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Now, Compaq Is...a Software Company?

By Sam Jaffe Just a few years ago, Compaq (CPQ) was known simply as the King of the Personal Computer. Then Dell's (DELL) direct-sales model emerged as the most cost-effective while Compaq stumbled. To grow, it began acquiring other businesses, most notably Tandem and Digital, both of which produced high-end servers based on proprietary chip technology. Compaq then became known as the one to turn to if you're a big company with broad computer-buying needs.

Now, new questions are swirling about what Compaq does, exactly. On June 25, it announced it was going to discontinue its line of high-end server chips, converting completely to Intel chips. On the same day, The Wall Street Journal reported it had come across an internal memo by Compaq CEO Michael Capellas that said Compaq had to stop thinking of itself as primarily a hardware maker and refashion itself into a "services" company.

FINE-TUNING. I doubt either of these moves is the answer to what ails Compaq. What Capellas is doing by discontinuing the chip lines and emphasizing services is becoming a software company. Hardware, as Michael Dell could have told you from his freshman dorm room, is a commodity. But software is complicated and customized, needing programmers, consultants, and service technicians to constantly fine-tune it. To compete in the services world, you have to be a software-oriented company, which IBM (IBM) has become with its focus on Windows 2000, Linux, and its own proprietary Unix system, AIX.

Just one problem: What software expertise does Compaq have? Its only significant proprietary code is Tru64, a version of Unix that's optimized for use with Digital's Alpha chips. Now that those chips are being discontinued, there's little reason to believe anyone would want to continue using Tru64. Compaq has made gestures of support for Linux, but it has hardly lifted the Linux banner in the same way that IBM and Hewlett Packard have. Sure, Compaq knows how to load Windows on to PCs, but that's hardly a high-margin business.

For so long, Compaq fought tooth and nail to be the leader in the PC business, only to mistake that aim as its ultimate goal. The ultimate goal of a technology business is to make more money than it did the year before. Recently, Compaq has had a harder and harder time doing that, and this latest shift in strategy is unlikely to reverse the tide.

The company may want to turn itself into a Texas version of IBM. Who could blame it? Big Blue successfully reengineered itself as a services company several years ago and reaped the rewards this year with a 33% rise in its stock price since Jan. 1.

By contrast, Compaq's stock is now trading below $14 a share, an 8.7% decline since the beginning of the year. For the most part, the stock has hovered between $25 and $30 a share for the past three years. It's hard to see a recovery in the near term.

DROP IN EARNINGS. The downward pressure on the stock price is due to a steady erosion of margins and revenue. In the face of an overall slowdown in tech spending, Compaq produced 4% less revenue in the first fiscal quarter, which ended in March, than in the same quarter in 2000. Analysts expect earnings per share for the second quarter to be $0.05, compared to $0.21 in the same quarter last year, according to FirstCall.

Capellas was hired a year ago to turn the PC maker around, and little was heard about services then. Instead, he spoke about a slow transition to the direct-sales method that Dell uses. Now, after everyone has seen what IBM has done with its services business, Compaq wants to jump on board. Capellas' memo called for the company to earn one-third of its revenue from services rather than the one-fifth it does now.

Some might see Compaq's decision to terminate its line of proprietary chips as a gutsy move. So much of the company's resources went into the acquisition and attempted integration of Tandem and Digital that throwing in the towel clearly took some corporate gumption.

But the fact is that neither acquisition, both of which were completed in 1998, ever became successful. The plug should have been pulled much sooner. By waiting to exit the business, Compaq gave archrival Intel enough time to create the Itanium chip, which will soon be the undisputed leader of the high-end server chip market. The Itanium has just been released and promises to outperform everything from Sun Microsystem's (SUNW) Sparc chip to IBM's PowerPC chips.

Mike Winkler, Compaq's executive vice-president for global operations, denies the discontinuation of the server chips was part of the "services-first" campaign, saying it was purely a technical change: "It was not by any means a deemphasis of hardware business for Compaq," he says. I'm somewhat skeptical, considering that Compaq is surrendering one of the few proprietary cards it holds.

SLUMBERING BEAST. Of course, not everyone agrees with me about Compaq. "You have to remember that Compaq has the second-largest IT services business in the world after IBM," says Dain Rauscher Wessels analyst Tom Coler, who has a buy rating on the stock. He agrees with the company's line: "This isn't a reorganization but just a slight change in focus." But in fact, most of Compaq's 38,000 information technology employees are in sales and technical support, not doing the high-end consulting work that IBM has gained a reputation for.

The change that Compaq is undertaking requires a fundamental shift in how the company sees itself. But it seems a slumbering beast is being awakened slowly. Capellas is calling for the 50% increase in services to happen over three to four years. He's taking three years to discontinue the server chips. By the time those deadlines roll around, some new fad likely will be sweeping the technology arena. Will Capellas' response in 2004 be to aim the huge company in another direction? Let's hope not.

If this restructuring doesn't deliver results, shareholders may feel inclined to thrown him overboard by then. In the meantime, it's unlikely this latest shift toward services will right the Compaq ship. Jaffe writes about the markets for BusinessWeek Online

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