Hewlett-Packard Common Stock Valuation

1. Hewlett-Packard Common Stock Valuation 1 Hewlett-Packard Common Stock Valuation As of April 2010 By Valentyn Khokhlov, MBA

2. Hewlett-Packard Common Stock Valuation 2 Purpose Intrinsic enterprise value of the firm is defined as the present value of its future cash flows. The valuation performed as of April 2010. The valuation assumes Hewlett-Packard will continue its operations as a going concern. The valuation is based on publicly-available information and certain assumptions by the author.

3. Hewlett-Packard Common Stock Valuation 3 Executive Summary The assessed intrinsic value of one share of Hewlett-Packard common stock is: $66.90 using the most likely scenario; $65.21 using the weighted-average of all scenarios. The current market price is $54.52 (as of Apr 15, 2010). The stock price is expected to increase. Analyst recommendation is strong buy.

4. Hewlett-Packard Common Stock Valuation 4 Valuation Model Overview Two-stage Free Cash Flow to the Firm (FCFF) model is used for the valuation. It’s a simplified version of McKinsey & Co model (by Copeland, Koller, Murrin). Detailed projections developed for FY2010-19, and a perpetual constant growth is assumed thereafter. FCFF is NOPLAT plus depreciation less reinvestments and increase in net other assets. WACC is used as the discount rate. Cash & short-term investments are considered as a non-operating zero-NPV asset. Operating leases and post-retirement benefits are included to the total debt. CAPM is used to determine cost of equity.

5. Hewlett-Packard Common Stock Valuation 5 Sources The main source of information is the latest HP annual report for FY2009:http://h30261.www3.hp.com/phoenix.zhtml?c=71087&p=irol-reportsAnnual Revenue growth projections and trends of selected items were based also on more recent financials of Q1FY10:http://h30261.www3.hp.com/phoenix.zhtml?c=71087&p=quarterlyEarnings Market data on S&P returns and historical stock prices are based on Yahoo! Finance:http://finance.yahoo.com/ Returns on Treasury securities are based on the U.S. Department of Treasury data:http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_main.shtml

6. Hewlett-Packard Common Stock Valuation 6 Financial Projections

7. Hewlett-Packard Common Stock Valuation 7 Growth Projections In FY05-09 HP had revenue growth of 5.72%, 13.78%, 13.50% and -3.22% respectively. The decline of FY09 has ended and the revenue growth has revived in Q4FY09 and Q1FY10. The last quarter growth is 1.3% (5.3% annualized). The expected revenue growth for FY10 is 5.3%, based on the latest quarterly data. In the short term it’s anticipated that HP will restore its growth to the pre-crisis level of about 11% in FY13-14. In the long run we assume a gradual decline to the perpetual growth level of 4% per year. The projected revenue growth is:

8. Hewlett-Packard Common Stock Valuation 8 Historical P&L

9. Hewlett-Packard Common Stock Valuation 9 Assumptions for P&L Forecast

10. Hewlett-Packard Common Stock Valuation 10 Forecasted P&L and EBITA

11. Hewlett-Packard Common Stock Valuation 11 Historical Balance Sheets

12. Hewlett-Packard Common Stock Valuation 12 Working Capital Considerations Items included to operating current assets are: Accounts receivable, Financial receivables, Inventory, Other current assets Cash & equivalents and Short-term investments are treated as a non-operating zero-NPV asset Items included to operating current liabilities are: Accounts payable, Accrued employee compensation, Deferred revenue, Other current liabilities Deferred taxes accounted for in NOPLAT Notes payable are treated as a short-term debt Accrued restructuring are not promoted to future and treated as a non-interest-bearing short-term obligation

13. Hewlett-Packard Common Stock Valuation 13 Operating Reinvestments

14. Hewlett-Packard Common Stock Valuation 14 Deferred Taxes Increase in Deferred taxes (an item of current liabilities) is included to NOPLAT, as suggested in the original McKinsey & Co valuation model. Deferred taxes are estimated to be 0.8% of revenue, the FY09 percentage of sales. Please note that deferred taxes partially reside in Other liabilities. They are not included here. While it’d be more correct to move them to this item, which increases both NOPLAT and Net other assets, there will be no difference in the resulting FCF.

