Can Compaq Survive as a Solo Act?

With competition heating up and sales shrinking, investors are losing faith

For three months, Compaq Computer Corp. (CPQ ) CEO Michael D. Capellas has been so gung ho about the $23 billion Hewlett-Packard Co. (HWP ) deal that he has been telling his top lieutenants there's no need for a fallback scheme. "Plan B is see Plan A," Capellas has said.

Now, it's time for a real Plan B. With opposition to the deal coming from members of the HP founders' families, Compaq is preparing for the bleak prospect of going it alone in an industry that has been ravaged by price wars, slowing growth, and consolidation. In a Dec. 7 memo, Capellas told employees that Compaq's "responsibility is to maintain a pragmatic view of our business and a clear focus on the future," no matter what happens with HP. At a board meeting on Dec. 13 in Houston, Compaq's directors were to discuss how to help sell investors on the deal and hash out plans should there be no deal. "Obviously at this juncture, Compaq has a Plan B," says Thomas J. Perkins, a Compaq director.

If the deal collapses, the future looks shaky for Compaq. Perkins says the company will remain independent. But going it alone after signaling to the market it needed a partner will be difficult. Compaq will have to focus on its best-performing businesses, like Windows servers and storage devices--and shed such poor performers as home PCs and high-end computers that are heavy on technology but light on market share.

Compaq's woes only deepened after the HP deal was announced on Labor Day. The distraction of the merger, coupled with the effect of September 11 and Typhoon Nari's impact on Compaq's supply chain, pushed third-quarter sales down 33% from the quarter a year ago, to $7.5 billion. Desktop computer sales fell 42%, and PC server revenue tanked 44%. For the period, Compaq lost $499 million, including a charge for losses from its investment in the Internet company CMGI. By contrast, Dell finished its third quarter ended Nov. 2 with a profit of $429 million on $7.5 billion in sales, which were off only 10%.

Time isn't on Compaq's side. Analysts have slashed next year's profit targets by 76%, to $271 million. And sales, expected to fall 23% this year, are pegged to drop 6% more next year, to $30.7 billion, which would be the lowest in five years, says Merrill Lynch & Co. analyst Steven M. Fortuna. The company is losing market share in key areas such as PCs, servers, and handheld computers, as rivals sow doubts about its future. If the merger with HP falls apart, UBS Warburg analyst Don M. Young says Compaq shares, already at an anemic $9.79, could tumble to $5, below its $6.63 book value. "The only company that really needs to do this deal is Compaq," says Young. "HP has options. Compaq has problems."

One solution may be for Capellas to drop some businesses. Analysts say that if the merger with HP fails, Compaq will have to exit the cutthroat consumer PC business, which accounts for one-third of its $17 billion in PC revenue. Already, Compaq is evaluating "any and all options," even taking products off retailers' shelves in favor of in-store kiosks and Web sales, says one executive in Compaq's PC business. Capellas declined requests to be interviewed.

UNDER ATTACK. Falling PC profits drove Compaq into the cushier server business in the early 1990s. Today, that business is under attack as well. While PC servers make up one of Compaq's strongest product lines, they have been steadily losing profitability. Late last year, Dell (DELL ) started a price war and by the first quarter was storming ahead in North America, the largest market, with a 32% share according to researcher IDC Corp. Only by slashing prices has Compaq been able to stay close to Dell with a 30% share. But it paid a price: Revenue fell 16% in the third quarter, to $1.4 billion, even as unit sales held steady. Dell has no plans to call a truce. Says CEO Michael S. Dell: "That's the last place we're going to lighten up."

Capellas can't count on pricey high-end computers to make up the sales shortfall. In the third quarter, IBM's share of total server revenues soared seven percentage points, to 30%, while Compaq's share fell nearly two points, to 14%, according to Gartner Dataquest. One reason for the gap is that IBM and Sun Microsystems Inc. are bringing out new high-end servers, while Compaq is phasing out its lineup in favor of new designs from Intel Corp. The new machines won't hit the market until 2004. The move holds promise for Compaq, which has conquered Intel-based server markets before. But if revenue continues to slide, Compaq will have to dump older product lines, analysts say.

Capellas will likely return to his ambitious plan to turn Compaq into a services company a la IBM (IBM ). On its own, though, Compaq has little chance of getting there. It lacks IBM's software prowess, a key to selling the large integrated solutions, as well as consulting and outsourcing skills that generate big revenues and steady profits. Compaq has a $7 billion services business, but 56% of its revenue comes from maintenance and support, which only grows as fast as computer sales.

For now, the Compaq board is backing the HP merger. The recent tussling over the deal does not spring from a change of heart on Compaq's part. "It's a deep flaw within Hewlett-Packard," says Perkins. Still, Capellas had better start fleshing out Plan B.

By Andrew Park in Dallas

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