Carly's Last Stand?

The inside story of the infighting at Hewlett-Packard

As Hewlett-Packard Co. (HWP ) Chief Executive Carleton S. Fiorina prepared HP's purchase of Compaq Computer Corp. (CPQ ) last summer, there were already red flags flying. In late July, when HP hired Goldman, Sachs & Co. to finalize the deal, the investment bankers' initial feedback was, "Are you sure you want to do this?" Goldman warned the stock would take a 10% to 15% hit right off the bat because of the massive risk of merging two $40 billion behemoths with such a big stake in the hardscrabble PC business. Then, on Sept. 2, two days before the deal was announced, Fiorina had to tweak her presentation to investors after a Goldman stock analyst warned that her pitch was too optimistic. And all the while, Fiorina knew that board member Walter B. Hewlett, the son of HP co-founder William R. Hewlett, might vote the 5.2% stake he controlled against the merger if Wall Street pounded the deal mercilessly.

The flags didn't fib. The merger news sent HP's stock skidding down 38% over the next two weeks, and Hewlett was true to his word. On Nov. 6, he gave Fiorina only a 30-minute warning before announcing he would vote his shares against the deal. That set in motion a bizarre tug-of-war, as Hewlett and Fiorina both hit the road to convince investors they knew what was best for the Silicon Valley icon. Each claimed they were making headway. Indeed, as late as Dec. 6, HP execs were chipper, saying the report being prepared for the David & Lucile Packard Foundation, HP's largest shareholder, with a 10.4% stake, was positive on how the merger would be executed. But on Dec. 7, Fiorina was dealt a body blow. The Packard foundation said it would oppose the deal, uniting the HP heirs against the merger.

Now Fiorina faces the Herculean task of persuading 67% of the remaining institutional shareholders to vote her way--or face her possible ouster. She has her work cut out for her. In interviews with eight institutional shareholders, BusinessWeek has learned that four are leaning against the deal, two will probably support the merger, and two are undecided. The eight hold about 7% of outstanding shares. Still, Fiorina says she can convince investors by the time they vote, which will probably be in March. "We started this because we think it's the right thing to do. And the foundation's decision doesn't change that," she says. And if she fails? She says she'll cross that bridge if she comes to it. "It is virtually unprecedented for a deal to go to shareowner vote and be voted down," says Fiorina. "If that were to happen, the board and management's credibility would be severely impacted."

In the face of daunting odds, Fiorina remains bold and unflinching--the very traits that brought her and HP to this high-wire perch. Ensconced in an HP conference room on a Saturday afternoon--just 24 hours after she received the Packard news--she maps out why the merger makes sense and why she has doggedly pursued it even though alarm bells sounded months ago. "My words to our board and to the Compaq board was that the market was going to hate this deal initially," says Fiorina. "The surprises were in degree." She didn't expect the stock to drop so far, nor did she expect Hewlett would oppose the merger publicly. She calls Hewlett's behavior "distracting and disruptive," and an "insult" to the HP board. Some management experts, however, say that if Fiorina knew Hewlett was wavering, she should have scrapped merger talks rather than risk a damaging proxy fight. "You have to question her business judgment," says Charles M. Elson, director of the Center for Corporate Governance at the University of Delaware. "Either [the board] failed to persuade him, or they ignored him. Either way, it's bad."

"ANALYZING AND ARGUING." The stage is now set for a soap opera of historic proportions. It pits HP's top brass against the children of beloved founders William Hewlett and David Packard, who are so revered that to this day their offices are left open and look as they did when the founders were alive--from the funky linoleum floors to the loose change atop Hewlett's desk. The face-off is sure to strain past and present allegiances: The Packard Foundation's board includes former HP CEO Lewis E. Platt, who backed the hiring of Fiorina. Richard A. Hackborn, a highly respected HP board member and a former HP exec of 33 years, also is a member of the Hewlett Foundation. Hackborn says if the deal doesn't go through, he'll resign. "The board has held many, many meetings analyzing and arguing about this deal. We think it's the best thing for the company. If the shareholders feel that's not the case, then I'm out of ideas." All told, these players will wage one of the biggest proxy fights in corporate history--one that could turn especially nasty. One HP executive hints at a possible lawsuit against Hewlett for improper corporate governance. Hewlett's attorney defends his client's actions. "What Walter is doing here is the highest example of a fiduciary trying to live up to his duties," says Stephen C. Neal, a partner in the law firm of Cooley Godward LLP.

