Where’s the Upside

On September 5, a standing-room-only crowd of investors at Boston’s Copley
Marriott hotel listened to Hewlett-Packard CEO Carly Fiorina and Compaq Computer
chief Michael 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 to mighty 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 President Edward Zander told investors on
September 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 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, 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 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.

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 CEO Craig 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 and
SAP to push HP gear. Then, over time, it will develop the consulting and
software smarts to help customers deliver whizzy new offerings.

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. 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. 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 and Andrew Park in Dallas,
with Steve Hamm and Geoffrey Smith in Boston, and bureau reports
in BusinessWeek. Copyright 2001 by The McGraw-Hill Companies, Inc