Against All Odds

It’s getting to be a bit like a movie with multiple
climaxes. HP CEO Carly Fiorina announces the HP-Compaq merger. Analysts and
investors thumb it down. Carly and Compaq chief Michael Capellas crisscross the
US of A canvassing support. Analysts begin to say–well, maybe, the merger just
might work in the (very) long run. Then the Hewlett and Packard families step in
and say—nothing doing, bad idea.

Analysts go back to their books to calculate shareholder
patterns and do voting analyses.

But the story’s just begun. In the worst setback since the
merger announcement, HP co-founder William Hewlett’s three children–Walter,
Eleanor and Mary Hewlett–announced on November 6 that they would oppose the
merger with Compaq if the matter ever came to a shareholder vote. Walter Hewlett
gave a long list of reasons why the merger didn’t make sense, including an
increased exposure to the not-very-profitable PC and low-end server segments,
reduced revenues from HP’s profitable printing and imaging business and Compaq’s
services profile.

But the more telling indictment came the very next day from
the other co-founder David Packard’s eldest son, DW Packard. He spoke out
angrily against the merger, against the abandon with which Fiorina had been
announcing lay offs (see quote above) and against her management style in
general. "For some time, I have been skeptical about management’s
confidence that it can aggressively ‘reinvent’ the HP culture overnight.
This is a culture that developed over many years and was thoroughly tested under
all kinds of business conditions. While change is necessary and inevitable, it
does not mean that every innovation in an improvement."

This was not just about the merger. It was about Fiorina
herself. Walter Hewlett sits on the HP board and according to one estimate, the
Hewletts own about 5 per cent of company stock. Packard does not sit on the
board and owns only 1.3 per cent of stock though the Packard Foundation run by
the family controls about 11 per cent of stock.

While together that might still be a formidable opposition in
a voting scenario, the question really is not about how much stock they own. But
how many shareholders they can influence. Given HP’s tightly knit culture so
far and the influence the Hewlett and Packard families have, that can be a lot
Carly Fiorina had known it would be a tough deal to sell from the very
beginning. But she seemed like she had the board in her pocket and that if she
worked hard and long and smart — she could get the others around — including
investors and customers. But in the last two months, she’s been confronted
with one bad piece of news after another. Since the merger announcement, the WTC’s
twin towers have crumpled, the PC market has entered into an official recession
and Compaq has posted miserable Q3 results. The markets have crashed so badly
that the deal initially valued at $24 billion, is now down to a little over $16
billion.

And just when analysts were beginning to reconcile themselves
to the HP Compaq merger going through — with or without their approval, the
families stepped in. Fiorina’s worst nightmare could have just begun.

At the time of going to press, HP’s year end results were
due (on November 15) and many analysts believed that the fate of the merger and
indeed, of Fiorina herself, would rest on how the company fared. However, since
the results will be out by the time you read this, we will not conjecture on
what Carly or the HP board will say viz a viz the merger. Instead, we will look
at what the IT universe looks like two months since the merger announcement and
its implications for HP and Compaq at this point of time.

The September effect

In two words, not good. Economists have been hesitating to
use the term recession for the last one year. But post September 11, investment
bankers are bracing themselves for one. The signs are apparent in the PC market.
And most of new HPs revenues come from this sector.

When Fiorina announced the merger on September 3rd, she
couldn’t have anticipated any of this. July and August had looked good and a
spike in September sales has been more or less and article of faith in the PC
industry. More than in any other quarter, the last month of Q3 accounts for
almost 50 to 70% of quarter sales. Mostly because of back-to-back school sales
and sales in Europe.

But then September 11 happened, a full 20 days before quarter
end and all estimations went for a toss. According to the Gartner Dataquest
quarterly estimation, worldwide PC shipments in the third quarter fell 12%
compared to the third quarter of last year. Compare that with an average growth
of 15 per cent witnessed in the past few years. Within those numbers lies an
even more uncomfortable truth for Fiorina - Dell has been the only company that
has seen growth in unit shipments over the quarter even as everyone else, HP and
Compaq foremost among them, took a beating.

"As we look out," he said, "visibility is very
tough." According to Gartner, Dell shipments grew by over 10 per cent while
Compaq shipped 3.18 million units, down by over 31% and HP shipped nearly 2
million units, down by 24.6%. Certainly, put together HP and Compaq pip Dell to
the number 1 position in terms of market share. But put together, HP and Compaq
shipments have also fallen by nearly 30% in the quarter.

At Compaq’s Q3 announcements, Capellas said the downturn,
September 11, falling sales after the merger announcement and a typhoon in
Taiwan, all contributed to "the perfect storm of troubles" for Compaq.
Another problem that Capellas did not mention—almost 42% of Compaq’s third
quarter revenues of $7.5 billion, came from PCs, which, in Walter Hewlett’s
words, is "neither growing nor profitable."

The investor effect

Investors have not been unaware of this. After September 11,
stock markets have plummeted everywhere and nowhere more so than the US. And
even there, HP and Compaq have led the charge downwards. Immediately after the
merger announcement, HP shares fell 19% with worries that the merger would do
nothing to boost either company’s profitability. Investors haven’t found
anything to change their mind since. By November first week, the value of the
deal had slid by 34% from $ 24 billion two months ago to a little over $ 16
billion.

