Valuation as of January 28, 2011

Valuation 1

Professor Ken Lehn

HPQ Valuation By: Taylor Will

March 4, 2011

Table of Contents

1. Hewlett-Packard’s Business

a. Overview of HPQ 1

b. Business Segments and Customer Base 1-4

c. Key Suppliers 4

d. Business Strategy 4-5

2. Analysis of Historical Performance

a. HPQ Compared to S&P 500 Tech Index (IXN) and DJIA 5

b. Historical Income Statements 6

c. EBIT, NOPLAT and Gross Cash Flow 6-7

d. Gross Investment and Free Cash Flow 7-8

e. ROIC 8-9

f. EVA 9-10

g. Selected Accounting Ratios 10

h. Current Management Team 11

3. Capital Structure

a. Debt 11

b. Equity 11-12

c. WACC 12-13

4. Future Projections and Analysis

a. Sales Growth 13

b. COGS 13

c. SGA 13

d. RD 13

e. D&A 13

f. Taxes 14

g. Investment in OWC 14

h. Capital Expenditures 14

i. Investment in Goodwill 14

j. Terminal Value 14

k. Sensitivity Analysis 14-15

l. Final Valuation Matrix 15

5. Recommendations 16-17

6. Appendix 18-26

a. Exhibit 1 18

b. Exhibit 2 18

c. Exhibit 3 19

d. Exhibit 4 19

e. Exhibit 5 19

f. Exhibit 6 20

g. Exhibit 7 20

h. Exhibit 8 20

i. Exhibit 9 21

j. Exhibit 10 21

k. Exhibit 11 21

l. Exhibit 12 22

m. Exhibit 13 22

n. Exhibit 14 23

o. Exhibit 15 23

p. Exhibit 16 23

q. Exhibit 17 23

r. Exhibit 18 24

s. Exhibit 19 24

t. Exhibit 20 25

u. Exhibit 21 25

v. Exhibit 22 26

w. Exhibit 23 26

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1. Hewlett Packard’s Business

a. Overview of HPQ

Founded in 1939 by Bill Hewlett and David Packard, Hewlett-Packard, commonly referred to

as HP, has grown to an international leader across multiple industries. Headquartered and

founded in Palo Alto, California HP provides various products, software, technologies,

solutions, and services in almost every country in the world. With a fiscal year ending on

October 31, HP recorded revenues just over 126 billion USD this past year.

b. Business Segments and Customer Base

Hewlett-Packard operates in seven different business segments. The first three fall under “HP

Enterprise Business;” this business includes Services, Enterprise Storage and Servers (ESS),

and HP Software. Although these three segments are not operating segments they will be

included in my valuation. HP provides financial data including the segments in order to

provide a complete view of their business. The remaining business segments include the

Personal Systems Group (PSG), the Imaging and Printing Group (IPG), HP Financial

Services (HPFS), and Corporate Investments. A breakdown of HP’s business segments can

be found on the last page of the Appendix.

HP Enterprise Business

Services

The services division of this segment provides consulting, outsourcing and technology

services. This division is broken into four business units: infrastructure technology

outsourcing, technology services, applications services and business process outsourcing.

Enterprise Storage and Servers

The ESS division provides a broad array of storage and server products. The portfolio

includes industry standard servers, business critical systems, and storage.

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HP Software

HP provides enterprise and service-provider software and services. HP Software’s business

units include: enterprise IT management software, information management/business

intelligence solutions and communications /media solutions.

Personal Systems Group

Measured by unit volume shipped and annual revenue, PSG is the leading provider of

personal computers in the world. This business segment includes a wide variety of products

for both commercial customers as well as every day consumers. HP breaks PSG into four

divisions when describing performance; these segments are as follows: commercial PCs,

consumer PCs, workstations and handheld computing. The commercial PCs are focused and

designed for enterprise and small-medium sized business customers. This product line

includes desktops, notebooks, as well as their TouchSmart series, mini-note PCs, Blade PCs,

and HP TwinClients. Consumer PCs includes the following consumer geared products:

desktops, notebooks, mini-notebooks, and TouchSmart desktops/notebooks. Workstations are

products designed for customers that are in the need of a system that can offer computer

animation, engineering design and other programs that demand high-resolution graphics.

Handheld computing includes the HP iPAQ Pocket PC series as well as a variety of PDA’s

and smartphones.

Imaging and Printing Group

IPG accounted for 20% of HP’s revenue in 2010. This segment of HP’s business provides

consumer and commercial printers, printing supplies, printing media, and scanning devices.

While these account for the majority of IPG, HP is also focused on imaging solutions in

commercial markets. Imaging solutions in commercial markets range from providing print

services solutions to looking into growth opportunities in commercial printing. IPG measures

performance through five categories: inkjet and web, laserjet and enterprise, managed

enterprise solutions, graphics, and printer supplies. Inkjet and web offers consumer and

small-medium sized business customer’s inkjet hardware, supplies, media, and HP’s retail

web business. The laserjet and enterprise category provides customers with laserjet printers,

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supplies, multi-function printers, scanners, and enterprise software solutions. The managed

enterprise solutions group offers managed print services products as well as solutions for

enterprise customers such as, workflow solutions in the enterprise environment. The graphics

category provides products and services for large format printing, large format supplies, and

specialty printing systems. Lastly, the printer supplies group includes laserjet toner and inkjet

printer cartridges, graphic solutions ink products and other printing-related media.

HP Financial Services

HP Financial Services is one of HP’s smaller business segments, accounting for only 2% of

HP’s total revenue in 2010. HPFS is worldwide in allowing customers to acquire complete IT

solutions such as, hardware, software, or services. HPFS offers a variety of services

including: leasing, financing, utility programs and asset recovery services, and financial asset

management for large global and enterprise customers. This segment provides to small-

medium sized businesses, educational and government entities, as well as others.