Much hangs in the balance. If the deal is scotched, HP could fall into a dangerous limbo as an incoming CEO tries to figure out a fresh strategy. Compaq's future would be even more precarious. By throwing in its lot with HP, Compaq has signaled that it can't go it alone. That's already damaging sales. In the most recent quarter, Compaq's revenues fell 33%, compared with an 18% drop for HP and a 10% falloff for rival Dell Computer Corp. Compaq insiders say they remain committed to the merger, though they planned to discuss a backup plan at a Dec. 13 board meeting. Compaq board member Thomas J. Perkins says that if it looks as if investors are going to turn down the merger, the boards should dump the deal before it gets to a vote. He thinks the feud is about who will run HP--Fiorina or the families. "This is really a struggle for the soul of Hewlett-Packard," says Perkins. "Compaq is a bit in the crossfire. We can only cheer from the sidelines [page 71]."

Fiorina has no doubts about who is running HP and that a merger with Compaq is the best thing for the venerable computer maker. She says that these are just the early days in her campaign to show shareholders just how smart the deal really is. Persuasive detail will be in a proxy statement due out early next year. There is at least one more quarter of financial results from both companies that could improve the picture. And as regulatory approval is obtained, execs will be freer to share the data they have on product road maps, synergies, and cost-savings. "It ain't over till it's over" says Fiorina.

When all this is added up, it shows the potential for a tech titan with clout in nearly every major market, says Fiorina. Compaq's huge storage business would vault HP ahead of EMC Corp. in the fast-growth business. Compaq's robust Himilaya servers are popular with corporate customers who want super-reliable gear. The deal could double the size of HP's computer-repair business, churning out roughly $1 billion in annual profits. And the pair could take better advantage of the powerful Itanium microprocessor developed by HP and Intel Corp. (INTC ) On top of it all are huge cost efficiencies--some $2.5 billion a year by 2004. As for the pitfalls of the PC business? Fiorina says cost savings there can turn this, too, into a profitable business. Some analysts agree. "There's enormous opportunity for synergies," says CS First Boston analyst George D. Elling, who thinks HP's shares will be worth $40 if the companies execute as planned.

That's a big "if." This merger would be the biggest in high-tech history. Operations in 160 countries would have to be melded together, thousands of redundant products discontinued, and some 15,000 people laid off. Any missteps could result in losses from the massive $27 billion PC business that could undercut synergies in other areas such as servers, storage, and consulting services.

TOO MUCH CHANGE? Clearly, HP, the granddaddy of Silicon Valley, will never be the same. Its congenial, egalitarian culture will careen headlong into Compaq's confrontational one. And the increased reliance on commodity hardware will alter "Bill's and Dave's" legendary formula for success. For decades, HP prospered by building the most innovative products--ones that carried the juiciest margins. Only then could they run the company according to the HP Way, a set of corporate values codified in 1957 that give as much authority and job security to employees as possible. This deal instead casts HP as the No. 1 player in the commodity PC business, which means low margins and low job security. "HP has a long tradition of product development and a long tradition of innovating for the future," Hewlett told BusinessWeek on Nov. 6. "We shouldn't try to purchase the past."

If Hewlett plays a leading role in this drama, the central character is Fiorina--a charismatic CEO, whose irrepressible, can-do spirit could turn out to be her best asset as well as her biggest liability. Experts say her willingness to take radical steps was just the tonic HP needed when its growth stalled during the economic boom. Brought in 28 months ago, Fiorina quickly set out to transform HP into a Web services powerhouse, providing all the gear that corporations would need to do business on the Internet. She collapsed 83 units into six centralized divisions, wiping out fiefdoms and creating a more effective selling organization. She scrapped HP's cushy profit-sharing plan in favor of bonuses tied to company performance. And she goosed innovation by creating an incentive program that has doubled the number of patents HP filed this year. That same gutsy style, however, has worked against HP during the past year when the company was juggling too many disruptive changes while trying to grapple with an economic slowdown. The result was missed financial targets and some market-share slippage. "If the economy hadn't gone bad, Carly might be a hero by now," says one recent HP departee. "In the real world, there was just no way all these changes could work out."

