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Corporate finance project – computer industry

KC.COLLEGE

EXECUTIVE SUMMARY

We chose the computer industry for our project. We picked five

hardware companies- Compaq, Hewlett Packard, Hitachi, IBM, and

Unisys – and one software company- Oracle- for our analysis.

CORPORATE GOVERNANCE

According to our analysis, we found that all of our chosen companies,

except for Hitachi, have good systems of corporate governance. We

have concluded that Hitachi’s corporate governance is weak, which is a

general characteristic of the Japanese style of management. However,

its large debt adds discipline to its management due to monitoring by its

lenders.

We also found some general characteristics in the computer industry.

First, the larger the company, the more attentive it is to its stockholders.

Second, in a fast-growing company such as Oracle, it is usual that CEO

is one of the founders of the company. This type of company gradually

transforms itself into a larger-type firm, such as IBM, and becomes more

attentive to its stockholders as it matures.

RISK AND RETURN

In the risk analysis section, we observed that high-risk companies, such

as Unisys, have larger betas and higher costs of equity. As a result of

our calculations, we estimated each company’s hurdle rate as follows:




KC.COLLEGE

Compaq HP Hitachi IBM Oracle Unisys

Current 0.00% 5.68% 42.99% 15.91% 3.99% 37.49%

optimal 20.00% 20.00% 40.00% 30.00% 5.00% 20.00%

Hitachi and Oracle have already realized their optimal financing mix. As

for HP and IBM, their debt ratios are lower than the optimal, so they

need to increase debt ratios by buying back their stock, which they did

recently. Compaq’s debt ratio is lower than the optimal, so Compaq

needs to issue short-term debt (based on the duration coming from the

regression analysis) in a mix of currencies, because the structure of debt

should reflect the mix of the revenues from each country. Compaq’sacquisition of DEC will lead Compaq’s debt ratio to increase, but we

believe the company still has some excess debt capacity. Unisys has to

decrease its debt ratio immediately by selling assets and renegotiating

with lenders. The company is in the process of restructuring its

businesses and its finances in an effort to come to terms with this

situation.

OPTIMAL CAPITAL STRUCTURE

Generally speaking, the debt ratio in the computer industry (12%) is

relatively lower than that in other industries. Considering our chosen

companies, mature ones such as IBM and Unisys have higher debtratios, while fast growing companies, such as Oracle and Compaq, have

lower ones. After our analysis, we reached the following optimal debt

ratios and paths to the optimal.




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Compaq HP Hitachi IBM Oracle

Unisys

Current 0.00% 5.68% 42.99% 15.91% 3.9

9%

37.49%

Optimal 20.00% 20.00%

40.00% 30.00% 5.00%

20.00%

Hitachi and Oracle have already realized their optimal financing mix. As

for HP and IBM, their debt ratios are lower than the optimal, so they

need to increase debt ratios by buying back their stock, which they did

recently. Compaq’s debt ratio is lower than the optimal, so Compaq

needs to issue short-term debt (based on the duration coming from theregression analysis) in a mix of currencies, because the structure of debt

should reflect the mix of the revenues from each country. Compaq’s

acquisition of DEC will lead Compaq’s debt ratio to increase, but we

believe the company still has some excess debt capacity. Unisys has to

decrease its debt ratio immediately by selling assets and renegotiating

with lenders. The company is in the process of restructuring its

businesses and its finances in an effort to come to terms with this

situation.

DIVIDEND POLICY

In summary, the dividend policies of companies in the computer industry

are such that they do not generally pay many dividends. In the

companies we analyzed, the rule of thumb is that for growth companies,the policy is to not pay dividends. For more mature companies,

dividends are one of the ways for returning cash to investors.

We found that growing companies such as Compaq and Oracle do not

pay dividends at all because of the need of the financing flexibility they

require to take advantage good investment opportunities. It is also the

case that stockholders in growing companies do not expect dividends




KC.COLLEGE

and would prefer cash returned to them in the form of buybacks. More

mature companies, such as HP, Hitachi and IBM, do pay dividends.

VALUATION

Based on our analysis in each section, we chose the valuation model for

each company as follows. Judging from the low average payout ratio,

we should not use the dividend discount model because the current

dividend payout does not show the real value of the companies.

Therefore, we chose Free Cash Flow models. Except for Compaq, we

used FCFE models because they do not have plans to change their

capital structure significantly. Since Hitachi’s current growth rate is low

and it is a mature company, a 1- stage FCFE model was chosen. On

the other hand, a 2-stage FCFE model is appropriate for HP, IBM, and

Unisys because we believe their lengths of faster growth periods would

be 5 years. In addition, we selected a 2-stage FCFF model for Compaq

because we concluded that the company’s capital structure should move

from the current debt ratio of 0% to the optimal of 20%. Finally, we

reached the following result of our valuation.


Valuation 33.71 51.57 916.08 106.02 32.05 10.83

CurrentPrice

28.25 61.63 959.00 104.63 31.08 13.88




KC.COLLEGE

CORPORATE GOVERNANCE ANALYSIS

A. Management and Stockholders

balance of power

As shown above, five of our six companies pay attention to their

stockholders. Overall, the board of directors of both Compaq and IBM

are ranked as the 3rd and 5th best boards in the U.S., respectively,

according to the Business Week annual survey. In these companies,

management power is stressed by the fact that there are only a few

insider directors and the companies have established a record of goodcorporate governance.