Corporate Investments

Accounting for only 1% of HP’s revenues in 2010, corporate investments generate the least

amount of revenue out of all seven segments. Corporate investments generates revenue

through HP Labs, network infrastructure products, mobile devices associated with the Palm

acquisition, certain business incubation projects, and licensing specific HP technology to

name a few.

With such a wide variety of products and services comes a wide variety of customers. Within

PSG and IPG there are products that are tailored to general consumers and there are products

that are manufactured with commercial intents in mind. Commercial products within these

business segments are focused on, but not limited to, small-medium sized businesses (in

general less than 1,000 employees). HP’s customer base within these segments also spans to

customers in need of computer animation and engineering design capabilities. It can be said

that with such a variety of products and services, HP reaches most if not all demographic

profiles.

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HP also depends on a wide variety of partners in order to reach their customers. HP heavily

relies on retailers such as Best Buy to sell HP products in their physical and internet stores.

Their customer base is expanded through independent distributors that sell HP products in

geographies or customer segments that HP has little or no presence. Many HP products are

integrated into original equipment manufacturers (OEMs) products and then sold. Resellers

purchase HP products, add to them, and then resell the product to targeted customers. Other

customers include advisory firms that partner or hire HP for their unique products and

services.

c. Key Suppliers

HP has alternate sources of supply for the majority of purchased materials. However, there

are a few products that HP relies on a sole source for. The products that have alternate

sources of supply or that have such sources readily available will not be considered key

suppliers. Instead, we will focus on the products that HP receives from a sole source. HP

relies on a single provider for the following: laser printer engines, LaserJet supplies, parts for

products with short life cycles, computer processors, and various software products.

Intel is the primary supplier of computer processors for HP. Reducing the risks associated

with having one supplier; they also have a relationship with AMD. HP will include more

AMD processors as acceptance of AMD in the market increases, thus reducing the risks of

having one supplier. Microsoft is a key supplier of software products for HP. Since the key

suppliers to HP are also key suppliers throughout the industry there is limited risk. Any

significant disruptions in the supply of the products just listed would likely result in industry-

wide disruptions. As a result, HP would not be at a disadvantage relative to their competitors.

d. Business Strategy

Year over year HP upholds many of the same corporate objectives and strategies. HP

emphasizes customer loyalty. Part of HP’s continuing strategy is to earn respect and loyalty

through consistently providing the highest quality value. HP is committed to market

leadership and growth. Growth opportunities can often be seen through HP’s acquisitions. In

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order to stay atop the market, HP is constantly developing and delivering innovative products

and useful services. Year over year, in order to accomplish the goals set forth HP achieves a

level of profit that allows them to finance their growth.

Looking forward into 2011, HP’s strategy is to drive growth, expand margins, and deliver

value to customers and stockholders. In addition to achieving their growth strategy through

acquisitions, HP plans on utilizing their sales force to cover more of the market and

aggressively expanding their presence into high-growth and emerging economies. As part of

their strategy for 2011, they plan on increasing investments in innovation. In recent years, HP

has focused on rationalizing research and development spending. Companies the size of HP

have many opportunities to increase efficiency. As part of their strategy to expand margins,

HP has set in place major initiatives in their supply chain operations and service delivery

model; both of which are expected to have a positive impact on their operating leverage.

2. Analysis of Historical Performance

a. HPQ Compared to S&P 500 Tech Index (IXN) and DJIA

Dating back to 2006, Hewlett-Packard has produced higher returns than the S&P 500 Tech

Index as well as the Dow Jones Industrial Average.1 Even through the difficult economic

times our nation and the world has seen within the past few years, HP has outperformed both

indices and has produced positive returns for the majority of the period shown in the chart.

Outperforming the selected indices can be attributed to several factors. One factor is that HP

has been able to consistently drive growth through a loyal customer base; a second factor is

the number of acquisitions they have participated in. Since 2006 HP has acquired 30

companies.2 The aforementioned acquisitions have enabled HP to produce positive growth in

sales for the past five years, except for 2009, which can be attributed to a poor economy and

consumer demand. Main competitors IBM and Dell also posted negative sales growth in

2009.3

1 Shown in Exhibit 1 2 Acquired companies are listed in Exhibit 2 of the Appendix 3 Shown in Exhibit 3

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b. Historical Income Statements

As stated above, HP has seen positive growth in sales for the past five years, excluding 2009

in which HP and the industry saw sales decline based off the year prior. Exhibit 4 shows

items from the income statement as a percentage of sales. Cost of goods sold dating back to

2005 has been steady between 75-76%. SGA has declined from 13% in 2005 to

approximately 10% in 2010, I will attribute this to cost cutting initiatives implemented within

the company. RD has also decreased since 2005 which can also be attributed to initiatives

within the company. According to the “letter from the CEO” in the 2010 annual report, (HP)

in the past few years has rationalized their research and development spending, reduced

inefficiency, and focused more acutely on practical applications. Depreciation and

amortization expenses have risen slightly in the past two years. EBIT has been on the rise

since 2005, which again, can be attributed to the decline in SGA and RD expenses. In order

to stay competitive in innovation and growth, I expect SGA and RD expenses to increase in

the coming years. HP’s business strategy for the next few years also supports my hypothesis.

Please refer to section 1d for more information on their business strategy.

c. EBIT, NOPLAT and Gross Cash Flow

Please refer to Exhibit 5 for this section. EBIT was calculated by subtracting SGA, RD and

DA from gross profit and then adding back adjustments for operating leases and retirement-

related liabilities. At this point, I am valuing HP’s operations; operating and retirement

related leases are not part of HP’s operations, thus they are added back to calculate EBIT.

Exhibit 6 shows how HP’s operating leases were calculated. In order to calculate the implicit

interest that is added back I obtained the total present value of HP’s future lease

commitments and multiplied it by their cost of debt for that given year. The cost of debt for

any given year was derived by summing the weighted YTM’s of HP’s bonds in that given

year. The method for deriving the cost of debt for any given year is shown in Exhibit 7. EBIT

is generally accepted as an indicator of a company’s profitability and can also be referred to

as their operating earnings. As you can see in Exhibit 5, EBIT has increased year over year

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(except for 2009, which is explained in earlier sections) showing the strength of HP’s

operations.

