Compaq's Power Play

How the Compaq-Digital deal will reshape the entire world of computers

Since taking over the world's largest maker of personal computers six years ago, Compaq Chief Executive Eckhard Pfeiffer has regularly sent shock waves through the PC business. Back in 1992, the Houston-based PC maker slashed prices by up to 32%, sending competitors scrambling to lower costs and match Compaq Computer Corp. Last year the German-born executive set the consumer-PC business on its ear with a line of home computers priced below $1,000, again forcing rivals to react swiftly or lose out on one of the fastest-growing segments of the PC business.

Get ready for another shakeup--only this one will reach far beyond the PC crowd and into every corner of the $700 billion computer world. On Jan. 26, Pfeiffer and Digital Equipment Corp. Chief Executive Robert B. Palmer concluded four days of intense negotiations by shaking hands on a record-breaking $8.7 billion acquisition. When completed in June, the deal will be the largest in the annals of the computer industry--topping AT&T's $7.4 billion purchase of NCR Corp. and IBM's $3.5 billion buyout of Lotus Development. It will create a new computer colossus with some $37.5 billion in revenues, second only to giant IBM in computer sales.

NEW LANDSCAPE. The import of this mega-merger, though, goes far beyond computer rankings. By acquiring Digital, Compaq is catapulted from the upstart, wild-and-woolly PC generation into the high-tech big leagues of companies that supply the world's most complex and critical information systems. Compaq's product offerings will now span the computing landscape, from $649 handheld computers to superpowerful $2 million fail-safe computer servers. More important, the company will command Digital's vaunted service and consulting staff of 22,000 people, who know their way around the computing back offices of the world's largest corporations--customers Compaq has been striving to reach, with modest success, for the past three years.

Compaq's timing couldn't be better. The merger comes just as corporations are grappling with wrenching change in their computing options and the way they do business. The move away from mainframe-style computing to cheaper, powerful servers tied to banks of PCs is accelerating as companies buy new equipment to ward off potential software problems posed by the year 2000. At the same time, the race is on to figure out how to link a mish-mash of corporate networks to the Internet for speedy access to customers and suppliers. Compaq will now be able to offer solutions on all fronts--low-cost, powerful computing systems, along with a cadre of consultants to install and maintain the high-tech gear.

Suddenly, the 16-year-old company has the key pieces to reshuffle the tech deck. Compaq is expected to bring its low-cost, take-no-prisoners PC economics into the high-end computing markets that IBM, Hewlett-Packard, and Sun Microsystems have long dominated. Compaq's lean operations, for instance, require it to spend just 15 cents for every $1 in sales, far below Hewlett-Packard and IBM, which spend 24 cents and 27 cents, respectively, for every $1 they add to the top line. "This is an example of a New Economy company growing up to replace a company that dominated in an earlier era," says John T. Chambers, chief executive of Cisco Systems Inc., the No.1 supplier of networking gear.

Even PC highfliers Dell Computer Corp. and Gateway 2000 Inc., long accustomed to running no-frills operations, can't assume it's business as usual. Now, their biggest competitor just upped the ante by adding a service and support team that will give business customers the velvet-glove treatment. This deal, says Pfeiffer, will "force others to rethink their positions."

Indeed, Compaq's sheer muscle and broad new reach may put it on a par with the industry's two agenda-setters: Microsoft Corp. and Intel Corp. Today, Microsoft calls the shots with its Windows software, which runs on 87% of desktop machines, while Intel's microprocessors claim 89% of the world's $21 billion computer processor market--a duopoly dubbed Wintel.

Now, Compaq, already the biggest seller of Windows software and Intel chips in its PCs, could be the flag bearer that pushes Wintel technologies upstream in servers for heavy-duty computing jobs--everything from inventory management to complex financial databases. A crucial ingredient: Digital has one of the largest trained sales and support staffs for hawking Microsoft's powerful Windows NT, which is Microsoft's linchpin for moving into the lucrative $30 billion corporate-software market. In the past, customers gravitated to Compaq's aggressively priced products but often would use a service company like Digital because of its superior systems-integration skills, says Microsoft Chairman William H. Gates III. "This gives them the best of both worlds," he says.

