HP-Compaq: Where's the Upside?

The merged giants will lead in PCs--but not in costs or technology

On Sept. 5, a standing-room-only crowd of investors at Boston's Copley Marriott hotel listened to Hewlett-Packard Co. (HWP ) CEO Carly Fiorina and Compaq Computer Corp. (CPQ ) chief Michael D. Capellas explain HP's blockbuster $25 billion deal to buy its long-time rival. When they left the stage 30 minutes later, the applause was barely audible. "They are two pathetic companies just trying to survive," said Sanjay Jhaveri, a technology analyst at Zurich-based Vontobel Asset Management, shaking his head. "Their backs are against the wall."

Boy, are they ever. Fiorina's record-setting purchase, by far the biggest in computer-industry history, is supposed to create a high-tech powerhouse capable of taking on everyone from scrappy Dell Computer Corp. (DELL ) to mighty IBM Corp. (IBM ) Armed with the market-share lead in PCs, back-office servers, and printers, the new HP would have the sheer bulk and reach to turn these two troubled companies into one far healthier one. But investors don't see it that way. Shares of both companies collapsed after the Labor Day announcement. With HP shares plummeting 21.5% and Compaq tanking 15.7%, together the pair lost $13 billion in market capitalization in just two days, raising questions of whether the deal can proceed. "It's like taking two stones and tying them together to see if they float," says one large institutional investor.

Fiorina insists the market is overacting. "People are surprised. Clearly, we still have a lot of educating to do," she told BusinessWeek. But gleeful rivals are portraying HP not as a new juggernaut on the rise but as a wounded behemoth. "When two sick companies combine, I'm not sure what you get," Sun Microsystems Inc. (SUNW ) President Edward J. Zander told investors on Sept. 5. "This is a great opportunity for us, IBM, and others to go after market share."

The critics could be right. While there's plenty of potential, this deal is beset by mind-numbing problems. If the deal goes through, the merged company will have a 19% share, making Fiorina the global PC Queen--just as the PC industry is dealing with a worst-ever downturn that has resulted in $1.2 billion in losses and 31,000 layoffs so far this year. And while the deal is designed to lift Compaq and HP from also-rans to leaders in cushier markets such as high-end servers and consulting, just combining revenue streams won't provide the technology or top talent to get the job done. Plus, the odds of pulling off a successful mega-merger are against HP: Historically, such deals in the computer industry have bombed badly even in bright economic times. And the prospect of another bungled tech merger has hungry rivals licking their chops. "Our sales guys' eyes are lighting up," says Sun's chief marketing officer, John Loiacono. Adds Dell CEO Michael S. Dell: "If [this] is anything like other [industry] mergers we have seen, they are very hard to make work and can create significant distractions while we will be delivering great value to our customers."

Indeed, the deal could leave HP in a dangerous no-man's land. The company must cut costs to the bone to beat Dell in PCs while pouring money into research and development and consulting to take on IBM and others on the high end. Since more than half the new company's sales would be from low-margin PCs and printers, analysts wonder where those R&D dollars will come from. Indeed, rather than build up its R&D kitty, both Compaq and HP are moving away from proprietary high-end computers to focus on models based on Intel chips.

A LEAP. There's also no guarantee that the combo will result in the services powerhouse Fiorina is banking on. The deal would make HP the No. 3 player behind IBM and EDS, with an impressive $15 billion in annual sales. But while Fiorina's aborted $16 billion bid for PricewaterhouseCoopers last fall would have brought in a full stable of top-notch consultants, Compaq brings mostly lower-paid computer-repair people. While Compaq boasted a big services win when it landed a $100 million contract with Sabre Inc. (TSG ), the travel-reservation giant is relying on EDS for the more profitable consulting and outsourcing services.

Given all the obstacles, Fiorina and Capellas are taking a huge leap. They insist the risks are manageable. Regardless of the turmoil in the tech market, they say, HP-Compaq will be perfectly positioned when corporations start spending again. More focused rivals, such as IBM, Sun, and EMC (EMC ) have dominated the most profitable niches, they add, but customers tired of bubble-era tech promises will cotton to the new company's soup-to-nuts approach. And by slashing costs to stem losses in the near term, Fiorina and Capellas are betting on growing with the industry at 10% a year, handily beating even IBM's 5% clip in recent years. "There's a huge opportunity for stronger growth and more stable growth," says Fiorina. "But this is a lot of news. It takes people time to digest it."