As David Katz of Matrix Asset Advisors said in his letter to
the two boards, "Investors clearly voted against the merger with their
feet. Both stocks have been in virtual free-fall since the September 3
announcement. On days where technology or the market has dropped, Compaq and HP
have led the charge. However, on days of recovery, your stocks have consistently
not participated."

Compaq shareholders are not likely to happy about this.
Despite the fact that this is slated to be the biggest technology merger of all
times, many people believed that the Compaq board accepted a relatively low
acquisition price - a 19% premium over the then market valuation. Specially when
just two months ago the valuation stood at almost double.

The HP board itself may be doing a bit of a rethink now,
especially after the explicit opposition from DW Packard and Water Hewlett (who
also sits on the board).

The FUD effect

While the economy is feeling none too good and investors none
too happy, its the FUD (Fear, Uncertainty and Despair) factor that is going to
determine the medium term health of the new HP. At the customer end the
trepidation is about product lines and questions about continuing support to
what is now a very large and complex family of products and technologies.

Analysts have been advising customers to insist on fine print
protection clauses in contracts with either HP or Compaq. Even so, as a Gartner
group analyst put it, "Customers just don’t know what product lines will
stay and which will go. They are being asked to make long term investment
decisions on insufficient data. And they can’t."

At a pre-announcement of lower revenue estimates in Q3,
Compaq admitted that customer FUD factor pressure had contributed to falling
sales. CFO Jeff Clarke said savings from the company’s cost cutting measures
had not been able to offset problems of the past month including slowing sales
after the merger announcement.

For the moment however, there isn’t a great deal Fiorina
can do about this. To avoid charges of collusion, she cannot announce the
rationalization of product lines till after the Justice Department’s approval.

The bigger problem however could come from FUD factor
reactions from employees. Both companies have already gone through multiple
rounds of lay-offs, not all of which were handled well. In July, Compaq had
announced 8500 lay offs while HP announced 6000 employees would have to go. On
September 3, Fiorina announced that another 15,000 employees would be laid off
from the new HP after the merger. She is, in fact, banking on a significant
portion of the expected $ 2.5 billion in savings to come from employee cuts.
That apart, both Compaq and HP have indicated that more pre-merger layoffs may
be on the way.

This is precisely what David Packard was reacting to when he
voiced his disapproval against the merger. HP has always been a very closely
knit company and the famed HP Way had a lot to do with how employees were
treated. Now many people, Packard among them, feel that Fiorina is threatening
that culture. Packard was particularly virulent about Fiorina’s "weakest
link" lay off policy — a modern day HR practice prevalent in the IT
industry where the "Bottom 5%" employees are weeded out, irrespective
of their absolute performance.

Packard said while opposing the merger, "HP never did
that. It never happened before. HP almost never laid anybody off."

Morale is low in both companies. Especially at Compaq where
employees feel a little more threatened. If and when the merger finally goes
through, competition for lower and middle management jobs will leave a lot of
bad blood behind. To go back to David Katz’s letter, "we also
believe...that synergies based on cost reductions from layoffs are not synergies
at all, but are in fact morale-destroying distractions. Our own due diligence
indicates that internal morale is poor at your companies, and that the reaction
internally to the merger is also quite negative."

One could argue that morale per se is not a big issue. Except
for the fact that it will have an immediate, telling and very negative affect on
sales and support services.

The near future

IDC has forecasted that PC sales are likely to remain under
pressure through 2002 with single digit growth expected in 2003. They are likely
to go up into double digit growth rates again in 2004 before settling down to
sub-10% figures. Corporations are not expected to go into a major upgrade cycle
anytime soon. The Windows XP launch on October 25 was supposed to push PC sales
but that, as it turns out, is not happening.

On the other hand, the recession has touched Europe and those
who were looking across the Atlantic for a spike in hardware sales will have to
do some recalculation. Even in India, the third quarter was completely flat. As
Suresh Vaswani of Wipro Infotech put it, "Typically, there is a 35% jump
from Q2 to Q3. But this year it was amazing–it was completely flat."

End of story? So what’s it going to be? Is Compaq merging
with HP or not? Is Fiorina on her way out or will she make it through this
storm?

Before the families got active, Fiorina and the HP board
seemed certain on both counts–Fiorina would stay and the merger would happen.
Even after the family statements, the HP board said, "While we regret the
family’s decision, we aren’t surprised. The HP board and both companies
remain fully committed to the merger and expect shareholder approval."

But boards are notoriously fickle things. Remember it was not
very long ago that there was talk of Fiorina losing her job for the botched up
Price Waterhouse Coopers deal? A lot more is at stake now. If the merger goes
through, HP is in for a long haul on integration issues. If the merger does not
go through, it has to pay a $ 675 million breakup fee for the merger. Either way
— expect a lot of activity at the HP end in the next few days.

As for Fiorina, the "Comeback Queen", has this
whole merger issue suddenly gone way above her or will she pull another rabbit
out of the hat and say to the board as she said to Micahel Capellas — "I’ll
make you an offer you cannot refuse." Hopefully, we’ll know the answers
soon enough.

Fiorina’s Things-To-Do List

Sarita Rani in
Bangalore