Or three worlds. The Microsoft-Intel-Compaq troika could be a hugely powerful combination that gives NT the oomph it needs to edge out the huge numbers of mainframes and Unix servers that corporations now rely on to run their businesses. Already, NT has captured 40% of the server market, with unit sales up a huge 80% from last year.

In essence, the three companies may well wind up acting like a virtual corporation lined up against IBM, Sun, Silicon Graphics, and the like. While Microsoft spends a hefty 17% of sales on research and development and Intel spends 9.4%, Compaq invests a measly 3.3%. Even after the merger, analysts expect Compaq will be able to keep its R&D costs to just 4.6%, thanks to Digital's decade of downsizing. That makes it possible for the Houston computer maker to undercut competitors across its product line, from bargain-basement PCs to powerful servers. Says Pfeiffer: "We want to do it all, and we want to do it now."

But first Compaq must digest Digital, which promises to be one of the biggest challenges Pfeiffer has faced to date. For years, Compaq has prospered through its single-minded focus on selling Wintel machines. Now it vows to turn itself into a one-stop shop, selling Wintel, as well as Digital's proprietary VMS computers and Unix machines--both used for big computing tasks. That means Compaq will likely face a massive sales reorganization as it melds its PC sales group with Unix sales reps. That's no small thing. Just this November, HP finished merging its Unix and PC sales staffs into one integrated force--a two-year effort that changed the jobs of 5,000 people. "It was big for us, and it will be orders of magnitude greater for them," says William V. Russell, HP's server chief.

Then there's the task of folding Digital's 54,300 employees into Compaq's considerably smaller 33,000-strong workforce. Worse, this must be done by companies based some 2,000 miles apart. To be sure, Compaq is credited with the smooth $3 billion acquisition of Tandem Computers Inc. last June. But Tandem, a Silicon Valley maker of high-end computers, had just 7,000 employees, and they weren't as demoralized as Digital's workers, who have weathered years of layoffs, losses, and flip-flop strategies. "Compaq could really get locked up in an execution nightmare," says Silicon Graphics Chief Executive Rick Belluzzo, who until recently ran HP's computer business.

And, face it, big tech mergers have a lousy track record, chiefly because it's so tough fusing differing product lines and corporate cultures. "Compaq will have to spend the next two years integrating and reinventing," says Edward J. Zander, Chief Operating Officer of Sun Microsystems Inc. "We'll spend it innovating."

Rivals dismiss the deal as only the final chapter in Digital's long decline. "We don't see DEC in the marketplace very much at all," says HP's Russell. "We don't even track our win rate against them anymore." Dell Computer Corp. CEO Michael S. Dell, whose company now uses Digital for customer service, says the merger is more likely to balloon Compaq's operating costs than its sales. "Companies with higher cost structures do very poorly," he says.

Still, it's hard to bet against Pfeiffer. Under the 56-year-old CEO, Compaq's run has been phenomenal. Revenues are up 500% since 1992 and show no sign of slowing--they're expected to climb 26% this year, to $31 billion, even without Digital. Last year, Compaq sold 10.1 million PCs worldwide, up a stunning 43%--more than double the industry growth rate. "If you look at the overall market, there were 11 million more PCs sold than in 1996, and Compaq picked up 30% of that," says analyst Ashok Kumar, of Loewenbaum & Co. Among rivals, none matches Compaq's sizzling pace--certainly not IBM, whose sales rose an anemic 3% last year. Not even Sun, whose revenues shot up 21% last year.

NEW RESPECT. In almost every business it has entered, Compaq has driven rivals to distraction. Three years after it charged into the home-PC business, Compaq's sales are running neck-and-neck with Packard Bell NEC Inc., the market leader. Packard Bell held a 31% share of retail PC sales to Compaq's 29% during October, according to researchers Audits & Surveys Worldwide. Even in segments with well entrenched suppliers, such as engineering workstations, Compaq has marched in unimpeded. Just a year after shipping its first PC-based workstations, it held a market-leading 16% share, leapfrogging Hewlett-Packard, Intergraph, and IBM. Meanwhile, Compaq has held the lead in PC servers since 1993.

