Mada Arslan HP Valuation A.

DCF model FCFF

BUY RECOMMENDATION Target Price Market Price Upside Potential Listed on NYSE Bloomberg Ticker Enterprise Value (million) MV Debt (million) Market Capitalization Outstanding shares (million) Bloomberg Industry Bloomberg Sector $ $ 22.75 20.35 11.81%

Characteristics of HP: Winding Down company: declining revenues and earnings, acquisitions thus growing inorganically, divestures Multinational company: operating in USA, Americas, EMEA, and Asia Pacific.

$ $ $

HPQ:US 34,358 20,453 47,065 1,974 Computers Technology

140,000 120,000 100,000 80,000 60,000 40,000 20,000 (20,000) 2005 2006 2007

HPQ

2008

2009

2010

2011

2012

Sales (Net)

Net Income (Loss)

Thus the distress point was pinpointed back to 2001. Financial Statements: TTM: since we are valuing HP as of 1 May 2013, we updated the income statement to reflect Q2 of 2013 figures and used the 10K 2012 report for balance sheet figures. Non-recurrent and recurrent charges: the $18,035 million expensed in 2012 as Impairment of goodwill and purchased intangible assets is considered a non-recurrent charge and was deducted from EBIT. Restructuring charges were deemed recurrent since every year HP is expensing such charges. Price Per Share & Dividends: We used adjusted closing prices for dividends and splits. Financial Ratios: Refer to excel sheet for detailed calculations.

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Tax rates: Effective Tax rate = 23.5% (from Q2_2013 report) Marginal Tax rate = 35% (from 10K_2012 report) Incorporating the fact that HP is a multinational, we can take the highest marginal tax rate across the countries & according to Damodaran: While some would push for an average tax rate, weighted by the income in each country, I think it makes far more sense to use the marginal tax rate of the country the company is domiciled in as a floor.
Damodaran Africa average North America average Asia average Europe average Latin America average Oceania average Middle east average Caribbean average Tax rate 29.02% 33.00% 22.89% 20.50% 28.30% 28.60% 12.00% 20.00%

Source: emergcompfirm.xls http://pages.stern.nyu.edu/~adamodar/ Beta: Regression Beta = 0.97 (v/s Yahoo beta 1.52 & Reuters 1.15) Since its a distressed company, using a bottom-up beta is no longer relevant and we deemed the start of the crisis in 2001. We regressed HPs result since 2001 against a global index since its a multinational: S&P Global Tech (http://finance.yahoo.com/q/hp?s=IXN&a=00&b=1&c=2001&d=04&e=22&f=2013&g=w ). No debt beta was added since HP is not a junk bond. Minimum bond rating is BBB.

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Cost of Equity:
Risk-free: 10 Year Treasury Yield Equity Risk Premium Beta equity: regression Country Risk Premium Cost of Equity (Re) 2.02% 6.06% 0.97 4.57% 12.44%

The Equity Risk Premium is derived from Damodarans 5.8% that is based on a risk-free rate of 1.76%. Country Risk Premium is based on regional weighted averages according to GDP as per Damodaran, multiplied by the percentage of revenues earned by HP in the regions:
Revenues Q2_2013 35% 10% 36% 19% Weighted regional CRP 10.19% 0.08 2.82% Weighted CRP 0.00% 1.02% 3.02% 0.53% 4.57%

USA Canada & Latin America EMEA: Europe, Middle East, Africa Asia Pacific, and Japan Total Weighted CRP

Cost of Debt: Since its not a junk bond, we can take YTM of the latest issued long-term bond: $1,200 issued at discount to par at a price of 99.863% in September 2011 at 6.0%, due September 2041 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,198
Cost of debt: N I PV PMT FV calculated interest After-tax Cost of Debt 6.01% 30 6% 1198 0 1,200 6.0121 3.91%

WACC: rWACC= we re + wD rD (1-Tc) + wp rp Weights of debt & equity are based on interest-bearing debt/equity. Since we do not have info about the targeted D/E of HP we will use the industry's. The industry D/E is 41.63% (Source: Reteurs: http://www.reuters.com/finance/stocks/financialHighlights?symbol=HPQ ). Thus the we = 70.61% and wD = 29.39%. There are no preferred shares. WACC = 9.93%

Mada Arslan Operating Lease: We will capitalize OL.

