390.00 $1,090.00 $422.00 $1,958.00 $859.00 $943.80

FCFE $83.00 ($411.00) $190.00 ($641.00) $812.00 $6.60

Cash to Shareholders

Payout Ratio

Cash Paid as % of FCFE

Oracle

Year 1993 1994 1995 1996 1997 Average

Net Income $98.26 $283.72 $441.52 $603.28 $821.46 $449.65

(Cap Ex - Depr) (1-DR) ($36.37) $140.25 $109.71 $85.34 $120.93 $83.97

Change in WC * (1-DR) ($11.14) $70.64 $268.68 $264.00 $422.47 $202.93

FCFE $145.77 $72.84 $63.13 $253.94 $278.06 $162.75


Payout Ratio

Cash Paid as % of FCFE 29.9% 111.4% 120.2% 44.5% 190.0% 99%


21

Unisys

Year 1993 1994 1995 1996 1997 Average

Net Income $565.40 $100.50 ($624.60) $49.70 ($853.60) ($152.52)

(Cap Ex - Depr) (1-DR) ($167.02) ($122.56) ($119.70) ($99.89) ($618.78) ($225.59)

Change in WC * (1-DR) $6.15 ($120.59) ($334.63) $356.05 ($204.67) ($59.54)

FCFE $726.27 $343.66 ($170.27) ($206.46) ($30.15) $132.61


Payout Ratio


IBM

Year 1993 1994 1995 1996 1997 Average

Net Income ($8,101.00) $3,021.00 $4,178.00 $5,429.00 $6,093.00 $2,124.00

(Cap Ex - Depr) (1-DR) ($2,469.29) ($2,265.10) ($604.12) $613.27 $1,261.75 ($692.70)

Change in WC * (1-DR) $2,180.61 $4,266.86 ($2,160.89) ($1,653.23) ($841.40) $358.39

FCFE ($7,812.32) $1,019.24 $6,943.01 $6,468.96 $5,672.65 $2,458.31

Cash to Shareholders $933.00 $672.00 $6,117.00 $5,711.00 $7,034.00 $4,093.40

Payout Ratio -11.5% 21.9% 14.1% 13.0% 12.9% 10%

Cash Paid as % of FCFE -11.9% 65.9% 88.1% 88.3% 124.0% 71%

By looking at the shaded areas in the above tables, we can get and idea of how much thecompanies could have returned to stockholders and how much they actually did.

The companies can be categorized in 4 ways by looking at how they return cash to stockholders.

1) Those that pay dividends: Hitachi2) Those that buyback stocks: Oracle3) Those that pay dividends and buyback stocks: Hewlett Packard and IBM4) Those that that do neither: Compaq and Unisys

1) Hitachi has been paying the same 11 yen per share dividend since 1990, even though itsprofits have been declining due to the Japanese recession. This is common in large matureJapanese companies. Even though this dividend is regular, its yield is just 1.15%. However,since its net income per share was just 25.55 yen in 1997, 11 yen per share means its payout ratiois 43%, which is not very low. Their 10-year historical dividend payout ratio is 26.31%.

As this is the only Japanese company in the group, the following information is included forcomparison.

Toshiba: Dividend pay out =Y10/Y18.7=53.5% Yield: Y10/Y547=1.82%Matsushita: Dividend pay out = Y13/Y39.4=33.0% Yield: Y13/Y1,985=0.65%

Compared with other Japanese computer and electronics companies, Hitachi's dividend ratios arebetween Toshiba and Matsushita: not so high but not so low.


22

Since most of Hitachi’s shareholders are institutional investors, they prefer capital gains andstable growth, rather than obtaining large dividends. This is due to the difference in taxtreatment.

2) Oracle is unique in our survey because it has been returning cash in the form of stockbuybacks. From the data, it seems that Oracle is transforming itself from a growth company to amore mature company. Since Oracle has never paid dividends, its investors are not expectingany in the future. As Oracle does not have as many good projects as in the past it is returningcash in the form of stock buybacks.

3) Hewlett Packard and IBM seem very similar on the surface in terms of their cash returningpolicies. Both companies have a low positive EVA, which is consistent with large maturecompanies which do not have attractive projects. However, with a little analysis we can seesome differences. HP is a typical large mature company with a relatively stable dividend payoutratio. It is also buying back stock.