KC.COLLEGE

B. FIRM AND FINANCIAL MARKET

SOURCE OF INFORMATION

COMPANY MONTHY TRADING ANALYSIS

COMPAQ $350 MILLION 34

HP $72 MILLION 27

HITACHI N/A NA

IBM $210 MILLION 21

ORACLE $184 MILLION 31UNISYS $28 MILLION 10

As reflected above, Compaq, Hewlett Packard, IBM, and Oracle are

well-followed firms. According to Zacks, there are more than 20 analysts

who follow these companies. While each company provides substantialamounts of information in the form of financial statements, many

external

sources

• 1: hitachi

• 2:unisys

• 3:hp

• 4:compaq

the firm • none




KC.COLLEGE

analysts and investors actively monitor the movement of these stock

prices.

In addition, these stocks trade frequently in these companies. Stock

trades for each company amount to more than $1 million monthly on

average. Both facts lead us to expect less bias in the information that is

available about these four firms.

In the case of Unisys and Hitachi, there seems to be a little bias in the

information available. Unisys is one of the largest software companies,

but it has suffered from large operating losses over the past five years.

There may be a possibility this company attempted to hide bad news aslong as it could. With Hitachi, the management consists of only the

inside directors. Considering how relatively unsophisticated the stock

market is in Japan, it is quite possible that the bias in the information

may be even larger than when compared to other US companies.

However, biased information is not beneficial for the companies in the

long-term, and both companies are well known to the public.

Considered that the companies wish to keep their corporate images in

their respective stock markets, such bias would not be so serious to themarkets.




KC.COLLEGE

C. Firms and Society

Social Consciousness and Image Factors

All companies in the analysis are committed to conducting their

businesses in a manner that is compatible with the environment and

protecting the quality of the communities where they operate. In their

annual reports, we can easily recognize that the management believes

that business must work in partnership with suppliers, government,

community, and industry groups in an effort to protect the environment.

These communities expect their hometown profitable

companies to contribute to their societies.

It is also interesting that most of companies in the computer industry

contribute to educational institutions such as public libraries and

elementary schools. While such contributions increase the

corporate images and benefit the communities, they also appear to be a

kind of investment. In the future, as computer use grows, the

educational institutions and current students can be potential customers.

We cite some current examples below.

Firstly, Unisys, while being a relatively low-profile company, provides

much needed services to a large number of companies and government

organizations. A recent Unisys publication tells of how the company

improved the voting system of Costa Rica by digitizing voter information

and producing tamper- proof voter identification cards. On other fronts,

very

high•

all six firms are here

very low • none




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Unisys sponsors the Science Learning Center, a joint project of Unisys

and the National Science Foundation. The SLC provides training to

elementary school teachers in ways to incorporate Internet and WWW

technology into their classes.

Secondly, according to the annual report of Hitachi, its corporate

philosophy is to contribute to society through the development and

application of superior technologies. Hitachi meets its responsibilities as

a good corporate citizen through the activities of Hitachi-endowed

foundations and programs designed to ensure Hitachi contribute to the

betterment of the community. For example, it has achieved notable

advances in the recycling of products, supported school libraries in

Thailand, and provided opportunities to enjoy Japanese art and culture

for Americans, etc.

As can be seen from the above examples, social concerns play

important roles in each company’s decision making.

STOCKHOLDER ANALYSIS

Institutional

holdings insider holdings

Hard wareindustry

50 – 60 % 30 -40%

Software industry 40 – 50 % 60%compaq 60 – 70% 0 -10%

hp 50- 60 % 30 – 40%hitachi 40 – 50% 0%ibm 50 – 60% 0-10%oracle 40 – 50% 50 – 60%unisys 40 – 50% 0 – 10%

To analyze the stockholders in each firm, we searched for a stockholdercomposite as of the end of 2008. As shown in the above graph,




KC.COLLEGE

institutional holdings account for about 40% to 60% in each company.

In IBM, the stockholders are well diversified, as there are no large

stockholders with more than 5% of the shares in IBM. Compaq and

Unisys have a few large institutional holders, but are sufficiently

diversified, given their shares are not disproportionately large compared

to other funds. Considering the scale of these firms, as well as the

average 50.3% and 47.3% institutional holding in the hardware and

software industries, respectively, these four companies are sufficiently

diversified.

On the other hand, with regard to insider holdings, all four firms (except

for Hewlett Packard and Oracle) have far lower insider holdings than

other companies in their peer groups1. In the case of Oracle, the CEO

is a co-founder of the company, while at HP, some of its directors are

related to the family. So the insider holdings of each firm are nearly the

same when compared to the industry average. The trading volume

implies that insiders of these firms may not have an impact on their

respective stock prices.

In summary, marginal investors are clearly institutional. Risk and return

models assume that the marginal investor is well diversified and that

only non-diversifiable risk matters. Here, the marginal investor is

the institutional investor, so this assumption should work well.




KC.COLLEGE

RISK PROFILE

OVERALL RISK PROFILE

The first step in assessing the relative risk of our companies against the

market was to run a regression, based upon the CAPM, of each of the

company’s stock against the market (in this case, the S&P 500), for the

period

2004 to 2008. The regressions yielded each company’s beta and

intercept, which was used to compute Jensen’s Alpha2. Jensen’s Alpha,when annualized, tells us how each stock performed against

expectations. The stocks that performed significantly better than

expected over this period were HP, Compaq, and Oracle. Only Unisys,

with the highest relative risk among the stocks, performed worse than

expected, with a Jensen’s Alpha of –13.5%.