2013 Lease (Rent) Expense in million PV of OL 2012 Lease (Rent) PV of Expense OL in million 1,012 780 665 517 351 218 805 4,348 955 694 558 409 262 154 449 3,481 (803)

Year

Year

PV of OL

1 2 3 4 5 thereafter Total

780 665 517 351 218 805 3,336

736 592 434 278 163 476 2,678

1 2 3 4 5 6 thereafter Total

Refer to excel sheet for details of the calculations. Research & Development: We will capitalize R&D assuming a 10 year life cycle.
Year R&D Expense Unamortized Portion Unamortized Value $365.30 $708.60 $1,047.60 $1,457.20 $1,900.50 $2,152.80 $1,978.20 $2,367.20 $2,928.60 $3,399.00 $18,305 Amortization Value This Year $365.30 $354.30 $349.20 $364.30 $380.10 $358.80 $282.60 $295.90 $325.40 $0.00 $3,076

-9 $3,653 0.1 -8 $3,543 0.2 -7 $3,492 0.3 -6 $3,643 0.4 -5 $3,801 0.5 -4 $3,588 0.6 -3 $2,826 0.7 -2 $2,959 0.8 -1 $3,254 0.9 current $3,399 1 Capitalized Value of R& D Expenses =

Mada Arslan Mergers & Acquisitions: M&A should be smoothed for the last 3-5 years by taking an average & the value of the M&A is calculated as cash paid or price per share x number of shares offered. The M&As were paid for in cash (includes cash paid for outstanding common stock, convertible bonds, vested-in-themoney stock awards and the estimated fair value of earned unvested stock awards assumedannual report 2012).
2012 $ mill 141 6,072 2011 $ mill 10,480 2010 $ mill 8,102 2009 $ mill 391 2008 $ mill 11,248

Acquisition Average

Return On Capital: ROC = EBIT (1-Tc) / BVCapital We adjusted EBIT for OL and R&D. We adjusted Book Value of Capital for Cash, Goodwill, PV of OL, unamortized portion of R&D, and minority interest. ROC = 5.03% < WACC Destroying Value FCFF:
FCFF = (EBIT + pretax cost of debt*PV of OL) (1-Tc) + R&D expense (current) - Depreciation expense of R&D (CAPEX - Depreciation + R&D expense - Depreciation expense of R&D + M&A) - NWC - in PV of OL

Adjusted EBIT CAPEX, net Depreciation (TTM) Current R&D (TTM) Depreciation of R&D M&A NWC PV of OL Reinvestment rate (RR) Growth = ROC * RR

4,371 279 1,548 3,372 3,076 6,072 150 (803) 102% 5.11%

Refer to excel sheet for further details. Since growth > Rf but < 10% we will use a 2-stage model: Growth: steadily declines over 5 years (conservative since distress company) to reach the Rf rate which was used as a proxy for the economic growth rate in the long-run Tax rate: since it's declining we need to be conservative, therefore we used the effective tax rate for the first 5 years then the marginal tax rate for the remaining years as HP can no longer defer its tax payments Reinvestment Rates: RR = g/ROC

Mada Arslan Terminal Value: Expected Liquidation Value Since its a distress company we used a liquidation value. There are 2 ways to estimate ELV: 1. Expected Liquidation value = Book Value of AssetsTerm yr (1+ inflation rate)Average life of assets 2. Earning Power of the Assets The limitation of the first approach is that it is based on accounting BV. We estimated the earning power of the assets based on TA2012*TAT2012. Cash (a): Cash interest income in 2012 was $155 million which is less than 2% but the Daily Treasury Yield Curve Rates for 1year is 0.12% so we should not discount cash for low returns. Adjusted Enterprise Value (b): HP falls under Reversible Decline with No or Low Distress since its minimum bonds rating is BBB according to Standard & Poors. Refer to Optimal Enterprise Value Model below for details on the calculated value. Market Value of Debt (c): Its the market value of interest bearing debt. Pensions/leases (d): Pension leases are computed as Employee compensation and benefits 4,058 + Pension, postretirement, and post-employment liabilities 7,780 in other liabilities. Employee Options (e): We valued the options using the modified Black & Scholes approach. These options are issued in the US therefore are considered tax deductible. We used time T = 2.5 years since average maturity of these options is 3 years, but since we are valuing in April 2013 we consider it T=2.5 and since those are American options thus they can be exercised anytime T/2=1.25. Rf of 0.2% was used to match the maturity of the options.
#shares options S S, diluted K T Rf continuous Rf 2 d1 N(d1) d2 N(d2) 1,974 87.296 20.35 19.49 29 1.25 0.19% 0.19% 0.14 0.38 (0.80) 0.21 (1.22) 0.11

