Guidance Puts Compaq in a Delicate Balancing Act

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Updated from 4:54 p.m. ET

Compaq (CPQ) reported earnings and revenue surpassing drastically lowered expectations Tuesday, sending the stock soaring in after-hours trading. But while investors were bidding up those shares, the company was quietly turning its guidance for fiscal 2001 into a high-wire act.

For the fourth quarter, Compaq said that, excluding charges, it earned $515 million, or 30 cents a share, surpassing the 28 cents that analysts polled by First Call/Thomson Financial were expecting. Revenue, meanwhile, came in at $11.5 billion, around $200 million more than expectations. Never mind that estimates for both earnings and revenue had been sharply reduced after Compaq warned investors of shortfalls in early December. Compaq shares caught fire on Instinet, rocketing as high as $24, or 20% above their New York close of $20.05.

But investors thinking of piling onto that bandwagon might want to look more closely at the guidance the company gave for 2001 sales and earnings. On the conference call following the earnings release, CEO Michael Cappellas told analysts to expect revenue to grow 6% to 8% in 2001. The low end of that growth rate would put Compaq's sales at $44.93 billion, or about $1.3 billion below the latest First Call consensus estimate. Even 8% growth would leave 2001 sales around $450 million short of Wall Street's expectations.

Moreover, Compaq thinks it will need a second-half rebound to get to that 6%-to-8% range. Capellas forecast sales growth in the 3%-to-5% range for the first half of 2001. For the first quarter, he told analysts that they should look for revenue to come in at $9.61 billion, nearly flat from the year-ago period and $600 million lower than the consensus estimate compiled by Multex.com.

Here's the kicker: Despite those reductions in guidance, Compaq isn't lowering its outlook for earnings per share in 2001. Capellas said the company remained comfortable with analysts' expectations of EPS growth in a 20%-to-25% range. Meanwhile, Capellas told analysts to expect earnings of 21 cents a share for the first quarter, a penny above the consensus, despite the expected $600 million shortfall.

Exactly how does Compaq plan to pull this off?

"That's the question I'm grappling with," said SG Cowen analyst Richard Chu. "I'm not sure. They're talking about a $2 billion drop in revenue between Q4 and Q1. I'm surprised that they effectively brought down revenue guidance fairly significantly, particularly for the first quarter, without changing EPS." (SG Cowen hasn't done recent underwriting for Compaq.)

The plan, according to Compaq, is to abandon the least-profitable parts of the market. In other words, adding a new twist to the unfolding PC price war story, Compaq claims it's not going to fight for market share in the low-end PC market.

"We will not price down to the very lowest levels to gain share that we know is fleeting," Capellas said. "We've learned that bought share is rented share. We prefer to take a more comfortable approach to pricing, one that is competitive but not as aggressive as we could be."

Capellas knows the cost of chasing market share. That strategy helped Compaq's commercial PC group rack up huge losses in 1999. It took the company, under Capellas' leadership, more than a year to bring the commercial business back into the black. This time around, Compaq lost money in its normally profitable consumer PC segment, thanks to a very tough pricing environment in that market.

Many investors would cheer a decision by Compaq to back off of the low-end PC market. But it remains to be seen whether Compaq can avoid the price war in the higher-end machines more typical in the corporate market. That market includes Dell (DELL), which vowed on more than one occasion to use price-cutting to win market share.

It's unlikely, then, that Compaq will be able to make its first-quarter and full-year earnings estimates without strong performances in its enterprise hardware businesses -- i.e., servers and storage devices. Both of those markets are seeing stronger demand than the PC industry, and both are more profitable.

But both are getting increasingly crowded by large firms like Hewlett-Packard (HWP), IBM (IBM), Sun Microsystems (SUNW) and EMC (EMC).

For now, Compaq flies through the after-hours markets with the greatest of ease. But Compaq will soon have to give analysts and investors more details on how it intends to carry out 2001's balancing act. The company will hold its annual analyst meeting Friday morning in Houston.

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Sometimes the corporate accountants taketh away.

Don't forget that Compaq's fourth-quarter results excluded a whopping $1.8 billion charge for the writedown of its tanked Internet investments, mainly CMGI (CMGI). Including that charge, the company lost $672 million, or 39 cents a share.

Compaq's writedown is about $800 million more than Capellas had estimated on the company's conference call following last month's earnings warning. Since that time, though, CMGI has plummeted another 35%. Compaq picked up its stake in CMGI -- a $220 million note and stock equivalent to 41.6 million split-adjusted CMGI shares, some of them preferred -- in June 1999 in exchange for 82% of its AltaVista unit. At the time the transaction was announced, those shares were worth about $2 billion. Now, they're worth about $271 million. It should be noted that Compaq never spent any cash for its CMGI stake.

CMGI isn't where the charges end, though. In June, Compaq spent $25 million to buy roughly 1.72 million shares of CMGI's publicly traded, online advertising subsidiary, Engage (ENGA).

Those shares are now worth about $3.1 million. Compaq also holds shares in such steadfast tech outfits as divine Interventures (DVIN) and AskJeeves (ASKJ), down about 86% and 98%, respectively, from their peaks.

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