NOPLAT is a measure of a firm’s operating earnings with adjustments made for taxes.

NOPLAT is found by subtracting taxes paid by an all equity firm from EBIT and then adding

any change in deferred taxes from the prior year. Exhibit 8 shows how taxes were calculated

on an all equity HP. We assume a corporate tax rate of 40% in the following calculations. We

calculate tax shields on interest expense, the implicit interest from operating leases and

retirement related liabilities, restructuring charges, and acquisition related charges by

multiplying them by the corporate tax rate of 40%. Taxes on HP’s other earnings is also

calculated by multiplying their other earnings from the income statement by the 40%

corporate tax rate. These tax shields less taxes on other earnings are then added to the income

tax expense to come up with the taxes on EBIT. Exhibit 9 shows the calculation needed to

adjust HP’s taxes to a cash basis. NOPLAT is now calculated by subtracting taxes on EBIT

from EBIT and then adding the change in deferred taxes. Gross cash flow is computed by

adding depreciation and amortization less amortization of goodwill to NOPLAT. Gross cash

flow for the past 5 years can be observed in Exhibit 10. Accordingly, based on the derivation

of NOPLAT, we see gross cash flows increasing year over year except for the 2008 to 2009

period.

d. Gross Investment and Free Cash Flow

Gross investment can be observed in Exhibit 11. HP’s gross investment in their operations is

a necessary calculation in order to determine the free cash flows of the firm. HP’s gross

investment will be calculated by adding their investment in operating working capital (OWC)

to their capital expenditures. HP’s investment in OWC is found by taking the change in

OWC year over year. OWC includes all operating assets less liabilities, shown in Exhibit 11.

As part of the operating assets I assumed operating cash to be 1% of sales for that year.

Excess cash is cash and cash equivalents minus HP’s operating cash and is excluded from

this calculation. HP does not specify whether other current assets are related to operations, so

for this calculation I am assuming they are. Congruent with the growth of the company, HP’s

operating working capital has, for the most part, increased over the past five years. The main

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reason we see an overall increase in OWC is likely due to the large amount of acquisitions

HP has followed through with (Exhibit 2). The two years that have negative investment in

OWC can be attributed to poor acquisitions and a slow economy. Included in HP’s gross

investment is their investment in all fixed assets, also known as their capital expenditures.

HP’s capital expenditures are calculated in Exhibit 11 by adding depreciation and the change

in property, plant, and equipment year over year. It is noteworthy to mention that the change

in PPE from 2007 to 2008 was $3,040 million, much higher than all other years. HP made

seven acquisitions in 2008 alone. The change in PPE lends itself to these acquisitions; the

firms HP acquired in this year are likely to have larger amounts of PPE when compared to

acquisitions made in the other years. Next, I calculated HP’s gross investment by adding their

investment in operating working capital and their investment in fixed assets. Shown in

Exhibit 11, there is an increase of $5.31 billion in HP’s gross investment from 2009-2010. In

2010, HP acquired 3Com, Melodeo, Palm, 3Par, and Arcsight; all of which, except Melodeo,

were valued at over a billion dollars. These acquisitions explain the large increase in gross

investment. Exhibit 12 will walk us through the calculation for free cash flow. The first step

is to calculate free cash flow before any investments in goodwill. This is calculated by

subtracting HP’s gross investment from their gross cash flow from operations. We can

observe a sharp decline in free cash flow before investment in goodwill from 2009-2010 due

to the increase in gross investments for that period. Goodwill is an intangible asset; goodwill

typically reflects the value of these intangible assets. HP is very active in acquiring different

companies, thus we see relatively large investments in goodwill. We observe higher

investments in goodwill during years HP acquired more or larger companies compared to

other years i.e. 2007, 2008, and 2010. Free cash flow can then be calculated by subtracting

investments in goodwill from the FCF before investment in goodwill. We can observe a

strong correlation between the years HP has negative free cash flow with high-acquisition

years4.

e. ROIC

Exhibit 13 details the calculations made for ROIC. ROIC is calculated by dividing NOPLAT

by the average operating invested capital for that period. Since NOPLAT is the operating

4 High-acquisition years are any years in which HP acquired a large number of firms or a few high-cost firms

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profits of a firm and the operating invested capital estimates how much capital a firm has tied

up or invested in their operations, the ROIC calculation shows us the return HP is receiving

on their operating investments. We see a very healthy ROIC for HP over the past five years.

This can be attributed to HP’s ability to consistently generate profits on their operations. We

also want to analyze how well HP is using investor’s capital. This is a very important

calculation for HP in particular due to the large amounts of acquisitions they have

participated in over the past five years. Including goodwill as a part of the calculation of

invested capital will yield an ROIC that shows whether or not the returns cover the

acquisition premiums. As you can see in the middle portion of Exhibit 13, for each year as a

whole, HP has generated positive returns on their acquisitions. This is not to say that every

acquisition HP has undertaken in the past five years has created a positive return on invested

capital, but rather all acquisitions combined within each given year have created positive

returns on invested capital. The large difference between ROIC and ROIC including

goodwill and intangibles is typical for a company participating in as many acquisitions as

HP. Next, I calculated ROIC including total investor’s funds. This calculation includes

capital used to fund investments in assets unrelated to operations which represents HP’s total

capital invested. As you can see in the bottom section of Exhibit 13, I approximated total

investor funds from the asset side of the balance sheet by adding excess cash, net identifiable

intangible assets and long-term financing receivables and other assets to invested capital

including goodwill and intangibles. The results show that four out of the past 5 years ROIC

of total investors funds was less than the company’s WACC. There are a few potential

explanations for this. One conclusion is that the seven acquisitions completed during 2008

created far more value than the acquisitions completed in 2010. However, many of the more

recent acquisitions completed late in 2010 may not have produced the projected value of the

acquisition, yet.

f. EVA

Exhibit 14 shows HP’s economic value added or economic profit for the past five years. As

you can see, I have calculated the economic profit using three different scenarios. Economic

profit is calculated by multiplying the difference in ROIC and WACC (economic spread) by

the invested capital. When valuing only HP’s operations we see that they have produced

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economic profits in the billions for the past five years. In HP’s case a more reasonable

calculation is adjusted for their acquisitions by using the invested capital including goodwill.