15. Hewlett-Packard Common Stock Valuation 15 Net Other Assets Post-retirement benefits are excluded from Other liabilities and treated separately as a part of debt. Net other assets are Other assets less Other liabilities (having post-retirement benefits excluded). In 2009 they were 0.36% of revenue, and this ratio is used for the purpose of this valuation. Increase in Net other assets is considered as a non-operating investment and deducted from the FCF.

16. Hewlett-Packard Common Stock Valuation 16 Goodwill Historically the amount HP invested in business acquisitions varied a great deal. Goodwill is $33,109 millions as of 2009, the all-time high, and it’s 28.9% of the FY09 revenue. We use a conservative approach that goodwill will increase with revenue, so that the current ratio of goodwill to sales (28.9%) will hold in future. Increase in goodwill is deducted from the FCF.

17. Hewlett-Packard Common Stock Valuation 17 Cost of Capital

18. Hewlett-Packard Common Stock Valuation 18 Target Capital Structure Target capital structure is assumed to be the same as the current capital structure. Market values of debt and equity as of April 2010 are used to assess the current capital structure. Target capital cost estimate based on historical debt and equity costs for 10 and more years. Cost of debt is risk-free rate plus risk premium on A-rated bonds (HP bond rating according to the report). Cost of equity is calculated with CAPM. Since target capital structure is the as the current one, % of interest in revenues is expected to be as of FY09. Note: Interest isn’t an operating expense, so it doesn’t affect NOPLAT directly, but the tax shield on the interest is added back to taxes on EBITA, thus effectively decreasing NOPLAT.

19. Hewlett-Packard Common Stock Valuation 19 Market Value of Long-Term Debt Market value of long-term debt is PV of future cash flows provided coupons are paid annually. Current T-notes rates are used as the risk-free rate:

20. Hewlett-Packard Common Stock Valuation 20 Market Value of Long-Term Debt

21. Hewlett-Packard Common Stock Valuation 21 Operating Leases The current operating lease commitments as per the annual report (page 144), in USD millions:

22. Hewlett-Packard Common Stock Valuation 22 Debt: Summary Cost of debt: Risk-free rate is 3.68% (historical average 3-years T-notes rate from 1999 to 2009); Risk premium is 0.69% (based on A-rated bonds premium); Pre-tax cost of debt is 4.37% (3.68% + 0.69%); After-tax cost of debt is 3.5% (based on 20% tax rate). Market value of debt (in USD millions) $25,895: Notes payable: $1,850 (book value is used as a proxy); Long-term debt: $14,637 (as per calculations); Operating leases: $2,981 (PV of commitments); Post-retirement benefits: $6,427 (book value). Accrued restructuring costs ($1,109) are not included to the debt. The same cost of debt is applied to the short-term debt, which insignificantly overestimates the total cost.

23. Hewlett-Packard Common Stock Valuation 23 Equity: Summary Market value of equity is $125,868 millions: Number of shares outstanding: 2,364,168,918 (annual report); Price per share: $53.24 (as of April 1, 2010). Cost of equity is 10.79%, as per CAPM with: Risk-free rate is 4.57% (average rate for 10y T-notes in 1999-2009 using the Department of Treasury data); S&P yield of 9.47% is used as a proxy for the market return (1960-2009 CAGR calculated using http://www.moneychimp.com/features/market_cagr.htm); Hewlett-Packard raw beta is 1.40 (calculated with linear regression using HP and S&P 500 monthly adj. close prices sample from 1999 to 2009 on Yahoo! Finance); Actual beta used is 1.27, as per Bloomberg adjustment (2/3 of the raw beta + 1/3).

24. Hewlett-Packard Common Stock Valuation 24 WACC The WACC is 9.55%:

25. Hewlett-Packard Common Stock Valuation 25 Valuation:The Most Likely Case Scenario

26. Hewlett-Packard Common Stock Valuation 26 Free Cash Flow Forecast

27. Hewlett-Packard Common Stock Valuation 27 Equity Valuation

28. Hewlett-Packard Common Stock Valuation 28 Sensitivity Analysis

29. Hewlett-Packard Common Stock Valuation 29 Scenario Analysis

30. Hewlett-Packard Common Stock Valuation 30 Average-Based Case

31. Hewlett-Packard Common Stock Valuation 31 Optimistic Case

32. Hewlett-Packard Common Stock Valuation 32 Conservative Case

33. Hewlett-Packard Common Stock Valuation 33 Distressed Case

34. Hewlett-Packard Common Stock Valuation 34 Summary of the Scenarios