IBM, on the other hand, appears to be behaving in the same manner. But by looking back a fewyears, we can discover a different reason for IBM’s actions. From 1991-1992 IBM’s stock pricefell 43%. This came on the heels of mounting loses as a result of mismanagement. In 1993,IBM’s new management, lead by Louis Gerstner, Jr., announced a decrease in dividends whichwas greeted with further downward pressure on their stock price. To counter this effect IBMstarted to repurchase its stock. In this way it returned cash to shareholders and helped bring theprice back up.

4) The last two companies also appear similar if looking at their dividends and buyback policies,but other than that, they are widely different. Compaq is a typical growth company. It has anEVA of 7.32%, which signifies that it is investing in good projects. Its policy of not returningmoney to shareholders and reinvesting it in projects is the definition of a growth company.

Unisys, on the other hand, is a company that has been loosing money for several years and hasposted negative FCFE for 6 of the last 10 years. It is not surprising that the firm does not payany dividends.


23

How much do we trust management at these computer companies?

First, in terms of corporate governance, except for Hitachi, we consider each company to haveappropriate corporate governance. Second, in terms of stock price performance, except forUnisys, each company’s stock has performed well compared to the market, after adjusting forrisk.

Excess Returns (Return on Stock-Required Return)

Recent 5 yearAverage Standard Div.

HP 8.64% 21.51%Hitachi 6.59% 11.96%Unisys -16.48% 60.11%Oracle 14.63% 13.17%IBM 12.66% 23.66%Compaq 27.12% 37.29%

Based on the table above, we can say that the companies that have smaller excess return (returnon stock – required return), such as Hitachi or IBM, tend to pay higher dividend, while acompany that has high excess return, Compaq, tends to pay no dividend. Therefore, we canconclude we can trust these companies management, except for Unisys.

Comparison to Peer Group

In comparing our companies to each other, as well as to a representative cross section of its peergroup, we have examined dividend yields and payouts.

ExpectedGrowth

DividendPayout

DividendYield

Price

Microsoft 23.81 0 0 64.63Intel 19.64 2.7 0.16 70.25Dell 29.58 0 0 42Micron 16.58 0 0 9.13DEC 12 0 0 37.13Cisco 29.85 0 0 55.753Com 24.15 0 0 34.94Compaq 20.38 0 0 28.25IBM 10 12.85 0.77 104.63Oracle 24.48 0 0 31.08HP 15.47 17.06 0.83 61.63Unisys 10.6 0 0 13.88Hitachi 2.07 41.46 0.01

The forecasted growth rates were taken from the Zacks service by way of Bloomberg.


24

We ran the two regressions in order to see how well expected growth predicts payouts andyields. The results are as follows:

Dividend Payout Ratio =24.4 - 1.02 (Expected Growth Rate)R-Sq = 48% (t=3.19)

Expect-ed

Growth

ActualPayout

Predict-ed

Payout

Differ-ence

Microsoft 23.81 0 0.11 -0.11Intel 19.64 2.7 4.37 -1.67Dell 29.58 0 -5.77 5.77Micron 16.58 0 7.49 -7.49DEC 12 0 12.16 -12.16Cisco 29.85 0 -6.05 6.053Com 24.15 0 -0.23 0.23Compaq 20.38 0 3.61 -3.61IBM 10 12.85 14.20 -1.35Oracle 24.48 0 -0.57 0.57HP 15.47 17.06 8.62 8.44Unisys 10.6 0 13.59 -13.59Hitachi 2.07 41.46 22.29 19.17

Dividend Yield =0.335 - 0.0108 (Expected Growth Rate)R-Sq = 8.9% (t=1.04)

Expect-ed

Growth

ActualYield

Predict-ed

Yield

Differ-ence

Microsoft 23.81 0 0.08 -0.08Intel 19.64 0.16 0.12 0.04Dell 29.58 0 0.02 -0.02Micron 16.58 0 0.16 -0.16DEC 12 0 0.21 -0.21Cisco 29.85 0 0.01 -0.013Com 24.15 0 0.07 -0.07Compaq 20.38 0 0.11 -0.11IBM 10 0.77 0.23 0.54Oracle 24.48 0 0.07 -0.07HP 15.47 0.83 0.17 0.66Unisys 10.6 0 0.22 -0.22Hitachi 2.07 0.01 0.31 -0.30

By looking at the shaded areas of the above left table, we can see how well the regressionpredicts payout ratios. The regression results suggest that HP and Hitachi are highcompared to other firms in the industry. However, this can be attributed to the largeportion of the sample group that does not pay dividends which provides little variationacross the group.