We observe economic profits in all of the past five years, except for 2009. A large decline in

ROIC for this period, coupled with a higher WACC resulted in (314) million dollars. The

economic profit for total investor’s funds shows negative numbers for all years except 2008,

a year in which they had exceptional returns due to acquisitions. I have two hypotheses as to

why HP has produced only one profit in the past five years. First, as stated earlier, in section

1a, the three business segments that fall under “HP Enterprise Business” are not operating

segments. These three segments accounted for approximately 44% of HP’s revenues in 2010.

Many of the acquisitions over the past five years have been firms that fall under the HP

Enterprise Business. A few notable acquisitions include that of Electronic Data Systems

valued at $13.9 billion and 3PAR valued at $2.35 billion. To calculate ROIC of investor

funds I included all intangibles, funds, and assets not related to operations. Since ROIC

including goodwill and intangibles incorporates the goodwill and intangibles of all

acquisitions, even the ones that are in relation to the HP Enterprise Business, some

intangibles, funds, and assets not related to operations may be accounted for twice. Since HP

does not provide in-depth segment data, I am unable to determine if and where there may be

a discrepancy. Second, the explanation may be as simple as HP is not creating value through

their acquisitions once total investor funds are accounted for.

g. Selected Accounting Ratios

Exhibit 23 shows liquidity and profitability accounting ratios for the past five years. HP’s

interest coverage ratio indicates that they are not burdened by their debt, this can be

attributed to HP’s capital structure discussed in a later section. The steady current ratio is a

good sign that HP remains liquid in that it would not have any trouble paying back short-term

liabilities. HP’s profit margin has steadily increased over the past five years. They have been

conscious of their costs in the years past and as addressed in the 2010 annual report they will

continue with trying to expand margins. ROA and ROE have been positive, but not very

consistent. From 2008-2009 ROA and ROE decrease.

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h. Current Management Team

Over the past six months there has been a significant change in HP’s management team.

Most notable is the change of President and Chief Executive Officer. In September of 2010

Léo Apotheker took over this role after Mark Hurd resigned due to inappropriate conduct.

Mr. Apotheker is on the right path for success. He plans to continue to acquire firms in order

to grow and increase economic profits of HP. He also plans on increasing investments in RD

and innovation, one measure I believe to be extremely important in order to stay competitive

in this industry. Since almost all of HP’s executives have held their positions for more than a

year, I evaluate the remainder of the HP management team based on the past performance of

HP. Thanks to these executives; HP has historically been a very stable and strong company.

Under new leadership and ambition I find HP’s management team to be very strong heading

into the future.

3. Capital Structure

a. Debt

Please refer to Exhibit 15 for the discussion on debt. In order to calculate HP’s total debt

value, I added short term debt, long term debt, retirement related liabilities, and the present

value of HP’s operating leases. HP currently has approximately $31.06 billion dollars worth

of debt. This is an increase of $18.968 billion dollars from the previous year. We also see a

large increase in total debt value from 2007-2008. The main reason we see large increases in

the value of HP’s debt for the 2008 and 2010 is because these are the same years in which

they had large acquisitions. Often in an acquisition the acquirer will take on the acquired

company’s debt. It is likely that some of the acquired companies had high debt levels which

HP took on. HP’s debt/equity ratio at the end of 2010 was approximately 25/75 (Exhibit 17).

b. Equity

The total value of HP’s equity from 2006-2010 is shown in Exhibit 16. Total equity value is

calculated by multiplying the total shares outstanding for that date by the closing price on

that day. There are multiple reasons as to why we see fluctuations in HP’s total equity value.

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First, I will address shares outstanding. Since 2006 HP has been buying back shares.

Repurchasing shares sometimes signals that the company believes they are undervalued.

Whether or not HP believes this to be true, one thing is for certain; when the level of

outstanding shares reduces it generally means that earnings per share will increase, often

driving up the price of a stock. The second reason we see fluctuations in HP’s total equity

value is due to the current price of HP. Depending on how the market values HP the share

price will fluctuate causing a fluctuation in total equity value. HP plans to continue to buy

back shares. On August 30, 2010 the board approved a $10 billion share buyback5.

Depending on the price of HP’s stock, this share buyback initiative can lower the equity

portion of HP’s capital structure. In 2006 the debt/equity ratio was approximately 10/90. Due

to an increase in total debt value, share buyback initiatives and a fluctuation in stock price,

HP currently has a debt/equity ratio of 25/75 (Exhibit 17).6

c. WACC

Exhibit 18 details the calculations that were made in order to find HP’s weighted average

cost of capital. The calculations for the cost of debt are provided in Exhibit 7. To find the

cost of debt used in the WACC calculation, I multiplied the cost of debt by .6 which is one

minus the tax rate. This calculation results in after tax cost of debt. Cost of equity was

calculated using the capital asset pricing model. I obtained historical risk free rates on 10

year treasuries from http://www.treasury.gov. HP’s beta’s were calculated through regression

analysis performed in excel, while the current beta was obtained from Value Line. I assumed

the market risk premium to be 6% higher than the 10-year treasury. HP currently has a

weighted average cost of capital of 6.91%. This essentially means that HP must pay 6.91%

interest for every dollar it finances. The significance of HP’s WACC can also be displayed

through Exhibit 14. When the WACC is higher than the ROIC HP shows a loss. HP’s WACC

will continue to change moving forward. Any change in the WACC is dependent upon HP’s

capital structure as well as the costs of debt and equity. I project that with continued share

buybacks and future acquisitions HP’s capital structure will change in that their debt levels

5 Note that HP’s stock price rose 3.5% following the announcement. 6 It is important to note that my calculations for the debt/equity ratio were performed off of market value inputs where other estimations of the debt/equity levels may be performed off of book value.