Now, Compaq will cast an even bigger shadow. Analysts say Sun will have to speed up investments in customer services, a notoriously weak area for the $8.6 billion computer maker. "We typically viewed Compaq as a supplier in the middle tier, not for our big transaction systems," says Monsanto Corp. Chief Information Officer Patrick Fortune. "Now, within one company, we can have that whole line."

The deal also is bad news for HP. Given Digital's problems and HP's ascent in the PC business in recent years, HP has carved out a position as the only soup-to-nuts supplier to challenge IBM for the biggest corporate customers. Should Compaq resuscitate Digital's computer business, HP would face a competitor with a product lineup not unlike its own--but with a history for slashing costs and forcing margins down industrywide. "This puts a strong new player into the mix," admits HP CEO Lewis E. Platt. "We'll be watching with interest and won't let any time pass before we respond."

IBM, the company Compaq must now surpass to become No.1, may be forced to revisit lagging PC operations. Until now, IBM has fended off efforts to match the sector's cutthroat pricing by linking PC sales with services. "This may be a wake-up call for IBM," says a consultant close to both companies. Further evidence of IBM's declining share of home-PC sales came on Jan. 28, when retailer Tandy Corp. announced it would no longer sell IBM PCs, opting for an exclusive 3-year Compaq deal. With IBM's sales dragging behind the PC industry's worldwide 15% growth rate, it could be forced to match Compaq's ultrathin hardware margins. That will likely require IBM to take additional steps to lower its manufacturing and distribution costs, they say. IBM declines comment.

Even Dell, the master of cheap PC assembly and delivery to corporations, can't blithely ignore the bulked-up Compaq. Dell will no doubt remain the lowest-cost PC maker--its overhead amounts to just 11.6% of sales vs. Compaq's 15%. But the move to networked computing and the rush to tap into the Net are prompting more companies to seek advice--not just machines. IBM's service business, for example, has ballooned from $2 billion to $19 billion in the past seven years. This trend could force Dell to invest heavily in a service and support team, raising its overhead costs. "Dell will have to fight fire with fire," says analyst John B. Jones Jr. of Salomon Smith Barney, "or change the game."

Changing the game is Pfeiffer's specialty. By tackling Digital, the computer world's longest-running tough-luck story, he is again flaunting conventional wisdom. He's betting that PC economics, where huge volumes make up for slim margins, can make Digital a winner. "What we realized before anyone, is the unlimited potential of the PC," says Pfeiffer.

That became clear to him in 1991 when he took over a bloated Compaq, slashed the workforce by 12%, and depth-charged prices on Compaq's PCs. The result: Compaq reset the competitive landscape, forcing PC rivals to whack costs and squeeze efficiencies out of manufacturing. Those that couldn't make the grade, such as AST Research Inc. and Apple Computer Inc., lost market share and were sidelined.

MARGIN MAGIC. Four years later, Pfeiffer disproved the notion that home PCs were money-losers. He further tackled costs and brought consumer marketing and retail skills to the computer maker. Last year, Pfeiffer drove the concept to new heights. By using low-cost chips, outsourcing assembly, and tightening sales policies, Compaq released a $799 PC with the same 11% gross margin as its most expensive home computer.

To get these tough jobs done, Pfeiffer has shown he's willing to do just about anything--even go up against Intel and Microsoft. Take the recent sales explosion in sub-$1,000 PCs, a segment Compaq jump-started late last year. At the time, Intel didn't offer a low-cost processor that would make it possible to sell a no-frills machine and still make money. Pfeiffer didn't wait for Intel to come around. He cut a deal with Cyrix Corp. and, more recently, Advanced Micro Devices Inc. to use their Intel-clone chips.

