In this article we look at evidence that strongly suggests IBM (IBM), despite being turned into a cash “machine,” has done so not through its own R&D efforts, but rather through massive cost cutting. And its strategy is errily similar to that of Hewlett-Packard (HPQ), even prior to today’s announcement of a $1.7 billion acquisition, its second large announced deal over the past week.
» Read more: IBM: A Case For Sam Palmisano firing Sam Palmisano
IBM (IBM) CEO Sam Palmisano should measure his words prior to speaking badly of others.
In an interview with the Wall Street Journal, Palmisano said that during former CEO Mark Hurd’s five-year tenure, Hewlett-Packard (HPQ) was hurt by sharp cuts in its R&D budget, and that the company was declining in relevance.
» Read more: IBM – CEO Sam Palmisano Should Look at Facts First
If one values a share of stock using the same analysis and judgment as that of owning a US Treasury bond, they would consider its worth to be the present value of its tax-adjusted free cash flows plus a terminal value; for that is how bonds are indeed valued.
» Read more: New Age Security Analysis
In March 2005, shares in NCR Corp (NCR) tumbled over 17% the day it was announced Mark Hurd, its CEO, would leave the company to join Hewlett-Packard (HPQ). At NCR, Hurd had cut costs while increasing revenues, and as a result, free cash flow grew substantially. As the shares in NCR were falling on the date of announcement, stock in Hewlett-Packard rose over 10%.
» Read more: Is Oracle’s (ORCL) 7% Rise Today Justified?
I was looking at some of this years’ winners and losers and couldn’t help but notice the discrepancy in returns of Hewlett-Packard (HPQ) versus Lexmark (LXK) going back 3 years. For this year, Lexmark is up 35% and Hewlett-Packard down 25%.
» Read more: Hewlett-Packard (HPQ) and Lexmark (LXK)—Cost of Capital Key to Forecasting Stock Price
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.
» Read more: HPQ: We Predicted It But …
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?
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.
» Read more: Hewlett-Packard (HPQ) Fair Value Estimate
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.
» Read more: HPQ, Business Acquisitions, and Share Buybacks
A quick reading of 3PAR’s (PAR) financial statements reveals the $1.6+ billion deal is not value-adding for HPQ shareholders.
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.
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.
If the equity market were to rise less than 7% this year, the following firms would be particularly impacted. Column 3 shows some firms have expected returns of 9%, which would appear particularly optimistic, especially since all firms on the list have plans that are underfunded by at least $1bil. and have a substantial asset allocation to equities.
Disclosure: No positions
Kenneth Hackel, C.F.A.
President
CT Capital LLC
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