By Megan Graham-Hackett
On Sept. 4, the computer industry learned of a monumental change to the competitive landscape: Hewlett-Packard (HWP ) said it would acquire Compaq Computer (CPQ ) for $25 billion.
H-P management, led by chairman and CEO Carly Fiorina, has positioned the merger as one which creates a leader in servers, imaging and printing, and access devices (meaning PCs and handheld devices), and a top-three vendor in storage, IT (information technology) services and management software. The deal will create a giant in the technology industry with annual sales of $87 billion.
But investors quickly soured on the deal. The value of the deal has since fallen to roughly $17 billion: the deal was based on H-P's stock, which has plunged 27% since it was announced. And Compaq shares have fallen sharply as well.
Why have investors reacted so negatively? There are several reasons -- and a couple of valid points argued by the two companies for doing the deal in the first place.
One reason investors may have reacted negatively to the deal is that the combination of Compaq with H-P creates a company with a substantial exposure to the weak PC industry: 33% of the new company's revenues will come from PCs and access devices, more than any other segment. Investors may not view this positively, because the PC sector is currently witnessing its most challenging year ever -- the first year in which PC shipments will be down year-over-year in the industry's history. And then there are factors specific to Compaq and H-P. Neither company has been performing particularly well in this environment. In fact, during the second quarter of 2001, Compaq and H-P, respectively, recorded the largest declines in PC shipments among the top five vendors.
Another reason investors haven't applauded the proposed combination is that the merger gets neither company closer to where they wanted -- and needed -- to go. The area in which both companies were actively seeking acquisitions, before the deal was announced, was services. In combination, the services capabilities of Compaq's core business added to H-P's does not yield an entity to rival services leader IBM Corp. (IBM ). The new services operation would claim 65,000 employees and $15 billion in sales, compared with IBM's force of 150,000 people and $33 billion in revenue.
And these figures don't tell the whole story. The most attractive areas within services are the higher-growth sectors of consulting and outsourcing. In these areas, the sum of Compaq and H-P's individual capabilities, S&P believes, does not yield an entity greater than the whole -- specifically, not a company that has a materially improved position in services.
But there are some valid points supporting the merger. For one, the cost efficiencies from the deal are both sizeable and achievable. H-P estimates that cost synergies could reach $2.5 billion. Because these savings will largely come about through a workforce reduction of an estimated 15,000 people, they are likely to be achieved. (In fact, the savings could be higher, since H-P has mentioned in press meetings that the number of layoffs could increase.)
Secondly, the computer industry was ripe for consolidation and H-P and Compaq wanted to lead this charge, not follow. The reason why companies don't want to enter the M&A (mergers and acquisitions) party after the initial wave of consolidation has started is that less attractive properties are the only ones left, and the prices have been bid up in anticipation that they'd be acquired. True, the computer industry was likely to meet a wave of consolidation -- it's the predictable life cycle of industries. The market for PCs has matured, growth rates have slowed, and profits will continue to be elusive for the participants until excess capacity is taken out. Thus the industry's participants consolidate (merge) to remove that excess capacity, in the hope that leaner cost structures will emerge, paving the way for future profits.
Obviously, reflecting on the decline of the share prices of H-P and Compaq, investors have not viewed the merger as a deft, proactive move by the senior management of those companies. Nor have other PC-oriented stocks been bid up in anticipation that there are a number of take-over targets as the wave of consolidation started by H-P and Compaq moves through the industry. But just as Carly Fiorina argues that the merger isn't just about cost synergies, nor just about PCs, the most persuasive argument about the merger is a combination of exactly those points: to take cost out of a money-losing business that was weighing on both companies' fundamentals. Perhaps if H-P embraced this part of the story, instead of downplaying it, and articulated how the new company could compete better in all areas (servers, storage, etc.) without the drain on resources from an inefficient PC business, the deal would be more palatable.
STILL HOLD BOTH.
Standard & Poor's currently carries a 3 STARS (hold) opinion on both H-P and Compaq. Our hold recommendation on these stocks is based on the view that the deal has high execution risks, balanced by the current attractive valuation of the shares. The confused customers and distracted sales people as the merger process evolves are not the things you want in the best of times in such a fiercely competitive industry -- and particularly not the kind of challenge your business needs in a weak economic environment.
However, we also suggest that current shareholders hold on to their existing positions because the valuation of the combined company, we believe, discounts these risks. On a pro forma basis, the shares sell at a price-to-sales ratio of 0.57 - well below the two companies' peers, and a discount to their respective historical averages. Even if one assumes that the pro forma sales results prove too high by 10%, the price-to-sales ratio is still an attractive 0.63.
Graham-Hackett is a technology analyst covering computer hardware and networking stocks for Standard & Poor's