And that may wind up being the ultimate irony of this saga. When all the details are spelled out, the merger may make sense. But it has gotten so bollixed up in squabbles with HP heirs and the ferment over changes within HP, that shareholders may shy away because it would mean even more disruption. And what of Fiorina, a self-described "change CEO"? She could become as successful as the master of change, Jack Welch, former CEO of General Electric Co. (GE ), or she could flame out like Jacques A. Nasser, a CEO who failed to get buy-in for his overhaul at Ford Motor Co. How HP wound up in this place serves as a cautionary tale for any executive trying to push through big makeovers without first building crucial support. "An outsider making change has a lot harder time than someone inside because they have no constituency," says Welch. The GE chairman says he doesn't know whether an HP-Compaq merger makes sense. But, he says, for a board member to vote one way and then reverse that stand is "unpardonable, it's a sin. It's corporate governance at its worst." He says this type of reversal wreaks havoc as employees who hate change think "they can get things back to the good old days."

Brand-new days were just what Fiorina had in mind last spring after she had revamped HP's organizational structure and was casting about for how to supercharge growth. In May, she hired consulting firm McKinsey & Co. to look at strategic options. These included a go-it-alone plan, one that would split the company up, and one in which HP would buy tech-services companies. Some of the options called for potential acquisitions. "Any name you throw at me, we've looked at them," says Fiorina.

DISCOMFORT. HP insiders say Compaq jumped to the fore on June 22. That's when Fiorina visited CEO Michael D. Capellas to see if he would license HP software but wound up talking about a merger instead. From the start, say insiders, HP execs and board members began hashing out the potential pitfalls of the merger. At one Thursday meeting in July, the McKinsey team gave board members a thick document outlining the synergies of the two companies. Hewlett, however, was not there. Instead, he was playing the cello in a concert at the Bohemian Grove north of San Francisco--an annual event he had appeared in for the past three years. Hewlett assumed HP would accommodate him, as it had in the past, and save important topics for the board's Friday session, says his attorney Neal. But HP's board plowed ahead, believing Hewlett wouldn't miss such an important session, says an HP insider.

In August, McKinsey went to the next step, laying out how HP might defy conventional wisdom and make a tech merger work. After studying a slew of deals, they reached this conclusion: Most of the botched tech mergers involved companies that were trying to buy their way into new businesses they knew little about. This deal, on the other hand, could be more like successful mergers in other industries where similar companies combined, such as Exxon and Mobil (XOM ). "There was a tremendous amount of deliberation," says Larry W. Sonsini, a partner with law firm Wilson Sonsini Goodrich & Rosati, who worked for HP during the negotiations.

And there was action. Two HP board members with experience doing huge mergers--Boeing CEO Philip M. Condit and Sam Ginn, who ran AirTouch Communications when it was sold to Vodafone Group (VOD ) in 1999--helped devise detailed integration plans. These included who would run each of the combined company's businesses and naming an integration office to merge the companies. Other board members developed cost reduction goals for each business. And the compensation committees of both boards worked up bonus plans to persuade key execs to stay on after the merger--to the tune of $55 million, should all the execs accept.

One issue the board did not successfully resolve was Hewlett's discomfort with the deal. "Walter was very vocal in the board meetings," says an HP insider. In an interview on Nov. 6, Hewlett said he was concerned that the acquisition would further expose HP to the PC business, diluting the earnings of its printing business. And one friend with ties to the Hewlett foundation says that Walter Hewlett feared the merger, combined with Fiorina's already radical reinvention of HP, would leave little of his father's company intact. Hewlett's vocal opposition should have been a warning in itself, say friends and colleagues of Hewlett's. They describe him as deliberate, analytical, and slow to make waves. Intensely private, he prefers playing chamber music and duck hunting to playing boardroom politics. "Walter is not the type to try to grab control of a board or twist arms to force his opinion," says former Bell Atlantic Corp. President James Cullen, who serves on the Agilent Technologies Inc. (A ) board with Hewlett.