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dividends/y/cs dividend yields C Value Options (after tax)

$ 0.50 2.46% 0.79 44.63

d1= [ln (S/K) + (rf y + /2) t] / t d2= d1 - t C= Se^(-y*t) N(d1) Ke^(-rf*t) N(d2) Minority Interest (f): No information on number of shares bought in those subsidiaries therefore we used BV. #Shares (g): We used the basic weighted-average #shares as per the 10K report that was used to compute net earnings per share. There are no different classes of common shares although some employee were granted restricted shares as stock-based compensations, Restricted stock has the same cash dividend and voting rights as other common stock and is considered to be currently issued and outstanding. Price per share- after iteration (h): We have used 3 iterations to get the price per share to converge to S, diluted. Refer to excel sheet for calculations details.

Mada Arslan The model:

g EBIT t EBIT (1-t) RR % WACC FCFF PV of FCFF PV of Operation Non-operating assets: Cash Loss Carry Forward Enterprise Value Enterprise Value adjusted Non-equity Claims: MV of Debt Pensions/leases Employee options Minority interests Equity Value #shares #options Price per share Price per share- after iteration

Y0 5.11% 4,371 24% 3,344 101.71 9.93%

Y1 4.49% 4,568 24% 3,494 89.41 9.93% 370 337

Y2 3.87% 4,745 24% 3,630 77.11 9.93% 831 688

Y3 3.26% 4,899 24% 3,748 64.80 9.93% 1,319 993

Y4 2.64% 5,028 24% 3,847 52.50 9.93% 1,827 1,251

Y5 2.02% 5,130 24% 3,925 40.20 9.93% 2,347 1,462

Y6 2.02% 5,234 35% 3,402 40.20 9.93% 2,034 1,153

Y7 2.02% 5,339 35% 3,471 40.20 9.93% 2,076 1,070

Y8 2.02% 5,447 35% 3,541 40.20 9.93% 2,118 993

Y9 2.02% 5,557 35% 3,612 40.20 9.93% 2,160 921

Y10 2.02% 5,670 35% 3,685 40.20 9.93% 2,204 855

ELV

115,569 44,837

54,559 11,301 9,142 75,002 76,232 20,453 11,838 45 397 43,500 1,974 87 22.04 22.75 a

b c d e f g BUY BUY

Mada Arslan Optimal Enterprise Value Model: Expected Value = Status Quo Value (probability of no management change) + Optimum Value (probability of management change)
Status Quo Enterprise Value probability of no management change Optimum Enterprise Value probability of management change Enterprise Value adjusted (b) 75,002 0.8 81,155 0.2 76,232

We considered the following changes when we computed the optimal value of HP: Operating margins will increase to the industry average of 7.61% (Reteurs) v/s the current 5.25% Divesture of assets that have negative EBIT: Corporate Investments segment Capital expenditures: zero. Live off past overinvestment NWC: based on industry current ratio of 1.56 (Reuters) v/s HPs 1.11. We expect this difference to double as HP improves its current assets by decreasing inventory on hand and speeding-up receivables collections Treat HP in valuing its DCF in the optimal phase as a mature company Probability of management change

Mada Arslan Optimal Enterprise Value Model

Y11-Going Concern 2.02% 8,560 35.00 5,564 28.01% 7.21% 4,005 38,463

g EBIT t% EBIT (1-t) RR % r (WACC, ROC) FCFF PV of FCFF PV of Operation Non-operating assets: Cash Loss Carry Forward Enterprise Value

Y0 4.06% 6,272 23.50 4,798 56.24 7.71%

Y1 3.85% 6,514 23.50 4,983 53.42 7.71% 2,321 2,155 60,712 11,301 9,142 81,155

Y2 3.65% 6,751 23.50 5,165 50.60 7.71% 2,551 2,199

Y3 3.44% 6,984 23.50 5,343 47.78 7.71% 2,790 2,233

Y4 3.24% 7,210 23.50 5,516 44.95 7.71% 3,036 2,256

Y5 3.04% 7,429 23.50 5,683 42.13 7.71% 3,289 2,269

Y6 2.83% 7,640 23.50 5,844 39.31 7.71% 3,547 2,272

Y7 2.63% 7,841 23.50 5,998 36.48 7.71% 3,810 2,266

Y8 2.43% 8,031 23.50 6,144 33.66 7.71% 4,076 2,250

Y9 2.22% 8,210 23.50 6,280 30.84 7.71% 4,344 2,227

Y10 2.20% 8,391 23.50 6,419 30.55 7.71% 4,458 2,122