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will rise slightly and their equity levels will decrease slightly. This is projection indicates that

HP is not at their target capital structure and that they would prefer to carry a little more debt

and a little less equity.

4. Future Projections and Analysis

a. Sales Growth

Sales growth is probably the most difficult projection to make. Over the past five years HP

has averaged around 8% growth. Value Line predicts 10% sales growth over the next five

years. Yahoo finance predicts 3.7% and 4.4% in 2011 and 2012 and Forbes projects 8-10%

growth. For my sales projection I estimated a base case of 9% in 2011-2015, 8% in 2016-

2019 and 5% thereafter. Aggressive and conservative growth scenarios can be observed in

Exhibit 22.

b. COGS As a percent of sales, HP’s cost of goods sold has proven to be rather steady over the past 5

years. I have decided to assume COGS to be 75.1% of sales. This is slightly lower than the

average over the past five years; however under new leadership and goals of “aggressively

expanding margins,” I believe HP will show a slight decline in their COGS.

c. SGA I project SGA to increase compared to the past few years. As discussed earlier, HP’s business

strategy includes increasing its sales force in order to continue growing. Given their future

strategy I am assuming SGA to be 10.5% of sales.

d. RD Also discussed in their business strategy, HP plans on ramping up their RD department in

order to continue growth and innovation. For my projections I have set RD to 3.4% of sales,

which is about a 1% increase from last year.

e. D&A D&A has been higher in the past two years compared to 2006-2008, D&A will be set as

3.4% of sales, slightly higher than the five year average.

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f. Taxes Since HP will continue to be taxed Internationally and by the U.S. I will keep an assumed tax

rate of 40%.

g. Investment in OWC Investment in OWC has fluctuated over the past five years; I will therefore hold investment

in OWC close to the five year average at 1% of sales.

h. Capital Expenditures HP does not give any indication as to whether or not they plan on increasing or decreasing

their capital expenditures in the coming years. I will hold capital expenditures at 3% of sales.

i. Investment in Goodwill HP will continue acquiring companies in the future, likely to come with these acquisitions

are investments in goodwill. It is hard to predict whether or not HP will have many

acquisitions in the coming years or few acquisitions. With that in mind I am holding

investment in goodwill at 4% of sales.

j. Terminal Value Exhibit 19 shows the inputs used in my calculation of terminal value and present value of the

terminal value. I calculated my terminal value by taking NOPLAT2021 divided by WACC. I

used the NOPLAT/WACC method in order to negate the assumption that companies have

infinite positive NPV projects. NOPLAT in 2021 is $17.56 billion divided by the 6.91%

WACC yielding a terminal value of $192.966 billion. The terminal value is discounted 10

periods resulting in a PV terminal value of $98.940 billion.

k. Sensitivity Analysis Please refer to Exhibit 20 for a detailed look at the sensitivity analysis. In order to see the

value of HP under multiple scenarios, I conducted a sensitivity analysis. I chose to examine

different scenarios of COGS, SGA, Investment in OWC, and CapEx. For each scenario I

deviated one percentage point above and below the assumed future expense as a percent of

sales. A decrease of 1% in COGS as a percent of sales will increase free cash flows by

$824.26 million and increases the share price by $9.51. Decreasing SGA by one percent will

save HP $1.374 billion dollars. FCF will increase by $824.26 million due to a 40% tax rate.

Identical to COGS HP’s value will increase by $20.825 billion. Exhibit also shows how

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changes in investment in OWC and capital expenditures affect HP’s value. Changes in

investment in OWC and capital expenditures are not subject to tax, therefore we will see any

savings translate directly to free cash flow. A decrease in one percentage point of IOWC

yields a savings of $1.374 billion and an increase in free cash flow of the same amount. If HP

lowers the percent of IOWC by one percent of sales they will see a $6.26 increase per share.

A one percentage decrease in CapEx as a percent of sales will yield an increase of $6.26 per

share, a savings of $1.374 billion which will translate directly to FCF and an increase in

value of $13.720 billion. Exhibit 20 also shows a sensitivity analysis of HP’s WACC. If HP

is able to reduce its WACC by one percentage point to 5.91% they will see an increase of

$12.89 per share and an increase in their enterprise value by $28.230 billion. Conversely, if

they are unable to control their weighted average cost of capital and there is an increase of

one percent to 7.91% they will see their enterprise value drop by $20.273 billion and a

decline of $9.26 per share.

l. Final Valuation Matrix Since much of the input data is uncertain, I have constructed matrix that shows HP’s value

under multiple circumstances, Exhibit 21 shows the multiple scenarios with data as of

2/28/11. Shown in Exhibit 22, a conservative growth scenario would be 6% in years 1-5, 4%

in years 6-8, and 3% thereafter. An aggressive growth in sales would be 12% in years 1-5

and 9% thereafter. As you can see in the exhibit, I used a base case with growth of 9% in

years 1-5, 8% in years 6-8 and 5% thereafter. The base case scenario with my calculated

WACC of 6.91% values HP at $125.490 billion or $43.12 per share. The market price of HP

on 2/28/11 was $43.63. Given HP’s recent announcement that they are scaling back revenue

projections, this seems to be an accurate valuation. If consumer demand for any line of HP’s

business were to pick up or if revenue projections increased for any other reason we could

see HP’s stock price rise to as high as $57.56. The best scenario for HP would be to have

aggressive growth rates with a lower weighted average cost of capital of 5.91%; this scenario

would price HP’s stock at $74.53 and would give a value of $194.282 billion.