HP did make Hewlett comfortable enough to approve the deal. After an August board meeting, Hewlett pulled aside Sonsini, HP's attorney, for advice. In a 10-minute discussion, Sonsini told Hewlett he could vote with the board to O.K. the merger and later vote his own shares as he saw fit without breaking his fiduciary duty to shareholders, says an HP insider. Hewlett never warned HP that he might publicly oppose the deal or declare a proxy fight, says the HP insider. Neal says Hewlett didn't explicitly say he would go public, but "no one had reason to believe he would come out quietly."

In hindsight, it's clear HP's board should have gone the extra mile to make sure Hewlett's misgivings wouldn't mushroom into a public showdown. At the time, advisors to the HP board debated among themselves whether to ask Hewlett to sign a document pledging his support for the deal, say HP insiders. In the end, they decided not to use such pressure tactics. "We didn't want in any way to embarrass the family," says an HP insider. "Instead, we decided to treat him like all other shareholders," and leave him free to vote as he wanted.

When the deal was announced, Hewlett's fears of an investor revolt came true. After the Sept. 4 merger announcement, HP shares plunged from $23.21 to $17.70 on Sept. 6, as investors slashed the value of the deal from $25 billion to $19 billion. Still, HP's brass didn't think Hewlett would break rank. Indeed, analyst John B. Jones Jr. of Salomon Smith Barney, Compaq's banker on the deal, sent a voice mail to top shareholders on Nov. 5 assuring them that the HP family still supported the deal. HP's execs also believed that. HP board member Hackborn, who sits on the Hewlett foundation, told Fiorina the foundation's stock committee did not plan to decide how to vote until January. By then, HP execs felt they would have swayed investor sentiment in their favor.

LITTLE WARNING. Unbeknown to HP, Hewlett was making his move. On Sept. 23, he visited the law offices of Cooley Godward in Palo Alto to make plans. His first step was to ask the stock committee of his parent's foundation to do their own financial analysis of the merger. The committee--which includes no family members, nor general board members such as Hackborn--gave the job to foundation Chief Investment Officer Laurance R. Hoagland. If Hoagland, a former director of Stanford University's $10 billion investment and real estate arm, decided the merger was in the foundation's best interest, Hewlett probably wouldn't vote the family trust's shares against it.

Hewlett, however, accelerated his timetable. Hoagland had planned to make his recommendation in January. With the stock languishing at around $16, Hewlett told Hoagland he couldn't wait. Hewlett wanted to know quickly whether Hoagland was going to oppose the deal--so he could do the same. His reasoning: If it's a bad deal, better to get it over with sooner rather than later. In early October, Hewlett hired San Francisco investment firm Friedman Fleischer & Lowe to do an analysis of the merger. When the foundation's stock committee agreed to meet on the subject on Nov. 6, Hewlett asked Friedman Fleischer to have their findings ready that day.

Hoagland and Friedman Fleischer came back with their conclusions that day: The deal would be bad for HP. Having already hired a press-relations firm to help get the word out, Hewlett called Fiorina to let her know what he was about to do. Just a half hour later, he issued the press release. Why did he give Fiorina so little warning? Insiders close to Hewlett say he was advised not to give her time to get out a press release and frame the issue to HP's benefit. The next morning, David Woodley Packard--who had resigned both from the HP board and the board of the David & Lucile Packard Foundation in recent years--announced he would vote his 1.3% stake against the deal as well. He felt the massive layoffs that would be brought on by the merger were counter to the HP Way.