Absorbing Digital will put such skills to the test. Digital, after all, is no plum. The company recently swung earnings into the black with a $75 million profit for the quarter ended Dec. 27. But its $13 billion in revenues are the lowest since 1990. And Digital has suffered $5.9 billion in cumulative losses since 1991. Addressing the company's low morale and leisurely release of new products will be Pfeiffer's first priority. There are signs Digital's culture may be waking up to what's ahead. At a meeting last week, a Digital manager asked the correct pronunciation of Pfeiffer's first name. "Aggressive," came the response from a co-worker.

Pfeiffer has a plan, as well as a reputation. "We believe we can apply a lot of the management abilities we've shaped very successfully in the last two years--be it asset management or combining some functions," he says. "There's lots of leverage there." Pfeiffer, however, won't reveal any restructuring plans until the merger officially closes in June. But analysts say he will likely pare Digital back to two pieces: a systems and software unit and a services business.

That means Compaq may jettison Digital's remaining software and peripheral product lines. Analysts also are betting he will fold Digital's lackluster notebook and PC operations and sell off some businesses, such as Digital's storage unit, to recoup a part of its purchase price. The result: Digital's workforce could shrink to about 45,000, from 54,000 currently, say experts.

Analysts agree the acquisition can deliver significant new revenues. "You have to ask how much of Digital's growth has been limited by its financial uncertainties," says technology analyst William C. Conroy of the Houston-based brokerage Sanders Morris Mundy Inc. "There may be some nice pickups" from customers' faith in Compaq, he says. Indeed, Compaq Chief Financial Officer Earl L. Mason says Digital will contribute to earnings within a year.

Achieving that goal will require a sizable hike in revenues from Digital's business. Compaq expects Digital's $5.8 billion service group to play a big role in that. "There is a very big multiplier effect," says a source close to the merger talks. "That's where IBM is using frontline services to drag big-iron sales along." Compaq's willingness to pay a nearly $2.5 billion premium to the company's Jan. 23 market cap reflects the conviction that Compaq's management can rapidly expand sales to Digital's 20,000 customers.

What made the deal happen now? Talks between the two companies had been on and off over the past three years. In mid-1995, when the two first began negotiating, Digital's stock was depressed to $42 and its market cap less than half its $13.8 billion in sales. At the time, the Digital board was unwilling to consider a sale, believing its shares were undervalued and Compaq would likely gut the company, according to a source close to the talks. Then last December, when discussions resumed, Palmer was joined in the negotiations by outside Digital director Frank P. Doyle, a retired General Electric Co. executive.

Doyle, who had played a key role in brokering the October sale of Digital's chipmaking operations to Intel, swayed the board in favor of a sale this time. "He helped the Digital board wrestle with the economic consequences of a stand-alone strategy," says a source close to the talks.

ROSE'S RAIDS. There also was a new team evaluating the deal for Compaq. Pfeiffer assigned CFO Mason and Enterprise Computing Group Senior Vice-President John T. Rose, who oversees Compaq's corporate-computing efforts. They have the background for the task--both are former Digital executives. They spent weeks evaluating Digital's products, customers, and finances. Rose's ties have helped land former Digital executives at Compaq, including vice-president for enterprise marketing Robert Fernander and vice-president of Compaq's networking division, William R. Johnson.

A gregarious manager who began his computer industry career at IBM and later ran Digital's PC business for seven years, Rose will be on the hot seat to make the deal work. "He's been the champion. This [acquisition] affects his ability to compete in the marketplace. More than anybody else, he's the guy Eckhard and the board are looking to say why this is the right target," says a Compaq insider.

Pfeiffer is looking to another former Digital manager to get the business contributing to profits by the end of the year. Under CFO Mason, who joined the company in 1996, Compaq has become a cash machine intensely focused on boosting return on invested capital. Since the start of 1996, Compaq has trimmed inventories by 27% even as it added nearly $10 billion in revenues. Compaq now turns over inventories 14 times a year, up from nine times at the end of September. The payoff from that ultrafast turnover: Compaq generated $6 billion in cash since the start of 1996.

Not bad returns for what is largely a low-margin PC business. Now, consider the potential impact of that operating style on big-ticket packages of servers, networks, software, and services. That's the landscape Pfeiffer now sketches for a dramatically bigger Compaq--and the world of computers.

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