Despite today’s large equity rally, the S&P is still down over 2% for the year, in sharp contrast to a median S&P 8% pension actuarial investment assumption, while 10-year bonds yield 2.64%, a long way from the needed 5.8% median discount rate assumption.
» Read more: Pensions – Many Won’t Be As Lucky As Heinz (HNZ)
The current fair value of Hewlett-Packard has been reduced to $43.52, based on our current free cash flow estimates, which includes various adjustments to cash flow from operating activities.
If you wonder why HPQ is now trading, despite the huge buyback announcement, which, when combined with its remainning $4.1 authorization, totals 16% of its outstanding shares, back to where it was on Friday, you need the book to your right: Security Valuation and Risk Analysis:
» Read more: Buy This Book-You Need to Learn About Risk and Valuation
Last week, on credittrends.com , I wrote:
Whether HPQ is successful or not in its bid, one would expect the Board to increase the $4.4 billion remaining authorization in its share repurchase program, both in an attempt to appease analysts and investors who have been critical of the firm as well as present a united and undaunted front to investors and customers of a Board having strength and conviction while potential new CEOs are being interviewed.
I do not agree with today’s announced additional $10 billion share repurchase as it does not add value to existing shareholders.
The CNNMoney.com August 29, 2010, article discusses the bidding war between Hewlett-Packard (HPQ) and Dell (DELL) for the little-known 3PAR (PAR).
» Read more: CNN Money Article: 3PAR bidding war: Are Dell and HP crazy?
The proper measurement of risk and reward is what distinguishes the mediocre from the superior executive. While perhaps the easy way out is to forgo investment opportunities altogether, historically noteworthy investors have shown the assumption of risk can bring on large returns. On the other hand, as we clearly see in the case of HPQ, the inappropriate assumption of risk can destroy value.
» Read more: Strategic Decisions Must Have Quantitative Backing For Success
When BP (BP) was in the heat of the Gulf explosion crisis, we presented our free cash flow sensitivity analysis (here) and forecast, showing the stock was fairly valued in the mid- to perhaps upper- $30s range. When the stock reached $40, we reported that investors were “getting giddy” over its prospects (see article here)—that were not warranted given its free cash flows, and increased cost of equity related to the uncertainly of its free cash flows and updated capital structure.
Here we do the same now for Hewlett-Packard (HPQ): which results in a fair valuation of $47.27.
While the bidding for 3PAR (PAR) is reminiscent of two drunks at a horse auction, whereby the winner is the loser, the 2 point decline in HPQ (HPQ) shares seems excessive. By taking $4.6 billion off its market value relative to the $1.6 billion (at last count) acquisition, investors appear to be ignoring the enterprise’s 8% free cash flow yield. The executives at HPQ have done an admirable job wringing costs out of the firm, from supply chain to benefits.
The fact that HPQ (HPQ) and DELL (DELL) have recently grossly underperformed the technology index is tacit recognition their pursuit of 3PAR (PAR) is a value destroying acquisition. Investor response is therefore appropriate in light of the minimum $1.6 billion cash outflow, in return for an asset that is barely free cash flow positive, and brings to light the seriousness in which business acquisitions must be analyzed. In fact, I estimate, 3PAR would need to add over $ 40 million in free cash flow for the deal to make sense, a scenario not foreseen for at least 3 years.
The Barron’s August 24, 2010, article discusses the impact ultra-low interest rates will have on corporate pension plans and balance sheets. It features CT Capital’s anlysis that a decline in bond yields can be as devastating to a savings plan as a drop in the stock market.
A quick reading of 3PAR’s (PAR) financial statements reveals the $1.6+ billion deal is not value-adding for HPQ shareholders.
In itsAugust 18th S1 filing, GM (GM) stated its US defined benefits plans were underfunded by $17.1 billion and its non-US plans by $10.3 billion. The Company states its discount rate should be approximately 75 basis points lower, given current rates.
ALBANY — State Comptroller Thomas DiNapoli revealed plans yesterday to slash the state pension fund’s growth forecast for the first time in a decade amid growing concerns about exploding retirement costs.
HEADLINE ON HEWLETT-PACKARD
Hewlett-Packard (HPQ: $39.72, $-1.0400,-2.55%) is down after Morgan Stanley (MS) says the company needs more aggressive buybacks to boost shares, Bloomberg reports. Morgan Stanley cut its price target to $56 from $62.
If this is a true representation as to how this analyst feels, it speaks poorly as to the state of current day security analysis.
Despite 2 analyst downgrades this past week, OTEX share are up 12% today, and now is now up about 10% since first recommended here.
While I will wait for the 10Q before additional comment, from the estimate of free cash flow and cost of capital, it appears the two large brokerage firm analysts were off the mark in their analysis.
Related article:
Disclosure: No positions
Kenneth S. Hackel, CFA
President
CT Capital LLC
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If you are interested in learning how to analyze the pension plan, including plan accounting, effect on earnings, cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.
Because I will be busy with final page proofs on the text, I will be unable to edit the full report on HPQ this week.
The analysis suggests, however, that selling in HPQ has been overdone, given its free cash flow, growth rate in cash flows (from operating activities and free), cost of capital (of 8.1%), return on invested capital, and stability measures. Adjustments were made which lowered reported operating cash flows and increased balance sheet debt.
For further information, please read related articles on this site.
Suffice it to say, I am quite busy with final page proofs of book to the right.
If you would like to learn what made us advise maximum cash in 2007, send out a BUY email in March 2009, and again advise caution going into 2010, when every investment strategist was bullish, all you need to do is learn how to appraise the cost of equity capital from a credit perspective. NO ONE DOES IT, BUT THEY WILL. WHY DON’T YOU?
I’ve been writing for a couple of years now about an impending cataclysm about to hit company earnings, cash flows and credit. As we know, many firms were bailed out from having to make stepped-up contributions thanks to the large rally in the financial markets in 2009.
CT Capital’s cost of capital and other models provide key data from which to decompose stock market risk. With that, our “crash predictor” is presented.
I am currently page proofing my upcoming text, a book I am sure could improve your investment returns, and at the same time, save you a lot of heartache. Order by clicking a picture of the book to the right.
It is a landmark book, half devoted to the analysis of free cash flow and metrics based off of free cash flow, such as return on invested capital. Do not use EBITDA for this. I expect the book will be widely adopted.
Corporate defined benefit plans are no better than 75% fully- funded, when adjusting for more realistic investment assumptions and the more powerful discount rate. This is in contrast to current financial reporting using exaggerated assumptions.
Between stock rallies comes news providing a dose of financial and economic reality, as in today’s report on jobless claims.
As I wrote in the article below, much of the cash appearing on balance sheets come courtesy of a lid on expenses and working assets.
As we are now within striking distance of fair stock market value, selectivity and caution is strongly advised.
It’s a hot topic these days.
What are companies to do with the great cash build? Good question—as the data strongly suggests those balances are only going to get larger. The data also suggests it will do so at a more leisurely pace.
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