H-P, Compaq Stagger Arm in Arm Into the PC Era's Twilight

For some, the news of Hewlett-Packard's (HWP) deal to acquire Compaq (CPQ) is a flashback to the Arlo Guthrie song Alice's Restaurant.

You'll remember that in Guthrie's musical tale, he gets into trouble when he and a friend, trying to dispose of a half a ton of garbage, spot another pile of garbage at the bottom of a cliff off the side of a side road. "And we decided," says Guthrie, "that one big pile is better than two little piles."

That's not to say that two companies with a combined $87 billion in revenues are no more than trash in the back of a red VW microbus. Rather, the point is that to outsiders, the problems faced by the two companies don't seem to be addressed by lumping them together.

As Nick Moore, portfolio manager at Jurika & Voyles succinctly put it, "It's hard to imagine what scale economies $90 billion has that $40 billion didn't."

The market at large didn't appear to disagree, after the $25 billion all-stock deal was announced late on Labor Day. At midday Tuesday, H-P was down $3.11 to $20.10, while Compaq was off 31 cents to $12.04 -- a 5% discount to Compaq's implied value in the deal, given that shareholders are slated to receive 0.6325 H-P share for each of theirs.

H-P and Compaq say the deal strengthens their hand in the high end of their product line and will help cut costs throughout the organization. Specifically, they say they'll cut $2.5 billion in expenses annually within two years of their deal's expected close in mid-2002. More precisely, three-quarters of those efficiencies will come from job cuts; the companies, each of which has already cut its work force, expect to trim another 15,000 from their combined employment rolls of 145,000. The balance of efficiencies is expected to come from standardization of subcomponents and improved logistics.

Go Dell It on the Mountain

But the skeptics are out there.

One is Martin Reynolds, research fellow at Gartner Dataquest. "I think they're going to find this to be a big challenge," says Reynolds. In the shrinking personal computer business with which both companies are struggling, the real problem isn't overhead, but the per-unit cost of distribution. It's not clear how working together on that effort will improve their chances of success, he says. And Dell (DELL) has wiggle room to cut its prices even lower should H-P and Compaq be able cut costs.

At the other end of the market, H-P and Compaq are hopeful that teaming up will equip them better to compete with companies such as IBM (IBM) and Sun Microsystems (SUNW) on products and services for large enterprises. But a bigger problem, says Reynolds, is fighting off advances from Dell into the high end.

The actual process of merging the companies is fraught with pitfalls, says David Brady, portfolio manager of the (SRYIX)Stein Roe Young Investor fund. "It's going to be such a big company," Brady says. "I don't think either management team has experience putting together an operation of this size."

To be sure, H-P CEO Carly Fiorina, who will remain as CEO of the enlarged H-P, and Compaq CEO Michael Capellas, who will become president, are aware of the challenges. They're already forecasting a less-than-5% revenue drop for the new H-P in the back half of 2002 and in 2003 as they manage the merger, but they insist they'll take care not to lose customers in the transition.

Depth Chart

But Brady says he expects Sun, IBM, Dell and others will be ready to take advantage of any potential disarray. "A principal concern I've had with H-P in the past is management depth," Brady says. Sure, the new blood with Compaq could help. But the transition will be tough, he says. "You're going to be stretching the people that are pretty well stretched," he says. Brady manages a small stake in Sun, but doesn't own the other companies he mentions.

Jurika & Voyles' Moore, who has been investing in tech stocks for more than a dozen years, says he knows of no big technology mergers that have worked well for shareholders. That's evident from deals like Compaq's deal for Digital Equipment, or AT&T's (T) acquisition of cable companies MediaOne and Tele-Communications Inc., for example -- not to mention Ma Bell's disastrous deal for NCR a few years back. "No tech company with problems ever fixed them this way," says Moore. "Ever." Moore's firm has no positions in Compaq or H-P.

As hinted by H-P and Compaq's acknowledgement of revenue slides, Moore says management will be able to dismiss any problems in the coming years as "integration issues." But the companies are just delaying the inevitable in the mature PC market, he says: "These things usually boil down to two drunks holding each other up."

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