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Compaq's Downturn: Worthless Experts Just Kept It Quiet

The analysts played dumb as the computer giant dropped another bomb on investors.

I've been getting a more-than-normal amount of grief lately for an observation advanced in this space not long ago. The proposition? That when it comes to investment advice likely to upset or alienate a corporate client, Wall Street analysts are persons of easy virtue.

In other words, they're ... oh, it should be clear enough what I think they are. And if you're still in doubt, then review the rant that ran in this space concerning research at

Merrill Lynch

and the Street's other top firms only two

columns ago.

Now comes yet more evidence showing how fundamentally worthless so-called sell-side research on Wall Street actually is. It may be emotionally comforting to read these warm and cuddling encouragements to "buy and hold the

fill in the name of your preference here" if you already own some of it and are looking for reasons to hang on. But as a guide for whether to buy something in the first place? Fuggeddaboudit!

Case in point: the astounding failure of nearly the whole of Wall Street to predict -- or indeed even catch the barest whiff of --



bombshell announcement of June 17. In that announcement, the besieged computer maker's acting chief executive, Benjamin Rosen, disclosed that Compaq would report as much as a 15-cent-per-share loss for the second quarter ending June 30, vs. Wall Street's consensus forecast of a 22-cent-per-share profit for the period.

As we'll see in a minute, the collective look of dumb stupefaction that greeted this announcement on Wall Street wasn't the result of mere oversight. You don't just "overlook" or somehow "miss" a $630 million swing to the negative in a company's earnings in a mere 90-day period.

What you do is ignore it because there is no percentage for you as an investment banking firm to say out loud what you know privately to be the case -- that your client's business is a mess, that the biggest acquisition in its history has turned into a fiasco, that the company has deteriorated into a Balkanized horror story of feuding divisions and that the board of directors can't even hire a chief executive to run the company.

On top of all that, why rub salt in the wound by issuing a downgrade and cutting the forecasted earnings to protect the investors from further carnage? All you'll be doing in the process is moving your own firm to the back of the line in the beauty contest that will soon be starting. Its purpose? To come up with some new Wall Street contrived scheme -- a new shelf registration, maybe, a new merger perhaps, or maybe just a plan to dump a load of assets that the company never should have acquired in the first place.

In sum, tell your buy-side clients what's on the way and you'll be cutting yourself out of the upcoming round of sell-side action. Better just to let nature take its course -- let the bad news come out on its own and then bite the bullet with the unavoidable downgrade and earnings cutback.

There can be no other explanation for the see-no-evil pose of Wall Street's blind monkeys concerning Compaq's deepening woes, all of which have been plain to see for months at least.

Compaq isn't some two-bit outfit that no one ever heard of or cares about. Compaq is the biggest personal computer maker on earth. More than 30 Wall Street analysts chronicle its fortunes and are constantly issuing updated forecasts about its earnings. That's as many analysts as cover


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and twice as many as cover


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And it is not as if information about Compaq is hard to come by. The company is huge. All by itself it employs 71,000 people. That's more employees than work at half the Baby Bells and nearly three-quarters as many as work for


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. Imagine the reaction if Wall Street had predicted that AT&T would earn 22 cents per share in the second quarter and then out popped a PR newswire release two weeks before the end of the quarter saying, "Sorry, guys, but you got it wrong -- we're actually going to lose 15 cents per share."

And it's not as if no one would care because it's just some electronic "boxmaker" in Houston. Beyond those 71,000 Compaq employees, there are millions more people with direct financial stakes in the company. More than half the entire company -- which is to say, close to $20 billion of equity value -- is held by mutual funds. Name almost any big fund you can think of --


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-- they've all got big stakes in Compaq.

And here's the most shocking thing of all about this situation: This isn't the first time Wall Street has missed the boat on the mess at Compaq. In fact, the same exact thing has been happening over and over again since the first of the year. As recently, in fact, as mid-April the company announced that it would be reporting roughly half the first-quarter earnings the blind monkeys had been expecting. Now it's happened all over again, only the downturn is even worse. In other words, this is a company that looks for all the world to be in a state of advanced collapse, and the only people who don't seem to realize it are the analysts who cover the stock.

Compaq's problems are fundamental to its core business: the manufacture and sale of personal computers. There was a time not so long ago when you could make a lot of money doing that. At the turn of the decade, the company ran a 20%-plus operating margin and a 12%-plus net margin from its computer business. But as more and more of the manufacturing end of the computer business migrated to low-wage countries in the 1990s, product prices began to slide industrywide, and Compaq's margins began to disappear. By last year, the company's operating margin had fallen to 5.6% and its net margin had all but vanished.