Next, I examined the R2 of the regressions, which explains the risk orvariance of each stock attributable to market sources, such as interest

rate risk, inflation risk, etc., and the remaining balance which indicates

the diversifiable risk that was associated with each company’s own

specific risk components. Oracle, which had the lowest relative risk

among the pack as measured by its regression beta, also had the

smallest portion of risk that was attributable to market factors compared

to the other firms.

We should note, however, that the standard error of the betas for all the

regressions was relatively high, with the exception of Hitachi. Hitachi’s

beta is close to 1, with a risk that is nearly the same as the market. This

is due to the fact that Hitachi is a huge and diversified conglomerate

firm. It is also worth noting that none of the firms achieved the same

level of performance that the hardware and software industries achieved

on average, as reflected by their very high Jensen’s Alphas. This is due




KC.COLLEGE

to the fact that all of our companies are large and have existed for

several decades. The industry averages, on the other hand, may be

overstated because they include many new entrants that are start up

companies, which often times perform better than expected.

Measuring Bottom-up Betas

Given that nearly all the companies’ regressions yielded high standard

errors in the beta estimates, it is worthwhile to check the validity of these

betas. Through estimating a bottom-up beta, we looked at each

company and the businesses they operated in, and determined a new

beta for the company based on the unlevered betas from industry

averages, multiplied by the relative divisional weight within each firm.

Below, we present each company’s estimated bottom-up unlevered

beta:

COMPAQ

Business EstimatedValue(MM)

Comparable Firms

Unlevered Beta

Division Wt. Wt. *Beta

Computer HW $42,375 Computer HW 1.37 100% 1.37

Firm $42,375 100.00% 1.37




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HEWLETT PACKARD

Business Estimated Value (MM)

Comparable Firms

UnleveredBeta

DivisionWt.

Wt. *Beta

ComputerServices

$99,491.7 ComputerServices

1.49 82.6% 1.23

Test andMeasurementProducts

$12,045 Test andMeasurement

Products

.80 10.0% .8

MedicalElectronicEquipment

$3,493.05 MedicalElectronicEquipment

.95 2.9% .03

ElectronicComponen

ts

$2,770.35 Electronic

Components

1.17 2.3% .03

ChemicalAnalysis

$2,2649.9 ChemicalAnalysis

.92 2.2% .02

firm $120450 100% 1.39

HITACHI

Business Estimated Value (M)

Comparable Firms

Unlevered Beta

DivisionWt.

Wt. * Beta

Computer HW Y2,611,729 Computer HW 1.37 46.53% 0.6375

ElectricalEquipment

Y822,304 ElectricalEquipment

0.8 14.65% 0.1172

Machinery Y2,178,967 Machinery 0.64 38.82% 0.2484

Firm Y6,501,322 100.00% 1.00




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IBM

us ness s ma e

Value(MM)

ompara e

Firms

n evere

Beta

v s on . .

Beta

Computer &Peripherals

$49,938.57 Computer HW 1.37 41.46% 0.57

SoftwareServices

$70,511.43 ComputerSoftware

0.98 58.54% 0.57

Firm $120,450 100.00% 1.14

ORACLE

Business Estimated Value(MM)

Comparable Firms

Unlevered Beta

Division Wt. Wt. *Beta

Computer SW $31,660 Computer SW 0.98 100% 0.98

Firm $31,660 100.00% 0.98

UNISYS

Business Estimated Value (MM)

Comparable

Firms

Unlevered Beta

Division Wt. Wt. * Beta

ComputerSystems

$2,653.16 ComputerSystems

1.37 38% 0.5206

InformationServices

$2,164.42 ComputerSoftware

0.98 31% 0.3038

GlobaCustomerServices

$2,164.42 ComputerServices

1.49 31% 0.4619

firm $6892 100.00% 1.29




KC.COLLEGE

MOVING TOWARD LEVERED BETAS

Before we can arrive at a new beta estimate, we must look at the relative

debt to equity ratios for each of the firms. The share price, shares

outstanding, market values of debt and equity, and the debt to equity

ratios for each of the firms are presented below:


Share Price $28.25 $61.63 Y959 $104.625 $31.08 $13.88

Shares O/S(MM)

1,500 1,041 3,337,000 968.1 977.97 250.47

MV of Eq.(MM)

$42,375 $64,154 Y3,200,000 $101,287 $30,395 $3,477

D/E 0% 6% 75.41% 18.92% 4% 100.81%

While Oracle’s market value of straight debt is $304.2 million, the

company has substantial operating leases on its books. When

discounted back at Oracle’s present cost of debt, which is 8%, the

present value of the company’s operating lease liability is $960.4 million.This addition increases Oracle’s market value of debt substantially to

$1,264.6 million, as reflected above.

The formula for moving from an unlevered to a levered beta is presented

below, along with the results of each company’s levered beta.




KC.COLLEGE

Levered Beta for Company = Unlevered Beta [ 1 + ( 1-t) (D/E) ]

Levered Beta for Compaq = 1.37 [ 1 + ( 1 - 0.36) (0%) ] = 1.37

Levered Beta for HP = 1.39 [ 1 + ( 1 - 0.30) (6%) ] = 1.45

Levered Beta for Hitachi5 = 1.00 [ 1 + (1 – 0.493) (75.41%) ] = 1.38

Levered Beta for IBM = 1.14 [ 1 + ( 1 - 0.36) (18.92%) ] = 1.28

Levered Beta for Oracle = 0.98 [ 1 + ( 1 - 0.36) (4%) ] = 1.01

Levered Beta for Unisys = 1.29 [ 1 + ( 1 – 0.36) (100.81%) ] = 2.12

Summary of Beta Estimates Used Forward in Analysis

RegressionBetas

Bottom-up Betas

Compaq HP Hitachi Unisys IBM Oracle

etaEstimate

. . . . . .