Will 16

5. Recommendations

In order for HP to create value for their shareholders they must reduce costs. First, I will

address an area in which it is not reasonable for HP to try and cut costs. Given HP’s future

growth strategy, they will have a very difficult time cutting SGA expenses. HP plans on

covering more of the market with their sales force, if anything, this is an indication that SGA

expenses are likely to increase in the coming years. However, HP will need to be

cognoscente of their SGA costs as we saw in the sensitivity analysis and increase of one

percentage in SGA as a percentage of sales will drive down their stock price by almost $10.

One cost area in which HP should look to decrease is cost of goods sold. Noted earlier, HP

has a wide variety of suppliers for the majority of their supplies. In a competitive market

such as this one, it may be beneficial to re-evaluate their current suppliers in order to find

suppliers that can deliver the same quality at a lower cost to HP. Even just a half percent

decrease in costs of goods sold as a percentage of sales will result in $412.13 million towards

FCF. HP can also increase value to share holders if they are able to reduce their WACC.

HP’s cost of debt has been very low the past two years. HP can reduce the WACC by re-

evaluating their corporate structure. If HP is able to increase the debt/equity ratio they will

see the a lower WACC. I recommend that HP continues to buy back shares. Buying back

shares will reduce the amount of equity in their capital structure, giving more weight to a

very low cost of debt. For example, if HP is able to buy back enough shares, or increase their

debt enough to reach a debt equity ratio of 40/60 they will have a weighted average cost of

capital of 5.51%. A WACC of 5.51% will increase their enterprise value by $42.584 billion

and will drive the stock price up $19.44. Another way HP can create value to shareholders is

through acquiring more companies. HP should be very diligent when it comes to acquiring

companies. Though they have had many successful acquisitions in the past, it is very unlikely

that all of their acquisitions in the past five years have generated value. HP should conduct a

proper valuation of all companies that have the potential to be acquired. If the valuation

proves to add value they should follow through with the acquisition. If the acquisition does

not add value they should reject it and search for other opportunities. Lastly, HP can add

value by growing their sales as long as expenses stay constant as a percentage of sales. In

order to grow sales, HP must continue being innovative and breaking into new markets such

Will 17

as cloud computing and tablet pc’s. Through their future growth strategy and under a new

leader, HP is poised to add value to shareholders.

Will 18

Appendix

Exhibit 1

Exhibit 2 Acquisition Date Company

2/7/2006 OuterBay

6/6/2006 Silverwire

6/27/2006 The Technology Partners

10/31/2006 VoodooPC

11/7/2006 Mercury Interactive

12/12/2006 Knightsbridge Solutions

12/20/2006 Bitfone Corp.

2/5/2007 Bristol Technology

2/27/2007 Polyserve

3/22/2007 Tabblo Inc.

4/24/2007 Arteis

6/19/2007 SPI Dynamic Inc.

7/23/2007 Opsware

7/23/2007 Neoware

9/13/2007 MacDermid ColorSpan Inc.

10/22/2007 Atos OriginMiddle East Group

2/1/2008 EYP Mission Critical Facilities Inc.

3/1/2008 NUR Macroprinters Ltd

3/26/2008 Exstream Software

3/31/2008 TOWER Software

8/11/2008 Colubris Networks

8/26/2008 Electronic Data Systems

10/1/2008 LeftHand Networks Inc.

8/4/2009 IBRIX, Inc.

4/12/2010 3Com

6/24/2010 Melodeo

7/1/2010 Palm, Inc.

