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Where’s the Upside

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DQI Bureau
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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.

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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.

How an HP-Compaq Combo Would Measure Up
  • PCs With 19% marketshare, it would be the world’s largest

    PC maker. But with PC sales and margins at record lows, the companies

    have lost a total of nearly $500 million this year, while Dell

    continues to gain muscle and mindshare
  • Printers HP’s dominant 50% market share would grow, as

    would sales of its hugely profitable printer ink. But margins and

    sales are weak, and pricing pressure is mounting from Lexmark, Canon,

    and other rivals
  • Low-end servers Compaq dominates, and the combined companies

    would have a huge 37% market share in Windows-based machines. But

    cutthroat competition from Dell and IBM could eat away at sales
  • Software Providing soup-to-nuts solutions for big

    corporations requires specialized software called middleware. But

    Hewlett Packard lags way behind rivals, and Compaq is a no-show
  • Storage Compaq’s $5.2-billion storage business should get

    a big boost as Hewlett Packard sells Compaq gear to its customers.

    Still the merger wouldn’t help HP take customers from storage giant

    EMC and others
  • High-end servers In this key high-margin market, Hewlett

    Packard and Compaq are laggards. Compaq will phase out its Alpha

    servers, while HP’s high-end Unix machines have stagnated against

    Sun Microsystems and IBM counterparts
  • Services HP and Compaq covet IBM’s services business. But

    62% of their 65,000 service specialists do basic computer repair, not

    the lucrative high-end consulting Big Blue specializes in
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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.

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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.

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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.

Making

a Case for Combining
The proposed merger of Hewlett-Packard

and Compaq Computer was panned by a skeptical Wall Street after it was

announced on September 3. Now Carly Fiorina, chairman and CEO of HP, and

Michael Capellas, chairman and CEO of Compaq, have a big sales job ahead

of them. On September 5, they spoke with BusinessWeek associate editor

Steve Hamm and computer department editor Peter Burrows to make their

case.

How are you trying to sell this merger to investors?

Fiorina: Initially people hear a cost- reduction story. And

there’s certainly a huge opportunity for value creation in the

relatively short term. But we need to continue to accentuate that there’s

huge opportunity for stronger growth and more stable growth. This is a lot

of news. It takes people time to digest it.

What’s your vision for how the combined company will look? Will it

be a growth company like Dell or an earnings company like IBM?

Capellas: With a company of this size, you won’t have the

growth rate of a smaller company, but you’ll also have steady earnings

growth with less variability.

Fiorina: Look at the revenue balance of the combined company. If

all it does is grow at market, and you’re talking about 10%, that’s

nothing to sneeze at for an $87 billion company. But you also get $1

billion a quarter of free cash flow. That’s pretty impressive.

What do you see as the real growth engines of the company?

Capellas: First and foremost you’ve got services growth, the

fastest-growing segment of the whole IT market. Managed services and

outsourcing is growing fastest. The customer service side is growing

slower but is very profitable.

Where are you taking services?

Fiorina: We’ll continue to organically grow, particularly the

outsourcing and consulting ends of the business. We’ll be looking for

strategic opportunities for acquisition. Also, consulting companies know

they need a partner with the engineering capability to build the technical

infrastructure. Who are they going to call? Are they going to call Dell?

Hell no. There’s one company they’re going to call. It’s this

company.

Can you ever be as efficient as Dell in the PC business?

Capellas: There is very clearly a balance between innovation and

being first to market on one hand, and pure, raw, low cost on the other

hand. If you don’t spend any money in R&D you will by definition

have a couple of points on the bottom line, but you’ll also never lead

in any new product categories, so you won’t get the margins there. A

model that puts nothing into innovation is not sustainable over time.

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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

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