KC.COLLEGE

For purposes of the analysis, we used the new bottom-up beta estimates

for only two of our companies, IBM and Oracle. In the case of IBM, the

software division has grown at a faster rate than the hardware division,

and correspondingly, its revenue resources have changed. In the case

of Oracle, it had a relatively high standard error in the beta estimate, its

regression beta was well below the software industry average beta

(while its bottom-up beta was more in line with industry average), and

Oracle had substantially increased its financial leverage in recent years.

3 All share data as of close of each company’s respective fiscal year

end.

4 Includes market value of $1,420 million of preferred shares for Unisys

Corporation.

5 Hitachi’s tax rate was estimated through running a regression of 10

years worth of income and tax data, yielding a marginal corporate tax

rate of 49.3%.

For all other companies, I used what we believe are the more reliable

regression beta estimates. In the case of Hitachi, both its regression

beta and its bottom up beta were 1. For HP, it has a high R-squared, its

standard error of the beta estimate is reasonably low, and its regression

beta is higher than the industry average. In the case of Compaq, we

used the regression beta for our analysis forward because there has

been no substantial change in the business mix or financial leverage of

the company. Lastly, for Unisys, it has been in a rather extraordinary

position because it has operated at a loss over the last several years.

This runs counter to how the industry has performed, so we believe the

regression beta is a more appropriate measure of risk for the company.




KC.COLLEGE

FROM BETAS TO COSTS OF EQUITY

To arrive at a cost of equity from the appropriate beta for each company,

we assumed a risk-free rate of 6%, the long-term treasury bond rate for

the period of our analysis. For the risk premium, we used a geometrichistorical risk premium for stocks over the long-term treasury bond of

6.16%. For our foreign company, Hitachi, we used the Japanese

riskfree rate of 1.88% and the same risk premium.

Using the CAPM formula, below we present the costs of equity

(expected returns) for each company:


Cost of Equity

15.55% 15.79% 8.04% 13.88% 12.22% 17.58%

As we can see, the return that investors expect to make on an

investment in Unisys, given its comparatively high risk, is the largest

among all companies at 17.58%. By comparison, Hitachi’s expected

return is the lowest at 8.04%. Its risk is the market risk and is based

upon the lower Japanese risk-free rate. The return that investors expect

to make by investing into any company becomes the cost of equity formanagers running that company.

ESTIMATING COSTS OF DEBT

The current bond ratings for all our companies are presented below,

which are factored into obtaining a current cost of debt for all companies:




KC.COLLEGE

For each company, I computed a cost of capital by taking the cost of

equity, estimated from the beta, along with the after-tax cost of debt.

The costs of capital for each company are presented below:

ESTIMATING COSTS OF CAPITAL

6 We used the long-term treasury bond rate of 6% for all companies

(except Hitachi, where we used the long-term treasury bond rate of

1.88%), adding on the appropriate default spread based upon each

company’s bond rating.

Compaq HP Hitachi IBM

Oracle Unisys

Bond Rating BBB AA Aa2 A+ BBB

Pre-taxCost of Debt6

8% 6.7% 2.58% 6.8% 8% 10%

After-taxCost of Debt

5.12% 4.69% 1.31% 4.35% 5.12% 6.4%

Compaq HP Hitachi IBM

Oracle Unisys

Cost of Equity

15.55% 15.79% 8.04% 13.88% 12.22% 17.58%

E/(D+E) 100% 94.32% 57%

84.09% 96% 49.8%

AT Cost of Debt

5.12% 4.69% 1.31% 4.35% 5.12% 6.4%

D/(D+E) 0%

5.68% 43%

15.91% 4% 29.86%

Cost of Capital

15.55% 15.16% 5.14% 12.37% 11.94% 12.41%




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Note that, in addition, Unisys has preferred stock outstanding. We

calculated the cost of preferred stock as: Cost of Pref. Stock = Pref.

Div./MV Pref. Equity = 120.4/1420.2 = 8.5

The cost of capital as calculated above for Unisys includes the weightedaverage cost of preferred stock of 8.5% multiplied by the preferred stock

ratio of 20.34%, yielding a total weighted average cost of capital of

12.41%.

The cost of capital for each company is the benchmark each company

uses to analyze projects on a predebt basis. In the next section, we will

determine how each company has performed based on their respective

costs of equity and costs of capital.