A similar situation is shown in the above right table, when we regressed yield againstgrowth. The results suggest that IBM and HP’s yields are too high compared to theindustry and that Hitachi’s are too low. However, as mentioned above, Hitachi is aunique case because it is a Japanese company operating under different constraints.

Conclusions on Dividend Policy

In summary, it seems that investors in our six companies know what type of dividendpolicy to expect. Except for Unisys, management has earned a certain measure of trustbased on excess returns for their investors. This gives the companies greater flexibilityfor investing and paying out dividends. It is also true that these companies generallystick to a given policy and their stockholders have chosen to invest accordingly.


25

VIII. Dividend Policy: The Tradeoff

The way the six companies return cash to stockholders is different and the reasons theyreturn the cash also vary.

The following tables sum up the dividend and stock buyback of the last 5 years.

HewlettPackard

Hitachi

Year 1993 1994 1995 1996 1997 Year 1993 1994 1995 1996 1997Dividends $228 $280 $358 $450 $532 Dividends 37.35 37.10 37.98 36.39 36.63

+ EquityRepurchases

$6 $25 $325 $726 $305 + EquityRepurchases


$234 $305 $683 $1,176 $837 = Cash toStockholders

Y37.35 Y37.1 Y37.98 Y36.39 Y36.63

Unisys Oracle

Year 1993 1994 1995 1996 1997 Year 1993 1994 1995 1996 1997Dividends Dividends

+ EquityRepurchases

+ EquityRepurchases

$43.63 $81.16 $75.86 $113.09 $528.21


$0.00 $0.00 $0.00 $0.00 $0.00 = Cash toStockholders

$43.63 $81.16 $75.86 $113.09 $528.21

IBM Compaq

Year 1993 1994 1995 1996 1997 Year 1993 1994 1995 1996 1997Dividends $933 $662 $591 $706 $783 Dividends

+ EquityRepurchases

$10 $5,526 $5,005 $6,251 + EquityRepurchases


$933 $672 $6,117 $5,711 $7,034 = Cash toStockholders

$0.00 $0.00 $0.00 $0.00 $0.00

In the following table we compare the 3 companies of ours that pay dividends to industryaverages:

DividendPayout

DividendYield

IBM 12.85 0.77

HP 17.06 0.83

Hitachi 41.46 0.01

Hardware Ind.Avg.

7.67 0.42

Soft.&ServInd. Avg.

7.25 0.19

Ind. Wt. Avg. 7.45 0.30


26

As shown above, our 3 companies have higher payout ratios and yields than the industryaverages. However, we must view Hitachi as an exception because it is a Japanesecompany and operates under different constraints.

To better understand some of the tradeoffs of different dividend policies, we willcompare the policies of Compaq and IBM, which exemplify two common dividendpolicies, namely the policy of paying dividends and the policy of not paying dividends.

Factor Implication for Compaq Implication for IBMStockholder Tax Preference Considering its history of

no dividends, stockholderschoose it for its capitalgains potential. In thefuture, stockholders wouldprefer buybacks overdividends.

IBM was a typical dividendpaying company before therecession, but 5 years oflow dividends have changedstockholders attitudes sonow they do not expect highdividends

Information Effects andSignaling Incentives

Considering its no-dividendpolicy, it is unlikely thatCompaq would usedividends to signalinformation about futurecash flows.

Its announcement that itwould reduce dividendssent its stock plummeting.

Effect on Flexibility Not paying dividends givesCompaq more flexibility inaccepting projects

Since IBM does not havemany good projects, theytend to return money tostockholders. Therefore,they do not require muchflexibility.

Bond Covenants andRatings Agency Concern

Considering that it has nodebt, this is not a concern

They have many bondholders, so ratings are aconcern and effects theirdividend policy.

