Compaq Forecasts Lousy Quarter

Updated from 5:28 p.m. ET

You can blame Dell (DELL Quote - Cramer on DELL - Stock Picks) for this one. Compaq (CPQ Quote - Cramer on CPQ - Stock Picks) reported first-quarter earnings a penny below drastically lowered expectations Monday and warned of a sharper decline in profits in the second quarter.

Compaq said that, excluding charges, it earned $200 million, or 12 cents a share, 1 cent shy of the 13 cents that analysts polled by Thomson Financial/First Call were expecting and below the 17 cents a share the company posted last year. Revenue came in at $9.2 billion, about $60 million higher than expected.

Those estimates weren't exactly pristine benchmarks. Last month Compaq warned that its first-quarter earnings would fall between 12 cents and 14 cents a share, the midpoint of which was a massive 38% below the company's prior guidance. It also cut its sales target to $9 billion to $9.2 billion -- as much as $600 million below the previous forecast and roughly 4% below the year-ago period, which itself was hardly a blowout quarter. That warning represented at least a tacit admission that Compaq was having difficulty sticking to the plan it outlined early this year: protect profit margins by remaining aloof from the price war that Dell is waging against its PC-making rivals.

The guidance CEO Michael Capellas gave on the conference call following the release Monday shows that nothing has changed much. Capellas said Compaq expects second-quarter revenue to be around $9 billion, about $200 lower than the first quarter and a considerable $2.2 billion, or 20%, below the same period in 2000. The outlook for profits is worse: about 5 cents a share, reflecting the cost of inventory reductions and the ongoing campaign against Dell for share of the enterprise hardware market. Analysts had expected the company would earn 17 cents a share in the second quarter, according to First Call.

Everyone has long known that about the vicious price-cutting in the PC business, which not surprisingly lost money in the quarter. The same story is replaying itself in the Windows NT server market. Price competition among competitors Dell and IBM (IBM Quote - Cramer on IBM - Stock Picks) caused Compaq to lose 2 to 3 percentage points in operating profit margins in the quarter, Capellas said. And it seems that fight will get only more intense. "There's no question that we're going to step up and protect that space and go after some share," he said.

So far, it's all unfolding as Dell said it would at its analyst meeting early this month. "The pressure from Dell continues to take a toll, both on the PC and in the Wintel server space," said David Bailey, an analyst at Gerard Klauer Mattison. (GKM hasn't done underwriting for Compaq or Dell.)

One of the things that is emboldening Compaq in its bid to match Dell blow for blow is the most recent in a long history of restructurings the company has undertaken. Highlighting the current effort is the elimination of 7,000 jobs, about 10% of its workforce and 2,000 more than Compaq said it would nix last month. The company said it would fire 4,500 workers and get rid of 2,500 more through attrition.

Meanwhile, Compaq is trying hard to reduce inventory, both its own and those within its channel of reselling partners. CFO Jeff Clarke said that channel inventory fell to 3.2 weeks from 3.9 weeks in the quarter. Compaq cut $250 million of inventory in the quarter, $150 million of which was on its books and $100 million of which was in the channel. Next quarter the campaign continues, with much more focus on the channel: Compaq targeted a reduction of $450 million worth of inventory. Of that figure, $300 million will come from the channel.

The company claims these reductions are permanent. If so, that can't but help in the long run. But in the meantime, the strategy could give Compaq less control over the terms on which it fights Dell on price. There's only one way to reduce inventory in the channel: stop selling products to channel partners until they've sold off the excess. In the meantime, while Compaq sits on its hands, Dell could be pumping new PCs and servers loaded with lower-cost components into the market.

Exactly where Dell's commoditization of the server market will lead that company is unclear at this point. But it's certainly giving everyone else fits.

"Dell continues to set the strategy for the industry," said Bailey. "That's had a severe impact on those that have had less efficient operations, and that's what Compaq is responding to."