So, in one of the oddest strategic redeployments of recent business history, the company decided to get into the potentially more lucrative services business by acquiring a company --

Digital Equipment Corp.

-- that was arguably even more troubled than Compaq itself.

Digital, in case you've forgotten, was at one time regarded as the absolute cat's meow in the computer game -- the Massachusetts-based mini-computer behemoth that seemed well along in eclipsing


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-- then being run by the ineffectual

John Akers

-- as the dominant computer company in the game

Well, so much for that. In a nitwit scheme to gobble up the personal computer market, Digital began making desktop PCs -- the very business that was collapsing out from under Compaq -- and wound up writing off billions in losses.

Meanwhile, the rest of Digital's business went to hell, and by the time Compaq acquired the company in a $9.6 billion stock-and-cash deal at the start of 1998, Digital's margins were no better than Compaq's and its worker productivity was actually a lot worse.

The theory behind the acquisition was that by buying Digital, Compaq would automatically acquire Digital's corporate business in selling and servicing servers, workstations and that sort of thing. But the company paid a 25% premium over the market for the whole of Digital when it actually wanted only the server and workstations part, then predictably enough found that it couldn't can enough people to make the deal pay for itself.

For more than a year thereafter, Compaq struggled (or maybe didn't struggle) to integrate Digital into its operations. During that time, the analysts -- having lapped up Compaq Chief Executive

Eckhard Pfeiffer's

malarkey about the deal being "accretive" to Compaq's earnings "within a year" -- cheer-led the combined companies' share price up from barely 23 in the spring of 1998 to more than 51 by the start of 1999.

With more than 1.7 billion shares outstanding (150 million of them as a result of the Digital deal alone), the $50-plus share price put a price tag of close to $87 billion on the company. But didn't any analyst bother to question whether this valuation made sense? At 51 per share, the company was selling for nearly 30 times what should have been the combined company's 1998 earnings of around $1.74 per share, whereas earnings in fact came in at a $1.71-per-share loss.

So much for "accretive within a year." Then, last February, Mr. Pfeiffer said right out loud in words of plain English for the whole world to hear that the period ahead wasn't shaping up any better, telling an analyst for

Credit Suisse First Boston

that earnings were turning out to be "weaker than expected."

That caused Wall Street's asleep-at-the-switch analysts to wake momentarily, knock a few cents off their quarterly earnings forecasts, and then go back to sleep. Meanwhile, the stock keeled over in a swan dive that by June 18 had carried it to under 22 -- a loss of nearly 57% in value since the start of the year.

Did any analyst foresee this obviously and easily foreseeable outcome? With the possible exception of a fellow at

U.S. Bancorp Piper Jaffray

, I have not been able to find any. As of June 17 -- that is, the morning of the company's most recent earnings announcement -- the consensus forecast among analysts was for 22 cents per share in the June quarter and 30 cents in the September quarter.

Only after the company popped the news and the stock lost another $1.2 billion in market value did the analysts tell their clients that maybe the stock hadn't been such a good bet after all. Said the people from Merrill Lynch, for example, in a research note that was delivered to clients a day after the news hit, "We have reduced our long-term rating from a 'buy' to an 'accumulate.'... Revenues and gross margins will likely be flat to slightly down sequentially." To which one is inspired to respond, "Geez, thanks for the heads up -- but how about having told us yesterday!"

The truth is, what the analysts pump out concerning most such big-cap companies in trouble isn't research at all, it's just marketing copy for their stocks. Never mind that Compaq, for example, has a good balance sheet and is still generating cash on an operating basis. None of the predicted results of the merger have panned out, earnings are in the toilet, and since the start of the year company insiders have sold or have filed to sell an utterly mindblowing $80 million worth of Compaq stock. That's not a vote of confidence in the future -- it's rats leaving the ship.

All of this was foreseeable from the very moment the merger with Digital was announced. Only the analysts missed out. Now their clients are paying the price. Tough noogies, folks, it's the way these things work on the street of dreams.

Christopher Byron's column appears in the New York Observer, and he also writes a Wall Street and investing column for Playboy. He is the former assistant managing editor for Forbes, the Wall Street correspondent for Time and the Bottom Line columnist for New York. Byron holds no positions in any of the stocks discussed in his column. While he cannot provide investment advice or recommendations, he welcomes your feedback at

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