INVESTMENT RETURN

ANALYSIS

Business Project Flow Characteristics Type of Financing/AppropriateDebt

ComputerHardware

Business

Be short term for personalcomputers,

medium term for mainframecomputers

Have cash outflows that are

primarily in dollars, but withinflows that are frequently inforeign currencies due to largeoverseas salesBe very competitive and volatile

Shortterm

Both in US $ and

foreign currency Linked

to a high-technology

index fund, if possible

ompu erSoftware

Business

e s ort term


primarily in dollars, but with

inflows that are frequently in

ortterm

Both in US $ and

foreign currency Linked




KC.COLLEGE

foreign currencies due to large

overseas sales

Can be considerably profitable

due to low fixed costs

to a high-technology

index fund, if possible

ec r caEquipment

e me um to ong term





overseas salesStable, but can be cyclical

xture o me um anlong term

Both in US$ and foreigncurrency

ElectricalMachinery

Be long term





overseas sales

Stable

Sensitive to exogenous factors,

such as politics and macro-

economic factors

Mixture of medium andlong term

Both in US$ and foreign

currency Linked to the

specific country ratings, if

possible

Test &Measurement

Medial

Electronic

Equipment,

Chemical

Analysis &

Service

Long term


primarily in dollars

Stable

High fixed costs

Mixture of medium andlong term

Mainly in US$




KC.COLLEGE

MEASURING PAST RETURNS

We assumed that the current book value of assets and equity of our

companies reflected the current capital and equity invested in existing

projects. Using the net income and book value of equity, we computed

the return of

equity of each firm as follows:


ROE 22.19% 21.08% 2.72% 29.4% 38.75% 176.29%

ROC 22.87% 16.13% 2.4% 12.77% 36.56% 9.29%

Hitachi’s ROE and ROC are extremely low compared with the US

companies. Unisys operates at a loss and thus, its ROE is negative.

Since Compaq and Oracle have little to no debt, their ROCs are not

much different from their ROEs. IBM’s ROE is significantly higher,

reflecting its relatively high debt ratio and its active stock buybacks.

Graphically, these returns appear as follows:

ROE & ROC

COMPANY RETURN ON EQUITY RETURN ON CAPITAL

Compaq 0 – 25% 0 – 40%

Hp 0-25% 0 – 25%

Hitachi 0-10% 0 – 10%IBM 0 – 40% 0 – 20%

oracle 0 – 50% 0 – 50%

unisys (150) –(200)% 0 – 15%




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EVALUATION OF PAST RETURNS

CALCULATION OF EQUITY EVA

Compaq HP Hitachi IBM Oracle Unisys Industry

Average

ROE 22.19% 21.08% 2.72% 29.4% 38.75% -176.29%

22.4%

Cost of Equity 15.55% 15.79% 8.04% 13.88% 12.22% 17.58% 12.8%

Equity Return Spread 6.64% 5.29% -5.32% 15.52% 26.53% -193.87%

9.6%

Equity EVA (MM) $555 $783 -Y172,000

$3,216 $562 - $939 $50.67

CALCULATION OF EVA

Compaq and Oracle are well outperforming their respective cost of

equity and cost of capital, meaning both companies are picking up good

projects. On the other hand, return spreads of cost of capital for HP and

Compaq HP Hitachi IBM Oracle Unisys Industry

Average

ROC 22.87% 16.1% 2.4%12.77% 36.56% 9.29% 25.24%

Cost ofCapital 15.55% 15.16% 5.14% 12.37% 11.94% 12.41% 12.31%

Capital ReturnSpread

7.32% 0.94% -2.74% 0.4% 24.62% -3.12% 12.93%

EVA (MM) $612 $182 -Y153,000

$183 $560 - $108 $101.45




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IBM are close to zero, as compared to their equity return spread of

5.29% (HP) and 15.52% (IBM). This suggests that since HP and IBM do

not have many good projects, they just buy back stocks alternatively.

Reflecting its low ROE & ROC, Hitachi’s return spread is negative, as is

its EVA. Hitachi’s ROE and ROC do not match the hurdle rates, thus its

EVAs are negative. Unisys’ projects did not generate necessary return

to the company

The accounting returns certainly give us general information on each

company’s performance. However, accounting returns do not

necessarily reflect the company’s real picture, because they are

influenced by certain accounting standards, and do not reflect market

value. Since, it is meaningful to use both book value basis returns andmarket value returns to get more precise and comprehensive information

of the companies in our analysis, we compared market value based

excess return (return on stock – required return) in the following dividend

chapter.

DIVIDEND POLICY: THE TRADEOFF

The way the six companies return cash to stockholders is different and

the reasons they return the cash also vary.

The following tables sum up the dividend and stock buyback of the last 5

years

HP

YEAR 2004 2005 2006 2007 2008

DIVIDENDS $228 $280 $358 $450 $532

EQUITYREPURCHASES

$6 $25 $325 $726 $305

CASH TO STOCKHOLDERS

$234 $305 $628 $1176 $837




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HITACHI

Year 2004 2005 2006 2007 2008

Dividends 37.35 37.10 37.98 36.39 36.63

+ EquityRepurchases

= Cash toStockholders

Y37.35 Y37.1 Y37.98 Y36.39 Y36.63

UNISYS

Year

2004 2005 2006 2007 2008

Dividends

+ EquityRepurchases


$0.00 $0.00 $0.00 $0.00 $0.00

ORACLE

Year 2004 2005 2006 2007 2008

Dividends

+ EquityRepurchases

$43 $81 $75 $113 $528

CASH HOLDERS $43 $81 $75 $113 $528




KC.COLLEGE

COMPAQ

Year 2004 2005 2006 2007 2008

Dividends

+ EquityRepurchases


$0.00 $0.00 $0.00 $0.00 $0.00

IBM

Year 2004 2005 2006 2007 2008

Dividends $933 $662$591

$706 $783

+ EquityRepurchases

$10 $5,526 $5,005 $6,251


$933 $672 $6,117 $5,711 $7,034




KC.COLLEGE

Dividend

Payout

Dividend

Yield

IBM12.85

0.77

HP17.06

0.83

Hitachi 41.46 0.01

Hardware Ind.Avg. 7.67 0.42

Soft.&ServInd. Avg.