Inside HP, the Hewlett and Packard offspring had quickly become a rallying point for the employees who had lost faith in Fiorina's management. In an Internet posting entitled "Walter Hewlett Is My New Hero," one HPer wrote on Nov. 11 that "he has given me a new energy simply by making his announcement. I pray that he gathers enough support to nix this deal, and hopefully, Carly can be swept under the rug along with it. Thank you, Walter, for standing up for what your Dad and Dave had created." While HP surveys done before Nov. 6 showed that 84% of employees supported the acquisition, that fell to 55% after Hewlett's bombshell. HP Vice-President for Human Resources Susan Bowick concedes that morale statistics are now "lower than we've ever seen them. Employees were really with us until Walter did what he did, but he opened up a flurry of doubt."

HP's brass fumed. Fiorina and board members had been frustrated with Hewlett's habit of missing parts of board meetings. Now they were angered about his going public, and about what they say was an unfair position paper prepared by Friedman Fleischer. "It's a misleading advocacy piece," says one HP executive. "Walter and David Woodley are acting without integrity in every conceivable way." Early next year, they vow they will refute Friedman Fleischer's findings in detail when they file their proxy statement.

GREAT EXPECTATIONS. To win over investors, Fiorina will have to convince them that the deal makes strategic sense and that she can implement it in a company already wracked by turmoil. Brought in as HP's first outside CEO, she quickly launched sweeping reforms that touched every facet of the company. The only problem is, it's unclear whether HP is better off for the changes. Indeed, some of the market share gains made in Fiorina's first year have begun to recede. While HP continues to dominate the inkjet and laser printer business with 41% share, its PC share has fallen from 7.8% to 6.9% over the past 12 months. Sales of HP's Windows servers have dropped from 10.6% to 8.2% in the same period. And while HP's share of the critical high-end Unix server business vaulted to 28% in the most recent quarter, up from 23.3% the year before, that puts HP back to where it was in early 2000, according to IDC. Meanwhile, HP remains an also-ran with single-digit share in software, storage, and consulting, says Technology Business Research Inc. analyst Robert Sutherland.

Worse, Fiorina was brought in by HP's board to find new sources of earnings growth, yet HP is more dependent than ever on its last gold mine: printer supplies such as ink cartridges and photo paper. This $9 billion business churned out $658 million in operating profit in HP's fourth quarter ended Oct. 31--the third consecutive quarter that it subsidized losses at the rest of the company, says Sanford Bernstein & Co. Fiorina says segments such as Unix servers and computer-repair services are making money. Still, "they're hanging on to profitability by a thread," says Sutherland.

How did this happen after such a promising start? Current and former employees say many of the problems stem from an organization reeling from too many changes. Out went the old system in which 83 product chiefs had their own research and development budgets, sales staffs, and profit-and-loss responsibility. Instead, there would be three "front-end" sales forces, for consumer products, corporate products, and consulting. These would market and sell products made by three "back-end" groups--printers, computers, and tech services and consulting.

At the same time, she cranked up expectations. Fiorina promised 15% revenue and earnings growth in the year ended Oct. 31, 2000. She delivered: Sales jumped 15.4% and earnings rose 15.8%. Such progress ended when tech buying started to drop in the fall of 2000. That November, HP missed the signs and continued to spend freely, while telling Wall Street it would make its numbers. It was only after the quarter had closed that Fiorina realized it was too late to hit the brakes. The result: HP's earnings of $922 million were 25% below Wall Street expectations. Even then, she didn't take her foot off the gas. She again pledged revenue growth of at least 15% for 2001, and days later told BusinessWeek that talk of a free fall in spending by telecom providers was untrue. "Telcos always say that this time of year," said Fiorina, a former Lucent Technologies Inc. exec who had spent 20 years selling to these accounts.

That earnings slip triggered a cascade of problems. For starters, it caused a 14% drop in HP's stock--which put an end to Fiorina's $18 billion bid to buy the consulting arm of PricewaterhouseCoopers. While panned at the time, the deal would have been far less onerous than the Compaq merger. What's more, the miscalculation forced management to take cost-cutting actions that were like stomach punches to HP's pampered troops. In December, HP asked workers to take five days of vacation, put off pay hikes for three months, and in January announced it would lay off 1,700 people.