9/2/2010 3PAR

10/22/2010 ArcSight

9/22/2010 Fortify Software

Will 19

Exhibit 3

2009 2010

HPQ Sales Growth -3.22% 10.02%

IBM Sales Growth -4.11% 5.09%

Dell Sales Growth -0.05% -13.42%

Exhibit 4

2006 2007 2008 2009 2010

Net Sales 91,658 104,286 118,364 114,552 126,033

Item

s as

a %

of

net

sale

s

COGS 75.47% 75.37% 75.50% 76.12% 76.00%

SGA 12.29% 11.72% 11.26% 10.14% 9.99%

RD 3.92% 3.46% 2.99% 2.46% 2.35%

Depreciation and Amortization 2.57% 2.59% 2.87% 4.17% 3.82%

Adjustment for operating leases 0.25% 0.25% 0.24% 0.19% 0.03%

Adjustment for retirement-related liabililties 0.13% 0.10% 0.12% 0.19% 0.07%

EBIT 6.13% 7.20% 7.73% 7.49% 7.94%

Taxes on EBIT 1.46% 2.68% 2.78% 2.86% 3.11%

Change in deferred taxes 0.34% 0.13% 3.04% -0.84% -0.15%

NOPLAT 5.01% 4.65% 7.98% 3.79% 4.67%

Investment in OWC -0.45% 2.40% 1.00% -1.15% 3.02%

CapEx 2.30% 2.72% 4.60% 3.16% 3.02%

Investment in goodwill 0.45% 4.72% 8.92% 0.68% 4.26%

Exhibit 5

2006 2007 2008 2009 2010

Net Sales 91,658 104,286 118,364 114,552 126,033

Cost of Products 55,248 63,435 69,342 56,503 65,064

Cost of Services 13,930 15,163 20,028 30,695 30,723

COGS 69,178 78,598 89,370 87,198 95,787

Gross Profit 22,480 25,688 28,994 27,354 30,246

SGA 11,266 12,226 13,326 11,613 12,585

RD 3,591 3,611 3,543 2,819 2,959

Depreciation and Amortization 2,353 2,705 3,401 4,780 4,820

Adjustment for operating leases 233 261 287 222 33

Adjustment for retirement-related liabililties 116 99 138 218 92

EBIT 5,619 7,507 9,149 8,581 10,007

Will 20

Exhibit 6

Year Lease Commitment Discount Factor Present Value of Lease Commitment

2009 2,535.00 0.959 2,430.45

2010 1,450 0.919 1,332.86

2011 788.00 0.881 694.47

2012 340.00 0.845 287.28

2013 159.00 0.810 128.81

2014 66.00 0.777 51.26

2015 66.00 0.745 49.15

2016 66.00 0.714 47.12

2017 66.00 0.684 45.18

2018 66.00 0.656 43.31

2019 66.00 0.629 41.53

Discount Rate 4.30% Total 5,151.41

Implicit Interest 221.60

1/1/2009 Exhibit 7

Price Amount Outstanding Value Weight Ask Yield To Maturity Weighted YTM

102.48 1499000000 1536175200 0.294947515 3.86 1.138497407

107.56 2000000000 2151200000 0.413033028 4.49 1.854518294

103.64 750000000 777300000 0.149242549 5.01 0.747705173

99.15 750000000 743625000 0.142776908 3.93 0.56111325

Cost of debt 4.30%

Exhibit 8

2006 2007 2008 2009 2010

Income Tax Expense 993 1,913 2,144 1,755 2,213

Tax Shield on interest expense 397 765 858 702 885

Tax Shield on IIE in operating leases 93 105 115 89 13

Tax Shield on IIE in retirement related liabilities 46 40 55 87 37

Tax Shield on restructuring charges 63 155 108 256 458

Tax Shield on Acquisition related charges - - 16 97 117

Tax on other earnings 252 183 - (288) (202)

Taxes on EBIT 1,341 2,794 3,296 3,274 3,925

Will 21

Exhibit 9

2006 2007 2008 2009 2010

Deferred tax assets-short-term 4,144 4,609 3,920 4,979 5,833

Deferred tax assets-long-term 1,475 961 792 1,750 2,070

Deferred tax liability-short-term 138 123 97 83 53

Deferred tax liability-long-term 291 397 3,162 4,230 5,239

Total deferred tax liabilities (5,190) (5,050) (1,453) (2,416) (2,611)

Change in deferred taxes 316 140 3,597 (963) (195)

NOPLAT 4,594 4,853 9,450 4,344 5,887

Exhibit 10

2006 2007 2008 2009 2010

NOPLAT 4,594 4,853 9,450 4,344 5,887

Depreciation and amortization 2,353 2,705 3,401 4,780 4,820

Amortization of goodwill 656 973 1,012 1,578 1,484

Depreciation and amortization less amortization of goodwill 1,697 1,732 2,389 3,202 3,336

Gross cash flow from operations 6,291 6,585 11,839 7,546 9,223

Exhibit 11

2006 2007 2008 2009 2010

Current operating assets

Operating cash (1% of sales) 917 1,043 1,184 1,146 1,260

Excess Cash 15,483 10,250 8,969 12,133 9,669

Accounts Receivable 10,873 13,420 16,928 16,537 18,481

Financing receivables 2,440 2,507 2,314 2,675 2,986

Inventory 7,750 8,033 7,879 6,128 6,466

Other current operating assets 10,779 11,997 14,361 13,865 15,317

Total current operating assets 32,759 37,000 42,666 40,351 44,510

Current operating liabilities

Accounts Payable 12,102 11,787 14,138 14,809 14,365

Other accrued liabilities 8,768 10,818 12,953 11,288 12,080

Total current operating liabilities 20,870 22,605 27,091 26,097 26,445

Operating net working capital 11,889 14,395 15,575 14,254 18,065

Investment in OWC (416) 2,506 1,180 (1,321) 3,812

CapEx

Change in net PPE 412 935 3,040 424 501

Depreciation 1,700 1,900 2,400 3,200 3,300

Capital expenditures 2,112 2,835 5,440 3,624 3,801

Gross investment 1,696 5,341 6,620 2,303 7,613

Will 22

Exhibit 12

2006 2007 2008 2009 2010

Gross cash flow from operations 6,291 6,585 11,839 7,546 9,223

Gross investment 1,696 5,341 6,620 2,303 7,613

Free cash flow before investment in goodwill 4,596 1,243 5,219 5,243 1,610

Change in goodwill 412 4,920 10,562 774 5,374

Impairment - - - - -

Investment in goodwill 412 4,920 10,562 774 5,374

Free cash flow 4,184 (3,677) (5,343) 4,469 (3,764)

Exhibit 13

2006 2007 2008 2009 2010

Operating net working capital 11,889 14,395 15,575 14,254 18,065

Net property 6,863 7,798 10,838 11,262 11,763

Operating leases 4,655 4,736 5,410 5,151 2,329

Operating invested capital 23,406 26,929 31,823 30,667 32,157

Average operating invested capital 23,594 25,168 29,376 31,245 31,412

NOPLAT 4,594 4,853 9,450 4,344 5,887

ROIC 19.47% 19.28% 32.17% 13.90% 18.74%

Operating invested capital 23,406 26,929 31,823 30,667 32,157

Goodwill 16,853 21,773 32,335 33,109 38,483

Invested capital including goodwill and intangibles 40,259 48,702 64,158 63,776 70,640

Average invested capital including goodwill 40,241 44,481 56,430 63,967 67,208

NOPLAT 4,594 4,853 9,450 4,344 5,887

ROIC including goodwill and intangibles 11.42% 10.91% 16.75% 6.79% 8.76%

Invested capital including goodwill and intangibles 40,259 48,702 64,158 63,776 70,640

Excess cash 15,483 10,250 8,969 12,133 9,669

Net identifiable intangible assets 3,352 4,079 7,962 6,600 7,848

Long-term financing receivables and other assets 6,649 7,647 10,468 11,289 12,225