As suggested above, when Compaq decides to return money to stockholders it should doso in the form of buybacks. IBM should continue its current dividend policy.


27

IX. Dividend Policy: A Framework

The following tables sum up our results of what the companies should have returned andwhat they did. It also shows where the companies paid out too much.

Hewlett Packard

Year 1993 1994 1995 1996 1997 Average

Net Income $1,177.00 $1,599.00 $2,433.00 $2,586.00 $3,119.00 $2,182.80

(Cap Ex - Depr) (1-DR) $397.00 $168.00 $318.00 $642.00 $557.00 $416.40

Change in WC * (1-DR) $556.00 $647.00 $721.00 $1,472.00 $1,676.00 $1,014.40

FCFE $224.00 $784.00 $1,394.00 $472.00 $887.00 $752.20

Cash to Shareholders $234.00 $305.00 $683.00 $1,176.00 $837.00 $647.00

Payout Ratio 19.4% 17.5% 14.7% 17.4% 17.1% 17.2%

Cash Paid as % of FCFE 104.5% 38.9% 49.0% 249.2% 94.4% 107.2%

Hitachi

Year 1993 1994 1995 1996 1997 Average

Net Income $77.29 $65.28 $113.91 $141.77 $88.33 $97.32

(Cap Ex - Depr) (1-DR) $91.50 $112.39 $90.87 $112.55 $132.60 $107.98

Change in WC * (1-DR) ($88.96) ($31.75) $37.16 $205.87 ($11.52) $22.16

FCFE $74.75 ($15.36) ($14.12) ($176.64) ($32.75) ($32.82)


Payout Ratio 48.3% 56.8% 33.3% 25.7% 41.5% 41%

Cash Paid as % of FCFE 50.0% -241.5% -269.0% -20.6% -111.8% -119%

Compaq

Year 1993 1994 1995 1996 1997 Average

Net Income $462.00 $867.00 $789.00 $1,318.00 $1,855.00 $1,058.20

(Cap Ex - Depr) (1-DR) ($11.00) $188.00 $177.00 $1.00 $184.00 $107.80

Change in WC * (1-DR) $390.00 $1,090.00 $422.00 $1,958.00 $859.00 $943.80

FCFE $83.00 ($411.00) $190.00 ($641.00) $812.00 $6.60


Payout Ratio


Oracle

Year 1993 1994 1995 1996 1997 Average

Net Income $98.26 $283.72 $441.52 $603.28 $821.46 $449.65

(Cap Ex - Depr) (1-DR) ($36.37) $140.25 $109.71 $85.34 $120.93 $83.97

Change in WC * (1-DR) ($11.14) $70.64 $268.68 $264.00 $422.47 $202.93

FCFE $145.77 $72.84 $63.13 $253.94 $278.06 $162.75


Payout Ratio

Cash Paid as % of FCFE 29.9% 111.4% 120.2% 44.5% 190.0% 99%


28

Unisys

Year 1993 1994 1995 1996 1997 Average

Net Income $565.40 $100.50 ($624.60) $49.70 ($853.60) ($152.52)

(Cap Ex - Depr) (1-DR) ($167.02) ($122.56) ($119.70) ($99.89) ($618.78) ($225.59)

Change in WC * (1-DR) $6.15 ($120.59) ($334.63) $356.05 ($204.67) ($59.54)

FCFE $726.27 $343.66 ($170.27) ($206.46) ($30.15) $132.61


Payout Ratio


IBM

Year 1993 1994 1995 1996 1997 Average

Net Income ($8,101.00) $3,021.00 $4,178.00 $5,429.00 $6,093.00 $2,124.00

(Cap Ex - Depr) (1-DR) ($2,469.29) ($2,265.10) ($604.12) $613.27 $1,261.75 ($692.70)

Change in WC * (1-DR) $2,180.61 $4,266.86 ($2,160.89) ($1,653.23) ($841.40) $358.39

FCFE ($7,812.32) $1,019.24 $6,943.01 $6,468.96 $5,672.65 $2,458.31

Cash to Shareholders $933.00 $672.00 $6,117.00 $5,711.00 $7,034.00 $4,093.40

Payout Ratio -11.5% 21.9% 14.1% 13.0% 12.9% 10%

Cash Paid as % of FCFE -11.9% 65.9% 88.1% 88.3% 124.0% 71%

By looking at the shaded areas in the above tables, we can get and idea of how much thecompanies could have returned to stockholders and how much they actually did.

