For many years, a top priority of Hewlett-Packard Co.'s share repurchase program has been to offset dilution from employee share programs. By mid-2005, HP had gone five years without significant dilution from employee stock option exercises. Then in 2005, HP's shares began to rise, unleashing a flood of employee stock option exercises.
HP's treasury had forecast the consequences of rising shares and had developed a tool to predict how many would be exercised at different prices. If the stock kept rising, "the number of shares [HP] would need to buy back to offset dilution would be much higher," says Kenneth J. Frier, vice president of corporate treasury.
Treasury proposed that HP come up with a way to offset future dilution. HP needed to: 1) set a price cap per share to buy back stock; 2) structure the transaction so that it would have an impact on shares outstanding over time rather than all up-front; 3) have efficient pricing; and 4) offer downside protection.
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HP considered several solutions, including entering into a set of collar transactions, where HP would prepay a series of out-of-the-money call options and sell out-of-the-money puts. The prepaid collar was the most complicated solution, but the more HP studied it, the better they liked the fit. It met all of the objectives. "It set a cap on our purchase price. It provided downside protection," says Tony Altobelli, the corporate finance manager. It spread out purchases and it was efficiently priced.
The project, begun in August 2005, was done by November. The hard part was determining how to apply existing accounting and legal guidelines to the transaction. "The accounting and legal guidelines didn't quite address" the new structure, says Altobelli. While Frier won't say how much the prepaid collar has saved HP, the collar went live in December 2005. Shares have since risen 30%.
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