ANGRY WORKERS. Things got worse. When management announced it would need to lay off 6,000 workers in July--less than a month after 80,000 employees had willingly taken pay cuts--the mood of many turned mean toward Fiorina. Management had tried to ward this off by sending out memos, saying layoffs were coming and that volunteering for pay cuts was no guarantee of continued employment. Still, many employees felt duped. And when a staffer shut down an internal message board after the Fiorina-bashing peaked, workers took it as a sign of insensitivity by their well-paid leader. "Either she has gotten remarkably bad advice, or she's actively trying to anger people," says one employee in HP Labs. A Fiorina backer, he thinks she should have taken a $1-a-year salary a la Apple Computer Inc.'s (AAPL ) Steven P. Jobs and Cisco Systems Inc.'s John T. Chambers, rather than her $2.9 million in salary and bonus for the year. Throw in the merger layoffs and "it's getting to be like Chainsaw Carly," gripes an HP veteran.

Fiorina's reforms fueled employee confusion. Take the front-back reorganization. On paper, it makes sense. HP's customers no longer have to deal with scores of different salespeople--and those that do call can sell the full suite of products. In reality, though, the new structure is riddled with problems, say more than a dozen current and former employees. For starters, managers accustomed to running their own show now lack the power to deliver on their goals. With no authority to set sales forecasts, back-end managers may not be able to allocate the R&D funds to stay ahead. At the same time, front-end sales reps may have trouble meeting their forecast if their back-end colleagues gin up the wrong products.

JUMP-START? These kinds of problems are a key reason investors worry about Fiorina's ability to execute such a megamerger. "It comes down to whether you believe management can pull it off or not," says Kevin M. Rendino, portfolio manager of the Mercury Basic Value Fund, which owns two-plus million HP shares. "If IBM CEO Lou Gerstner said he wanted to buy Compaq, I'd give him the benefit of the doubt. But what has she done to make me think she can pull this off? There's not a long enough track record---or enough accomplishments."

Fiorina's supporters argue that it's too soon to judge her results, which she always said would take three years or more to pay off. Even Gerstner took five years to transform IBM (IBM ) from a lumbering dinosaur into a limber powerhouse--and he didn't have to deal with the economic downturn of the past year. HP supporters point out that only a handful of major tech companies have remained profitable throughout the slump, including Microsoft, Intel, IBM, Oracle (ORCL ), and HP. "Before she became CEO, I was seriously thinking of shorting the stock," says Allison Kent, an HP manager in Richmond, Va. "But I think she knows exactly what needs to be done."

The game plan for winning big investors centers on Institutional Shareholder Services, which makes recommendations on proxy voting to many top HP shareholders such as Barclays. HP management will meet with ISS by the end of the year, and ISS is expected to provide an opinion shortly after the proxy is issued early next year. If ISS votes in favor, HP will then have to win over less than 50% of other shareholders. One wildcard that may play in their favor: Many institutions own both HP and Compaq shares and may vote for the deal on the assumption it would lift Compaq shares more than it would hurt HP's.

The essence of her message to investors is simple. She says the computer industry will commoditize and consolidate faster than people think. To stay ahead of that curve, HP needs to do a deal now that will give it enough bulk to take advantage of volume sales. She says the two companies buy $65 billion worth of materials a year. Execs figure that by combining they can save 1% of that, but she says the number could well be higher--say, 3% or 4%. Executives also believe they can make their PC business more efficient by moving closer to a Dell-like model of selling direct and doing away with the middleman. Compaq is closer to that model and can help HP make the leap. Says Compaq former chairman, Ben Rosen: "[The deal] will jump-start both companies in their race for efficiency."

That's assuming the deal happens. Much will be put to the test between now and the shareholder vote--a merger, a chief executive, and the fate of one of America's great companies. Massive change is always difficult, and executives either fall on their faces, like Nasser, or become heroes, like Welch. Which one Fiorina becomes will serve as a lesson for decades to come.

Corrections and Clarifications "Carly's last stand?" (Cover Story, Dec. 24) should have said that analyst George D. Elling works for Deutsche Banc Alex. Brown Inc., not Credit Suisse First Boston.

By Peter Burrows

Contributing: Andrew Park in Dallas, Jim Kerstetter in San Mateo, Calif., and bureau reports

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