7.25 0.19

Ind. Wt. Avg. 7.45 0.30

As shown above, our 3 companies have higher payout ratios and yields

than the industry averages. However, we must view Hitachi as an

exception because it is a Japanese company and operates under

different constraints.

To better understand some of the tradeoffs of different dividend policies,

we will compare the policies of Compaq and IBM, which exemplify two

common dividend policies, namely the policy of paying dividends and the

policy of not paying dividends.




KC.COLLEGE

Factor Implication for Compaq Implication for IBM

Stockholder Tax Preference Considering its history of nodividends, stockholderschoose it for its capital gainspotential. In the future,stockholders would preferbuybacks over dividends.

IBM was a typical dividendpaying company before therecession, but 5 years of low dividends have changedstockholders attitudes so nowthey do not expect highdividends

Information Effects andSignaling Incentives

Considering its no-dividendpolicy, it is unlikely thatCompaq would use dividendsto signal information aboutfuture cash flows.

Its announcement that itwould reduce dividendssent its stock plummeting.

Effect on Flexibility Not paying dividends givesCompaq more flexibility in

accepting projects

Since IBM does not havemany good projects, they

tend to return money tostockholders. Therefore,they do not require muchflexibility.

Bond Covenants andRatings Agency Concern

Considering that it has nodebt, this is not a concern

They have many bondholders, so ratings are aconcern and effects theirdividend policy.

As suggested above, when Compaq decides to return money to

stockholders it should do so in the form of buybacks. IBM should

continue its current dividend policy




KC.COLLEGE

DIVIDEND POLICY:

A FRAMEWORK

The following tables sum up our results of what the companies should

have returned and what they did. It also shows where the companies

paid out too much.

The companies can be categorized in 4 ways by looking at how they

return cash to stockholders.

1) Those that pay dividends: Hitachi

2) Those that buyback stocks: Oracle

3) Those that pay dividends and buyback stocks: Hewlett Packard and

IBM

4) Those that that do neither: Compaq and Unisys

1) Hitachi has been paying the same 11 yen per share dividend since

1990, even though its profits have been declining due to the Japanese

recession. This is common in large mature Japanese companies. Even

though this dividend is regular, its yield is just 1.15%. However, since its

net income per share was just 25.55 yen in 2008, 11 yen per share

means its payout ratio is 43%, which is not very low. Their 10-year

historical dividend payout ratio is 26.31%.

As this is the only Japanese company in the group, the following

information is included for comparison.

Toshiba: Dividend pay out =Y10/Y18.7=53.5% Yield:

Y10/Y547=1.82%

Matsushita: Dividend pay out = Y13/Y39.4=33.0% Yield:

Y13/Y1,985=0.65%




KC.COLLEGE

Compared with other Japanese computer and electronics companies,

Hitachi's dividend ratios are between Toshiba and Matsushita: not so

high but not so low.

Since most of Hitachi’s shareholders are institutional investors, they

prefer capital gains and stable growth, rather than obtaining large

dividends. This is due to the difference in tax treatment.

2) Oracle is unique in the survey because it has been returning cash in

the form of stock buybacks. From the data, it seems that Oracle is

transforming itself from a growth company to a more mature company.

Since Oracle has never paid dividends, its investors are not expecting

any in the future. As Oracle does not have as many good projects as in

the past it is returning cash in the form of stock buybacks.

3) Hewlett Packard and IBM seem very similar on the surface in terms of

their cash returning policies. Both companies have a low positive EVA,

which is consistent with large mature companies which do not have

attractive projects. However, with a little analysis we can see some

differences. HP is a typical large mature company with a relatively

stable dividend payout ratio. It is also buying back stock.

IBM, on the other hand, appears to be behaving in the same manner.

But by looking back a few years, we can discover a different reason for

IBM’s actions. From 1991-1992 IBM’s stock price fell 43%. This came

on the heels of mounting loses as a result of mismanagement. In 1993,

IBM’s new management, lead by Louis Gerstner, Jr., announced a

decrease in dividends which was greeted with further downward

pressure on their stock price. To counter this effect IBM started to

repurchase its stock. In this way it returned cash to shareholders and

helped bring the price back up.




KC.COLLEGE

4) The last two companies also appear similar if looking at their

dividends and buyback policies, but other than that, they are widely

different. Compaq is a typical growth company. It has an EVA of

7.32%, which signifies that it is investing in good projects. Its policy of

not returning money to shareholders and reinvesting it in projects is the

definition of a growth company.

Unisys, on the other hand, is a company that has been loosing money

for several years and has posted negative FCFE for 6 of the last 10

years. It is not surprising that the firm does not pay any dividends.

How much do we trust management at these computer companies?

First, in terms of corporate governance, except for Hitachi, we consider

each company to have appropriate corporate governance. Second, in

terms of stock price performance, except for Unisys, each company’s

stock has performed well compared to the market, after adjusting for

risk.

Excess Returns (Return on Stock-Required Return)

Recent 5 year

Average Standard Div.

HP 8.64% 21.51%

Hitachi 6.59 11.96%

Unisys -16.48% 60.11%

Oracle 14.63% 13.17%

IBM 12.66% 23.66%

Compaq 27.12% 37.29%

Based on the table above, we can say that the companies that have

smaller excess return (return on stock – required return), such as Hitachi

or IBM, tend to pay higher dividend, while a company that has high




KC.COLLEGE

excess return, Compaq, tends to pay no dividend. Therefore, we can

conclude we can trust these companies management, except for Unisys.