The companies can be categorized in 4 ways by looking at how they return cash tostockholders.

5) Those that pay dividends: Hitachi6) Those that buyback stocks: Oracle7) Those that pay dividends and buyback stocks: Hewlett Packard and IBM8) Those that that do neither: Compaq and Unisys

1) Hitachi has been paying the same 11 yen per share dividend since 1990, even thoughits profits have been declining due to the Japanese recession. This is common in largemature Japanese companies. Even though this dividend is regular, its yield is just 1.15%.However, since its net income per share was just 25.55 yen in 1997, 11 yen per sharemeans its payout ratio is 43%, which is not very low. Their 10-year historical dividendpayout ratio is 26.31%.

As this is the only Japanese company in the group, the following information is includedfor comparison.

Toshiba: Dividend pay out =Y10/Y18.7=53.5% Yield: Y10/Y547=1.82%Matsushita: Dividend pay out = Y13/Y39.4=33.0% Yield: Y13/Y1,985=0.65%

Compared with other Japanese computer and electronics companies, Hitachi's dividendratios are between Toshiba and Matsushita: not so high but not so low.


29

Since most of Hitachi’s shareholders are institutional investors, they prefer capital gainsand stable growth, rather than obtaining large dividends. This is due to the difference intax treatment.

2) Oracle is unique in our survey because it has been returning cash in the form of stockbuybacks. From the data, it seems that Oracle is transforming itself from a growthcompany to a more mature company. Since Oracle has never paid dividends, its investorsare not expecting any in the future. As Oracle does not have as many good projects as inthe past it is returning cash in the form of stock buybacks.

3) Hewlett Packard and IBM seem very similar on the surface in terms of their cashreturning policies. Both companies have a low positive EVA, which is consistent withlarge mature companies which do not have attractive projects. However, with a littleanalysis we can see some differences. HP is a typical large mature company with arelatively stable dividend payout ratio. It is also buying back stock.

IBM, on the other hand, appears to be behaving in the same manner. But by looking backa few years, we can discover a different reason for IBM’s actions. From 1991-1992IBM’s stock price fell 43%. This came on the heels of mounting loses as a result ofmismanagement. In 1993, IBM’s new management, lead by Louis Gerstner, Jr.,announced a decrease in dividends which was greeted with further downward pressure ontheir stock price. To counter this effect IBM started to repurchase its stock. In this way itreturned cash to shareholders and helped bring the price back up.

4) The last two companies also appear similar if looking at their dividends and buybackpolicies, but other than that, they are widely different. Compaq is a typical growthcompany. It has an EVA of 7.32%, which signifies that it is investing in good projects.Its policy of not returning money to shareholders and reinvesting it in projects is thedefinition of a growth company.

Unisys, on the other hand, is a company that has been loosing money for several yearsand has posted negative FCFE for 6 of the last 10 years. It is not surprising that the firmdoes not pay any dividends.


30

How much do we trust management at these computer companies?

First, in terms of corporate governance, except for Hitachi, we consider each company tohave appropriate corporate governance. Second, in terms of stock price performance,except for Unisys, each company’s stock has performed well compared to the market,after adjusting for risk.

Excess Returns (Return on Stock-Required Return)

Recent 5 yearAverage Standard Div.

HP 8.64% 21.51%Hitachi 6.59% 11.96%Unisys -16.48% 60.11%Oracle 14.63% 13.17%IBM 12.66% 23.66%Compaq 27.12% 37.29%

Based on the table above, we can say that the companies that have smaller excess return(return on stock – required return), such as Hitachi or IBM, tend to pay higher dividend,while a company that has high excess return, Compaq, tends to pay no dividend.Therefore, we can conclude we can trust these companies management, except forUnisys.

Comparison to Peer Group

In comparing our companies to each other, as well as to a representative cross section ofits peer group, we have examined dividend yields and payouts.