Total investor funds 65,744 70,678 91,557 93,798 100,382

Average total investor funds 65,051 68,211 81,118 92,678 97,090

NOPLAT 4,594 4,853 9,450 4,344 5,887

ROIC investors funds 7.06% 7.11% 11.65% 4.69% 6.06%

Will 23

Exhibit 14

Economic profit: operating invested capital 2006 2007 2008 2009 2010

ROIC 19.47% 19.28% 32.17% 13.90% 18.74%

WACC 9.40% 8.21% 6.07% 7.28% 6.79%

Economic spread 10.07% 11.07% 26.09% 6.62% 11.95%

Invested capital 23,594 25,168 29,376 31,245 31,412

Economic profit 2,376 2,786 7,666 2,069 3,754

Economic profit: operating invested capital with goodwill

ROIC 11.42% 10.91% 16.75% 6.79% 8.76%

WACC 9.40% 8.21% 6.07% 7.28% 6.79%

Economic spread 2.01% 2.70% 10.67% -0.49% 1.97%

Invested capital 40,241 44,481 56,430 63,967 67,208

Economic profit 810 1,200 6,022 (314) 1,322

Economic profit: total investors funds

ROIC 7.06% 7.11% 11.65% 4.69% 6.06%

WACC 9.40% 8.21% 6.07% 7.28% 6.79%

Economic spread -2.34% -1.10% 5.58% -2.59% -0.73%

Invested capital 65,051 68,211 81,118 92,678 97,090

Economic profit (1,523) (749) 4,523 (2,405) (707)

Exhibit 15

2006 2007 2008 2009 2010 As of 2/28

Short term debt 2,700 3,186 10,176 1,850 7,046 7,046

Long term debt 2,490 4,997 7,676 1,398 15,258 15,258

Retirement related liabilities 2,515 2,099 1,495 3,692 6,427 6,427

Present value of operating leases 4,655 4,736 5,410 5,151 2,329 2,329

Total debt value 12,360 15,018 24,757 12,091 31,060 31,060

Exhibit 16

2006 2007 2008 2009 2010 As of 2/28

Shares outstanding 2,721 2,574 2,416 2,364 2,190 2,190

Closing price 39.46 51.16 35.28 49.06 41.93 43.63

Total equity value 107,363 131,679 85,244 115,986 91,845 95,550

Exhibit 17

2006 2007 2008 2009 2010 As of 2/28

Debt/value 10.3% 10.2% 22.5% 9.4% 25.3% 24.5%

Equity/value 89.7% 89.8% 77.5% 90.6% 74.7% 75.5%

Will 24

Exhibit 18

2006 2007 2008 2009 2010 As of 2/28

Total value 119,723 146,697 110,001 128,078 122,904 126,609

Debt/value 10% 10% 23% 9% 25% 25%

Equity/value 90% 90% 77% 91% 75% 75%

K debt 5.01% 5.52% 5.31% 4.30% 1.40% 1.73%

K equity calculation

Risk free rate-10 yr treasury 4.46% 3.97% 2.93% 3.21% 3.36% 3.42%

Beta 0.999 0.86 0.80 0.80 0.95 0.95

Market risk premium 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%

K equity 10.45% 9.11% 7.75% 8.01% 9.06% 9.12%

Weighted average cost of capital (WACC) 9.40% 8.21% 6.07% 7.28% 6.79% 6.91%

Exhibit 19

NOPLAT 2021 13,330

WACC 6.91%

Terminal value (cv) 192,966

Will 25

Exhibit 20

COGS

2011 COGS 2011 FCF Value Stock price

76.1% 104,543 (668) 104,665 33.61

75.1% 103,169 157 125,490 43.12

74.1% 101,796 981 146,315 52.63

SGA

2011 SGA 2011 FCF Value Stock price

11.5% 15,798 (668) 104,665 33.61

10.5% 14,424 157 125,490 43.12

9.5% 13,051 981 146,315 52.63

Investment in OWC

2011 IOWC 2011 FCF Value Stock price

2.0% 2,748 (1,217) 111,770 36.85

1.0% 1,374 157 125,490 43.12

0.0% 0 1,530 139,209 49.38

CapEx

2011 CapEx 2011 FCF Value Stock price

4.00% 5,495 (1,217) 111,770 36.85

3.00% 4,121 157 125,490 43.12

2.00% 2,748 1,530 139,209 49.38

WACC Sensitivity Analysis

Value Stock price

5.91% 153,720 56.01

6.91% 125,490 43.12

7.91% 105,216 33.86

Exhibit 21

Growth assumptions (millions)

WACC Conservative Base Aggressive

5.91%

Value 119,553 153,720 194,282

Stock price 40.41 56.01 74.53

6.91%

Value 98,851 125,490 157,106

Stock price 30.95 43.12 57.56

7.91%

Value 83,982 105,216 130,412

Stock price 24.17 33.86 45.37

Will 26

Exhibit 22

Growth Scenarios

2011-2015 2016-2019 After 2019

Aggressive 12% 9% 9%

Base 9% 8% 5%

Conservative 6% 4% 3%

Exhibit 23

2006 2007 2008 2009 2010

Liquidity

Interest Coverage 24x 19x 27x 22x 36x

Current Ratio 2.2 2.2 2.0 2.3 2.2

Profitability

Profit Margin 7.2% 8.4% 8.8% 8.8% 9.1%

ROA 8.0% 9.8% 9.2% 8.8% 9.2%

ROE 14.9% 18.2% 18.4% 15.5% 16.8%

HP

HP Enterprise Business

Services

Infrastructure Technology Outsourcing

Technology Services

Applications Services

Business Process

Outsourcing

Enterprise Storage and

Servers

Industry Standard Servers

Business Critical Systems

Storage

HP Software

Enterprise IT Management

Software

Information Management and Business Intelligence

Solutions

Communications and Media

Solutions

Personal Systems Group

Commercial PCs

Consumer PCs

Workstations

Handheld Computing

Imaging and Printing Group

Inkjet and Web Solutions

LaserJet and Enterprise Solutions

Managed Enterprise Solutions

Graphics Solutions

Printer Supplies

HP Financial Services

Corporate Investments