COMPARISON TO PEER GROUP

In comparing our companies to each other, as well as to a

representative cross section of its peer group, we have examined

dividend yields and payouts.

ExpectedGrowth

DividendPayout

DividendYield

Price

Microsoft23.81

0 064.63

Intel19.64

2.7 0.1670.25

Dell29.58

0 042

Micron 16. 0 0 9.13

DEC 12 0 0 37.13

Cisco 29.85 0 0 55.75

3Com 24.15 0 0 34.94

Compaq 20.38 0 0 28.25

IBM 1012.75

0.77 104.63

Oracle 24.48 0 0 31.08

HP 15.4717.06

0.83 61.63

Unisys 10.6 0 0 13.88

Hitachi 2.0741.46

0.01

The forecasted growth rates were taken from the Zacks service by way

of Bloomberg.




KC.COLLEGE

We ran the two regressions in order to see how well expected growth

predicts payouts and yields. The results are as follows:

Dividend Payout Ratio =

24.4 - 1.02 (Expected Growth Rate) R-Sq = 48% (t=3.19)

Expected

Growth

Actual

Payout

Predict- ed

Payout

Difference

Microsoft 23.81 0 0.11 -0.11

Intel 19.64 2.7 4.37 -1.67

Dell 29.58 0 -5.77 5.77

Micron 16.58 0 7.49 -7.49

DEC 12 0 12.16 -12.16

Cisco 29.85 0 -6.05 6.05

3Com 24.15 0 -0.23 0.23

Compaq 20.38 0 3.61 -3.61

IBM 10 12.85 14.20 -1.35

Oracle 24.48 0 -0.57 0.57

HP 15.47 17.06 8.62 8.44

Unisys 10.6 0 13.59 -13.59

Hitachi 2.07 41.46 22.29 19.17




KC.COLLEGE

Dividend Yield =

0.335 - 0.0108 (Expected Growth Rate) R-Sq = 8.9% (t=1.04)

ExpectedGr

owth

Actual

Payout

Predict- ed

Payout

Differ ence

Microsoft 23.81 0 .08 -.08

Intel 19.64 .16 .12 .04

Dell 29.58 0 .02 -.02

Micron 16.58 0 .16 -.16

DEC 12 0 .2 -.21

Cisco 29.85 0 .01 -.01

3Com 24.15 0 .07 -.07

Compaq 20.38 0 .11 -.11

IBM 10 .77 .23 .54

Oracle 24.48 0 .07 -.07

HP 15.47 .83 .17 .66

Unisys 10.6 0 .22 -.22

Hitachi 2.07 41.46 .31 .30

By looking at the shaded areas of the above left table, we can see howwell the regression predicts payout ratios. The regression results

suggest that HP and Hitachi are high compared to other firms in the

industry. However, this can be attributed to the large portion of the

sample group that does not pay dividends which provides little variation

across the group.

A similar situation is shown in the above right table, when we regressedyield against growth. The results suggest that IBM and HP’s yields are




KC.COLLEGE

too high compared to the industry and that Hitachi’s are too low.

However, as mentioned above, Hitachi is a unique case because it is a

Japanese company operating under different constraints.

Conclusions on Dividend Policy

In summary, it seems that investors in our six companies know what

type of dividend policy to expect. Except for Unisys, management has

earned a certain measure of trust based on excess returns for their

investors. This gives the companies greater flexibility for investing and

paying out dividends. It is also true that these companies generally stick

to a given policy and their stockholders have chosen to invest

accordingly.




KC.COLLEGE

VALUATION

Valuation summary

$us per share

Two of the companies are pretty overvalued: Hewlett Packard (19.5%)

and Unisys (28.2%). When we change the 5-year growth rate of Hewlett

Packard (18.28% to 23.5%), expected values match the current prices.

Therefore it can be said that the market expects HP to grow much faster

than its fundamental growth capacity (14.99%). Unisys is losing money

every year. Without its preferred stock, it would have negative

shareholder's equity. It's bond rating is "B." Even when we made a

pretty optimistic profit plan for Unisys, its stock is still quite

overvalued. Although Compaq is also overvalued by FCFE model by

35.5%, if we change the capital structure of Compaq to the optimal level(debt ratio from the current 0% to 20%) and use FCFF model, the value

of share becomes $33.71, which is pretty close to the current price.

Therefore, markets may expect that Compaq will change its capital

structure and take on debt in future. On the other hand, IBM and Oracle

are slightly undervalued. Therefore, we recommend selling short HP

and Unisys, and buying IBM and Oracle.

2. Choosing the right model

Value Actual

Price

Difference (actual-value)

DDM FCFE FCFF amount %

HP 40.38 51.57 - 61.63 10.06 19.5% Overvalued

Unisys 1.36 10.83 - 13.88 3.05 28.2% Overvalued

Compaq 17.37 20.85 33.71 28.25 -5.46 -16.2% Undervalued

IBM 84.38 106.02 - 104.63 -1.39 -1.3% UndervaluedOracle 22.95 32.05 - 31.08 -0.97 -3.0% Undervalued

Hitachi 1009.04 916.08 - 959 42.92 4.7% Overvalued




KC.COLLEGE

For the valuation, we can made the assumptions listed below. More

details are on the attached "The Values of Equity in Computer

Companies."