ExpectedGrowth

DividendPayout

DividendYield

Price

Microsoft 23.81 0 0 64.63Intel 19.64 2.7 0.16 70.25Dell 29.58 0 0 42Micron 16.58 0 0 9.13DEC 12 0 0 37.13Cisco 29.85 0 0 55.753Com 24.15 0 0 34.94Compaq 20.38 0 0 28.25IBM 10 12.85 0.77 104.63Oracle 24.48 0 0 31.08HP 15.47 17.06 0.83 61.63Unisys 10.6 0 0 13.88Hitachi 2.07 41.46 0.01


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The forecasted growth rates were taken from the Zacks service by way of Bloomberg.

We ran the two regressions in order to see how well expected growth predicts payoutsand yields. The results are as follows:

Dividend Payout Ratio =24.4 - 1.02 (Expected Growth Rate)R-Sq = 48% (t=3.19)

Expect-ed

Growth

ActualPayout

Predict-ed

Payout

Differ-ence

Microsoft 23.81 0 0.11 -0.11Intel 19.64 2.7 4.37 -1.67Dell 29.58 0 -5.77 5.77Micron 16.58 0 7.49 -7.49DEC 12 0 12.16 -12.16Cisco 29.85 0 -6.05 6.053Com 24.15 0 -0.23 0.23Compaq 20.38 0 3.61 -3.61IBM 10 12.85 14.20 -1.35Oracle 24.48 0 -0.57 0.57HP 15.47 17.06 8.62 8.44Unisys 10.6 0 13.59 -13.59Hitachi 2.07 41.46 22.29 19.17

Dividend Yield =0.335 - 0.0108 (Expected Growth Rate)R-Sq = 8.9% (t=1.04)

Expect-ed

Growth

ActualYield

Predict-ed

Yield

Differ-ence

Microsoft 23.81 0 0.08 -0.08Intel 19.64 0.16 0.12 0.04Dell 29.58 0 0.02 -0.02Micron 16.58 0 0.16 -0.16DEC 12 0 0.21 -0.21Cisco 29.85 0 0.01 -0.013Com 24.15 0 0.07 -0.07Compaq 20.38 0 0.11 -0.11IBM 10 0.77 0.23 0.54Oracle 24.48 0 0.07 -0.07HP 15.47 0.83 0.17 0.66Unisys 10.6 0 0.22 -0.22Hitachi 2.07 0.01 0.31 -0.30

By looking at the shaded areas of the above left table, we can see how well the regressionpredicts payout ratios. The regression results suggest that HP and Hitachi are highcompared to other firms in the industry. However, this can be attributed to the largeportion of the sample group that does not pay dividends which provides little variationacross the group.

A similar situation is shown in the above right table, when we regressed yield againstgrowth. The results suggest that IBM and HP’s yields are too high compared to theindustry and that Hitachi’s are too low. However, as mentioned above, Hitachi is aunique case because it is a Japanese company operating under different constraints.

Conclusions on Dividend Policy

In summary, it seems that investors in our six companies know what type of dividendpolicy to expect. Except for Unisys, management has earned a certain measure of trustbased on excess returns for their investors. This gives the companies greater flexibilityfor investing and paying out dividends. It is also true that these companies generallystick to a given policy and their stockholders have chosen to invest accordingly.


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X. Valuation

Value Actual Difference (actual-value)DDM FCFE FCFF Price amount %

HP 40.38 51.57 - 61.63 10.06 19.5% Overvalued

Unisys 1.36 10.83 - 13.88 3.05 28.2% Overvalued

Compaq 17.37 20.85 33.71 28.25 -5.46 -16.2% Undervalued

IBM 84.38 106.02 - 104.63 -1.39 -1.3% UndervaluedOracle 22.95 32.05 - 31.08 -0.97 -3.0% UndervaluedHitachi 1009.04 916.08 - 959 42.92 4.7% Overvalued

1. Valuation Summary

Two of the companies are pretty overvalued: Hewlett Packard (19.5%) and

Unisys (28.2%). When we change the 5-year growth rate of Hewlett Packard (18.28%

to 23.5%), expected values match the current prices. Therefore it can be said that the

market expects HP to grow much faster than its fundamental growth capacity (14.99%).

