Investor response is therefore appropriate in light of the minimum $1.6 billion cash outflow, in return for an asset that is barely free cash flow positive, and brings to light the seriousness in which business acquisitions must be analyzed. In fact, I estimate 3PAR would need to add over $ 40 million in free cash flow for the deal to make sense, a scenario not foreseen for at least 3 years.
At CT Capital, we penalize the cost of capital due a significant business acquisition the extent of the mark-up dependent on the size of the deal in relation to various financial metrics. Of equal importance, and often lost, is the impairment to financial flexibility of the new combined entity.
In Hewlett-Packard’s case, the firm has $4.4 billion in remaining authorization on a share repurchase program, which in itself does not create value for shareholders and raises concern to the capital structure when depleted, especially if a new large program is announced given current growth. All share buybacks do is aid GAAP metrics, such as P/E or ROE. It never has, nor ever will, create value for shareholders if the stock is fairly valued. We all know, executives have a tendency to publicly overstate the value of their business.
Also raising cost of capital for HPQ was the loss of a significant executive.
Therefore, the recently reported rise in free cash flow for HPQ has been overcome by the increase in the cost of equity capital. The quantification of risk, as measured by the cost of equity capital, is a central tenant in fundamental security analysis.
Disclosure: No positions