Researcher Backs H-P-Compaq Merger

Updated from 4:40 p.m. EST

Carly Fiorina can take a breath. Just one, then it's time to start campaigning again.

Research firm Institutional Shareholder Services issued its report after the market's close Tuesday, lending crucial backing to the merger between Hewlett-Packard (HWP Quote) and Compaq(CPQ Quote). The ISS vote was considered a leading way for Hewlett-Packard to well up enough support overcome the Hewlett and Packard families' intention to vote their 18% against the merger.

"We believe that the Compaq merger provides a better means of maximizing long-term value by exploiting the potential of all of H-P's assets rather than just a single 'crown jewel,' " concluded report author Ram Kumar.

The 25-page document is a high-level discussion of HP's current plan for joining with Compaq, streamlining its operations, combining two distinct cultures and paying its executives should the merger go through. The ISS report is light on numbers, a breakdown of the two companies' product lines and in-depth discussion of the companies' markets. Instead it hinges on a she-said, he-said, detailing Fiorina and HP's plan vs. dissident board member Walter Hewlett's proposals. In the end, author Ram Kumar sides with H-P CEO Fiorina, but applauds Hewlett's vigilance and urges his continued participation on H-P's board of directors.

Both sides made predictable comments. Fiorina emphasized that the ISS was a "truly independent expert" in a press release heralding the decision. On the wrong side of the coin, Walter Hewlett dismissed the ISS decision based on his belief that it ignored the issue of shareholder value. In a statement Hewlett said ISS has "a predisposition to support management and makes a general presumption that boards do the right thing," something Hewlett does not hold to be true in HP's case.

Technically, only Barclay's Global Investor has pledged to follow the ISS recommendation when it votes its 3.1% stake, because CEO Patricia Dunn sits on the HP board. Yet ISS claims 20% of HP institutional shareholders as its clients, and in recent weeks it's become clear that a series of high-profile players have traveled through the ISS offices in an attempt to pitch their feelings on the merger. Obviously, both sides in the proxy fight have taken the ISS seriously.

Needham & Co. analyst Charlie Wolf thinks the ISS report will be well-read, but disagrees that it will definitely decide the outcome of the proxy vote. "Institutional shareholders are going to read this very carefully," Wolf said "But I think H-P loses the institutional shareholder vote. They may make it up with individuals, though. Individual investors may have a tendency to side with management, but that's not a certainty in this case, given that the founders' families are against it."

Onlookers have been divided in handicapping the outcome of the proxy vote in recent weeks as the battle between Hewlett-Packard management and board member Walter Hewlett escalated in intensity and sheer volume of paper. Though the Packard Foundation decision in December to vote against the merger opened a period in which Wall Street considered the pairing at risk, a cavalcade of advertisements, Securities and Exchange Commission filings and stump speeches by Hewlett-Packard swayed pundits in the months following. Recently, as the salvos among the company, Hewlett and David Packard have come at an even pace, the feeling grew that the Institutional Shareholder Services recommendation could make the deciding call.

Large announced supporters include Alliance Capital (2.3% of shares) and Putnam Investment (2.53%), but the Hewlett and Packard families alone control 18% of the company and have adamantly opposed the Compaq purchase. Only three of the top 10 institutional shareholders have publicly announced their intentions, leaving the ISS a crucial gauge to the success of the battle to sway investors.

Hewlett argues in the name of shareholder value, complaining that a combined HP/Compaq would be weighted toward the brutally low-margin personal computer business. CEO Carly Fiorina and Richard Hackborn, board member and builder of H-P's printer business counter that the Compaq purchase is about making HP a No. 1 player in the markets of the future, such as services, rather than relying on H-P's current lineup of products.

ISS's Kumar accepts the Fiorina/Hackborn point of view. He highlights the 600 people H-P and Compaq have working on integrating the two employee bases as an unusual step that may help the pairing overcome past tech merger shortcomings. The report also points to Compaq's more up-to-date PC operations as a plus that could push the combined PC business to profitability. He also notes Compaq's 62 inventory turns, compared to HP's 25 turn rate. Kumar notes that Compaq is "not too far short of Dell's eye-popping 70 turns per year."

Wolf refutes that line of thinking, however, on the basis that Compaq outsources manufacturing in its consumer PC business and that inflates its turns number. "That doesn't speak to the efficiencies of model," he scoffs. "That argument is crap."

Without a doubt, the ISS opinion is the most forceful voice of support for the merger outside HP's management structure. ISS has become a formidable ally as HP tries to balance out the Hewlett and Packard opinions, Wall Street analyst opposition and pressure on its shares.

On the day of the September merger announcement, HP shares fell 19%, while Compaq shed 10%. In the following months, HP stock went up as much as 24%, perhaps because of the increasing potential that the merger would fall through. Compaq shares did the opposite, falling 31% mid-November after a tough quarterly report.

Hewlett-Packard shares rose 0.2% in Tuesday trading to close at $20.60, while Compaq shares fell 0.7%% to $10.58, reflecting the uncertainty surrounding the ISS decision.