Unisys is losing money every year. Without its preferred stock, it would have negative

shareholder's equity. It's bond rating is "B." Even when we made a pretty optimistic

profit plan for Unisys, its stock is still quite overvalued. Although Compaq is also

overvalued by FCFE model by 35.5%, if we change the capital structure of Compaq to

the optimal level (debt ratio from the current 0% to 20%) and use FCFF model, the

Value and Actual Price

0 20 40 60 80 100 120

Hitachi

Oracle

IBM

Compaq

Unisys

HP

US$ per share Value Actual


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value of share becomes $33.71, which is pretty close to the current price. Therefore,

markets may expect that Compaq will change its capital structure and take on debt in

future. On the other hand, IBM and Oracle are slightly undervalued. Therefore, we

recommend selling short HP and Unisys, and buying IBM and Oracle.

2. Choosing the right model

For the valuation, we made the assumptions listed below. More details are on the

attached "The Values of Equity in Computer Companies."

(1) 5 year rapid growth, 2 stage model

Except for Hitachi and Oracle, we used a 2-stage model for valuation because each

company has high expected growth for the first five years due to the computer

industry's faster growth rate (fundamental EPS growth: 21% in hardware and 18% in

software) than general U.S. economy (5%). On the other hand, although all of four

companies have moderate barriers to entry and high expected growth rates, the size of

most of the companies are large, so the length of high growth periods should be

moderate. Therefore, we estimate that they will grow at a higher rate for the first five

years, and then the growth rate will become stable. Since Hitachi is a mature company,

and Japanese economy has still not recovered, we estimate Hitachi should already be in

a stable growth period, and therefore chose a 1-stage model. On the other hand,

Oracle's expected growth rate is so high (28.95%) that we used a 3-stage model with 5

years rapid growth and a 5-year transition period.

(2) Cash flows to equity and cost of equity

Basically, except Compaq, we use free cash flows to equity as cash flows, and costs

of equity as discount rates for three reasons. First, each company's dividend payments

do not always show each company's actual value. Therefore, free cash flow model is

more preferable than the dividend discount model. Second, we expect that their capital

structures would not change significantly, except Compaq. Therefore, free cash flow to

equity should be more appropriate than free cash flow to firm. Third, since each

company would not take highly risky projects or change its business structure

significantly in the future, the current cost of equity is appropriate for discount rates.


34

Since Compaq should change its capital structure gradually from zero to 20%, we

also used FCFF model and discounted by cost of capital (15.5%). However, since

Unisys almost finishes its capital restructuring , we use current debt ratio for this

valuation.

(3) 50% fundamental growth, 25% analyst's expectations, and 25% EPS growth

We assigned the following weights for the rapid growth rate. We weighed

fundamental growth at 50%, analysts’ expectation at 25%, and 25% for the historical

growth rate of earnings per share. We did this because the fundamental growth rate is

too objective and based on the growth of earnings. However, since Unisys’s

fundamental and historical growth rates are negative, we only used the analysts’

expectation for the company. For Hitachi, since we couldn’t get reliable analysts’

expectations, we weighted it 50% on fundamental and 50% on historical growth. On

the other hand, since Oracle's EPS growth (68.29%) is unusually high, we weighted

50% on fundamental and 50% on analysts' expectations.

(4) 130% Capital expenditure/ Depreciation

Since computer industry is capital intensive industry, capital expenditure is usually

larger than depreciation even in mature companies like IBM. Therefore, we estimate

that stable capital expenditure should be 130% of depreciation, which is the current

industry average. In Unisys, however, we estimate its capital expenditure to be the

same amount as depreciation because of its current downsizing process.

3. The problem of Unisys

It is difficult to evaluate the value of Unisys because it has been losing money for

the last several years. Based on the assumptions below, even given that its current EPS

is negative $5.30, due to the restructuring efforts and selling non-performing assets, we

hope the firm will recover in five years and then grow at a stable rate.

Key assumptionsSales growth 2.89% (Unisys average 95-97)Operation margin catch up industry average in 2001Operating margin after 2001 6.33% (Current Industry average)Non-operational costs 4.21% (Unisys average 95-97)Preferred Dividend 111 (1997 level)


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Net Income after pref. dividend Turn to positive in 2001, and grow stable

Unisys Profit Plan

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Operation Costs Total Costs Revenue

research on computer industry - nyupages.stern.nyu.edu/~adamodar/pdfiles/cfprojs/computers.pdf ·...

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