Wishful thinking? Fiorina and Capellas do have a lot to work with. The deal, which they hope to close by next summer, would create a giant with revenues of $87 billion this year. That's just a smidgen smaller than IBM. It will dominate huge swaths of the tech landscape, not just PCs but also printers, where HP owns a more than 50% share and runs a hugely profitable printer-ink business. It will have a broader reach than any other tech company, from retail stores that sell to consumers to sophisticated back-office gear. "Combining their hardware skills and service efforts gets them much closer to critical mass across the board," says Intel Corp. (INTC ) CEO Craig R. Barrett. "It would seem to me to make a whole lot of sense."

The idea is simple enough: First, fall back on the cost efficiencies that come with sheer bulk, then concentrate on gaining momentum on the higher-growth, high-margin sectors. By combining operations, Fiorina expects to emerge with a far more efficient company able to churn out profits thanks to volume. HP estimates it can save $2.5 billion a year starting in 2004, largely by cutting 15,000 jobs. And it will exploit its market power for everything from better deals with suppliers to pressuring software developers such as Oracle Corp. (ORCL ) and SAP (SAP ) to push HP gear. Then, over time, it will develop the consulting and software smarts to help customers deliver whizzy new offerings. "Today is about changing the game--not only for our two companies but about changing the industry itself," says Fiorina.

The proposed deal is winning praise from HP's allies. Besides Intel's Barrett, Oracle CEO Lawrence J. Ellison is a fan. "This will be the biggest hardware company in the world, and that gives them tremendous market power," says Ellison, who dismisses Wall Street's chilly response. "Keep in mind, the [stock] market is the one that said Ariba Inc. was more valuable than Daimler Benz. That's the market for you."

All true. But Fiorina and Capellas still face a mind-numbing merger that will involve integrating scads of overlapping product lines and 150,000 people in 160 countries. HP has never done an acquisition anywhere near this big. And many of Compaq's problems stem from its 1998 purchase of Digital Equipment, which itself was billed as a vehicle to transform Compaq from a mere purveyor of hardware to a soup-to-nuts tech-services provider to take on IBM. What's more, both companies have struggled to absorb sweeping reorganizations in their own right. Many HP insiders feel Fiorina should have backed away from the PC business and other trouble spots rather than add to HP's complex structure.

But that's hardly an option for Fiorina. HP is more reliant on its core PC and printer sales then ever. With 42% of HP's growth coming from PCs in 2000, there was no backing out now. And while PC sales help the top line, profits from the printer-supplies unit held up the bottom line. The $7 billion operation, which makes printer ink and paper, brought in all of HP's $469 million in profits for the past two quarters, according to analysts. Fiorina's plan had been to let the high-end computing business--servers, storage, software, and services--do the heavy lifting in 2001. But the economic downturn and poor execution, including product delays and reorganization-related confusion, quashed that.

And while the merger gives HP gigantic market share in many areas, that share is shrinking in many key areas. Although it enjoys the biggest share of the PC market now, the combined company's share is expected to remain flat, while Dell grows 30% a year. HP's 35% share in servers is down from 39% in 1999, according to Gartner Dataquest analyst Martin Reynolds. And while HP should benefit from Compaq's surging storage business, other areas of big share gains are few. Mostly, it could gain in nascent markets such as handhelds, where Compaq's iPaq is a hit, or in markets where it has a small presence.

Still, Fiorina is convinced she's on the right track. "I wouldn't do this if I thought it would be a detour," she says. "I only do it because I think it will accelerate our progress." She admits the challenges are great, and there are holes in the strategy. Once the merger is moving smoothly, by next year, she says she'll look at more acquisitions to pump up that services capability. But not now. "We can't bite off more than we can chew," she says. And if she already has? Given the sweeping internal problems each inherited from predecessors and the economic downdraft they've since run into, it's likely neither Fiorina nor Capellas could have achieved their respective grand ambitions on their own. Then again, it's not at all clear they'll be able to do it together, either.

By Peter Burrows in San Mateo, Calif., and Andrew Park in Dallas, with Steve Hamm and Geoffrey Smith in Boston, and bureau reports

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