(1) 5 year rapid growth, 2 stage model

Except for Hitachi and Oracle, we used a 2-stage model for valuation

because each company has high expected growth for the first five years

due to the computer industry's faster growth rate (fundamental EPS

growth: 21% in hardware and 18% in software) than general U.S.

economy (5%). On the other hand, although all of four companies have

moderate barriers to entry and high expected growth rates, the size of

most of the companies are large, so the length of high growth periods

should be moderate. Therefore, we estimate that they will grow at a

higher rate for the first five years, and then the growth rate will become

stable. we estimate Hitachi should already be in a stable growth period,

and therefore chose a 1-stage model. On the other hand, Oracle's

expected growth rate is so high (28.95%) that we used a 3-stage model

with 5 years rapid growth and a 5-year transition period.

(2) Cash flows to equity and cost of equity

Basically, except Compaq, we use free cash flows to equity as cash

flows, and costs of equity as discount rates for three reasons. First,

each company's dividend payments do not always show each

company's actual value. Therefore, free cash flow model is more

preferable than the dividend discount model. Second, we expect that

their capital structures would not change significantly, except Compaq.

Therefore, free cash flow to equity should be more appropriate than free

cash flow to firm. Third, since each company would not take highly risky

projects or change its business structure

significantly in the future, the current cost of equity is appropriate for

discount rate. Since Compaq should change its capital structure

gradually from zero to 20%, I also used FCFF model and discounted by

cost of capital (15.5%). However, since Unisys almost finishes its capital

restructuring , I use current debt ratio for this valuation.

(3) 50% fundamental growth, 25% analyst's expectations, and 25% EPS

growth




KC.COLLEGE

I assigned the following weights for the rapid growth rate. I weighed

fundamental growth at 50%, analysts’ expectation at 25%, and 25% for

the historical growth rate of earnings per share. I did this because the

fundamental growth rate is too objective and based on the growth of

earnings. However, since Unisys’s fundamental and historical growth

rates are negative, we only used the analysts’ expectation for the

company. For Hitachi, since we couldn’t get reliable analysts’

expectations, we weighted it 50% on fundamental and 50% on historical

growth. On the other hand, since Oracle's EPS growth (68.29%) is

unusually high, we weighted 50% on fundamental and 50% on analysts'

expectations. (4) 130% Capital expenditure/ Depreciation Since

computer industry is capital intensive industry, capital expenditure is

usually larger than depreciation even in mature companies like IBM.

Therefore, we estimate that stable capital expenditure should be 130%

of depreciation, which is the current industry average. In Unisys,

however, we estimate its capital expenditure to be the same amount as

depreciation because of its current downsizing process.

3. The problem of Unisys It is difficult to evaluate the value of Unisys

because it has been losing money for the last several years. Based on

the assumptions below, even given that its current EPS is negative$5.30, due to the restructuring efforts and selling non-performing assets,

we hope the firm will recover in five years and then grow at a stable rate.




KC.COLLEGE

CONCLUSION

I believe that the computer hardware and software industries have huge

opportunities for further growth in the future based on the following

reasons: 1) I expect that the customer base will continue to expand,both domestically and internationally; and 2) new related businesses,

such as network computer and IT solution consulting business, were

created and grew at a rapid pace.

Compaq has been growing rapidly and is likely to continue to do so in

the future, given its relatively small company size. Through acquiring

DEC, Compaq is entering into the network business, which is a businessof both high profitability and risk. However, I believe Compaq’s good

brand image will make it possible to earn higher operating margins.

HP’s diversification into relatively low risk businesses, such as electrical

manufacturing, medical electronics and chemical analysis, provides the

company with buffers to exposure in its highly risky computer hardware

business. On the other hand, its diversification may limit its opportunitiesto capture any high growth opportunities in the computer hardware

business. So, together with its big size, I anticipate that HP’s growth will

be stable in the future.

Hitachi should increase its ROE and ROC in order to match the required

hurdle rates. Its low ROE and ROC are a reflection of Hitachi’s power

structure between strong incumbent managers and weak stockholders.

If stockholders acted to check the managers, it would be harder for the

firm to generate a negative EVA. Thus, we do not foresee high growth

for Hitachi. Given the current bad fundamentals for the Japanese

economy, it may grow only modestly.

While focusing on the computer hardware business, IBM transitioned

into other areas, such as software services and consulting, which are

relatively less risky than its current stronghold. IBM’s policy to buy back

stocks suggests that the company does not have many good projects to

invest. So, we anticipate that IBM will grow at a moderate rate.




KC.COLLEGE

Oracle, on the other hand, is concentrating on the fast-growing software

service business. Given that the company is still relatively small, there is

room to grow for the company, although its growth may be volatile.

Unisys is in the process of turning itself around. Since new CEO LarryWeinbach came on board in September of 1997, Unisys is focussing on

the future. Unisys has since contracted out to manufacture desktop

computers and low-end servers, and is now concentrating on its

mainframes and high-end servers.

More importantly, Unisys is over 80% of the way towards achieving

Weinbach’s goal of reducing debt by $1 billion dollars by the year 2000.

This success resulted from the conversion of $616 million in bonds and

the retirement of $198 million in additional debt. With this financial

restructuring and the streamlining of itsmanufacturing operations, we

believe that Unisys is poised to make a comeback.




:BIBLIOGRAPHY

1:hp.com

2:caompaq.com

3:Unisys.com

4:oracle.com

5:ibm.com

6:hitachi.com

7:google

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