HP and Compaq: It's Showtime

The cost-cutting looks doable, but other synergies may be more elusive than expected

On a sunny San Francisco weekend in early May, few passersby gave a second thought to signs at a downtown hotel pointing to the "Leadership Readiness Summit." But inside a packed ballroom, the crowd was riveted. After 48 hours of near-nonstop meetings with 325 managers from Hewlett-Packard Co. (HPQ ) and Compaq Computer Corp., HP Chief Executive Carleton S. Fiorina was giving final marching orders to her top lieutenants just days after the merger was completed. Seven decades ago, Fiorina said, no one thought it was possible to build a Golden Gate Bridge. Many naysayers, she added, believed the same about an HP-Compaq combo. Her rallying cry: Prove them wrong.

That may be tougher than Fiorina imagines. Granted, HP won kudos at a June 4 meeting in Boston with securities analysts for revealing that it has accelerated cost savings from the merger. But executives also said that, even though two computer giants have been folded together, the new HP still depends on printers and services for all of its profits. What's more, recent execution gaffes and strategic decisions about product lines going forward suggest Fiorina could have a hard time keeping her promise of holding the revenue loss from the merger to just 4.9%.

In the wake of the meeting, at least five analysts cut their revenue projections for HP--by 7% to 10%. "We understand that we have a lot to prove in the near-term," says Fiorina. Still, she insists the company can meet the merger goals on revenue slippage.

So far, the integration scorecard is mixed. At the Boston meeting, HP President Michael D. Capellas boasted that the company's printing and services divisions are "great bookends" that prop up sales and profits even when tech spending is in a slump. Looking at the books of the divisions in between, it's clear they need something to hold them up. If the companies had been operating as one, the HP and Compaq PC units would have posted a loss of $163 million in the second quarter, ended Apr. 30, compared with a $187 million loss a year earlier. The two divisions that make high-end servers, storage machines, and enterprise software would have lost $233 million in the second quarter, compared with a $1 million profit a year earlier.

Offsetting those dismal results were the printing division's $767 million in profits and a $358 million gain from services. A year earlier, printers would have contributed $364 million and services would have added $411 million. For the future, there's little prospect of change: The company says the printer business will grow by 10% in 2003 and 2004. By contrast, personal computer sales will fall this year and grow less than 2% next year. And profits? Expect losses or breakeven until 2004, when HP predicts its PC unit to turn in steady profits again.

In short, the PC operation appears to be moving in the wrong direction just now. While the company's goal is to emulate more closely Dell Computer Corp.'s build-to-order, direct-sales model, recent execution problems show little progress on that front. As consumer retail demand for PCs fell sharply in April and May, inventory in HP's sales pipeline widened from six weeks' supply to eight, while Compaq's rose from four weeks to six, says broker UBS Warburg. Dell (DELL ), by comparison, had just four days' finished goods on hand during the same period. Now, HP's inventory overhang means that the company will have to offer discounts and other sales incentives, producing more losses in the third quarter, Capellas says. "April-May is always a weak time," he says. "It was just weaker than we expected."

Worse, that weakness may continue if HP can't decide which PC brand it wants to focus on. The company surprised many when it said it will continue selling both HP and Compaq PCs in stores. HP says the two take up more shelf space, which will keep competitors from poaching their combined retail market share of more than 60%. But they'll also compete against each other for consumers' dollars and could create confusion. If that happens, "You'll find they will pull the plug on one line very quickly," says Gartner Dataquest analyst Martin Reynolds.

HP says the two brands will appeal to different groups. Compaq will be pitched to consumers who want to set up home offices and connect wirelessly to the Internet, says Jeff Clarke, Compaq's former chief financial officer and co-head of the integration efforts. PCs from HP, meanwhile, will be positioned as home entertainment devices and as digital imaging machines for photography enthusiasts. The secret sauce, Clarke says, is that two brands will create more PC sales than a single brand. And that means HP can sell more add-ons such as printers and digital cameras, which have higher profit margins.

Fiorina says the integration is on track. At the Boston meeting, she said the merger would help HP cut costs by at least $3 billion annually by 2004, outstripping earlier estimates of $2.5 billion in annual savings by then. "We are moving faster and achieving more" than expected, she said. The accelerated cost savings come from leveraging HP's new bulk to renegotiate contracts for supplies such as memory chips and hard drives. A big chunk of the savings--$1.5 billion annually--will come from trimming the payroll. On June 4, HP said it expected about 4,000 workers over age 50 to accept a generous, early-retirement buyout offer. In all, HP plans to pare 10,000 jobs by November--out of an expected 15,000 job cuts--hoping to quickly remove a cloud of uncertainty that has left many of HP's 145,000 workers in limbo.

Even though executives have devoted more than 1 million worker-hours to plans for integration, many hard choices remain. Before the merger, Fiorina proposed an aggressive, adopt-and-go plan--which called for lining up competing HP and Compaq products side by side, then killing off whichever was the weaker of the two. That led to the elimination of most HP-branded server computers using processors from Intel (INTC ), Compaq's Tru64 Unix operating system, HP business PCs, and its Jornada handheld. Yet much work remains: Before the merger, HP and Compaq made a total of 85,000 products. By November, the company will have cut that to 62,000. "We'd all like to see them quickly simplify their product line, but I think they're moving as fast as they can," says Merrill Lynch & Co. analyst Steve Milunovich.

The new HP still has a little time to enjoy the honeymoon. For now, Fiorina & Co. can blame weak results on the continued muted tech recovery. But the clock is ticking as skeptics look for signs that a bigger HP translates into a better HP. The cost cuts, they say, are a good first step, but HP will need to boost sales if the merger is to fulfill its real potential. "It is simply too early to tell what HP will be capable of delivering post-integration. The company needs to walk before it can run," says analyst Toni Sacconaghi of Sanford C. Bernstein & Co. If Fiorina truly wants to create a new HP as strong as the Golden Gate Bridge, she has a lot of building ahead of her.

By Cliff Edwards in Boston, with Andrew Park in Dallas

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