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.
The blended cost of capital takes into account various factors which could result in disparate outcomes, including the possibility of a prolonged period of slow growth in free cash flows (for which CT Capital’s model has built-in 2% annual growth rates through 2032 and then returns to shareholders $40 per share). As shown below the $40 terminal value at a 9% cost of equity is responsible for just 15% of present fair value.
The cost of equity capital model we use at CT Capital actually assigns a cost of capital for HPQ of 8.5%, which yields a fair value estimate of $45.79. This fair value had been reduced from its prior fair value of $48.24 a month ago due to the departure of Mark Hurd and the proposed $2 billion deal to purchase 3Par (PAR) in a value-destroying acquisition. Keep in mind the ultimate value of 3Par will be higher due to outstanding vested in-the-money stock awards and the estimated fair value of earned unvested stock awards assumed by HP. The large goodwill from the deal, which represents the excess of the purchase price over the net tangible and intangible assets acquired, is not deductible for tax purposes, although tax deductible stock awards are.
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.
We would not agree with a continuing share repurchase, especially given the economic slowdown as well as the materialness that value-enhancing acquisitions have meant to HPQ these past 4 years. To deplete resources and financial flexibility when in the throes of an equity swoop makes little sense. If such action becomes reality, we would further increase the cost of capital by at least 25 basis points, which would lower fair value to a maximum of $44.63.
While HPQ is not on CT Capital’s buylist, given continuing events, including today’s increase in its bid to $30 share for 3Par and a strong quarter of operations, it does present an interesting case for the securities analyst.
Disclosure: No positions
If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.