Compaq Squares Off Against Analyst Over Report of Rising Inventories - TheStreet

More than a year after CEO Eckhard Pfeiffer was shown the door, talk remains cheap at

Compaq

(CPQ)

.

Investors lopped 11% off the company's shares Thursday after

Salomon Smith Barney

analyst Richard Gardner downgraded the stock on second-quarter revenue and inventory concerns. And a rebuttal from Compaq combined with a groundswell of support from the analyst community did nothing to stop the bleeding. Friday, while the rest of the PC sector rebounded from the prior session's sympathy selloff, Compaq slid another 1/8 to 25 9/16. (Solly has no recent underwriting relationship with the company.)

The week's events have put a new cloud of uncertainty over a company that is clearly still struggling to restore Wall Street's faith in its credibility. That cloud could linger until Compaq reports its second-quarter earnings in late July. In the meantime, investors must contemplate the stark difference between Gardner's caution and Compaq's reassurances.

Dispute Ensues Over Compaq's Inventories

In his note, Gardner called attention to possible inventory pileups at Compaq on both the corporate and retail sides. Of the latter, he wrote: "We have talked extensively about the weakness in U.S. retail PC sales this quarter, and we believe that Compaq's channel inventories are the highest among the major retail PC vendors."

Compaq immediately fired off a denial, saying that its channel inventory, or products held by resellers and retailers, "has been low and in some cases near stock-out levels."

It shouldn't be surprising that Compaq's defense has received a lukewarm response from investors, who still recall the boxmaker's 1999 difficulties. Many analysts were caught by surprise by the profit warnings Compaq issued in last year's first half.

Given that history, why are so many on the sell-side sticking up for Compaq? A host of analysts, including

Donaldson Lufkin & Jenrette's

Kevin McCarthy,

Merrill Lynch's

Steve Fortuna and

Lehman Brothers'

Dan Niles have come out and defended the company against Gardner's attack. (None of those brokerages have performed recent underwriting for Compaq.)

"A lot of people upgraded Compaq over the last three months," says David Bailey, an analyst at

Gerard Klauer Mattison

, which hasn't done any underwriting for Compaq and rates the stock a hold. "They don't want this story to come out now."

Of course, Gardner could be just plain wrong. The company's resellers, for their part, are singing the same song as Compaq. "We've decreased our inventory substantially from the beginning of the year," says Terry Tysseland, senior vice president of operations for

Ingram Micro

(IM)

, which resells PCs for both Compaq and

Hewlett-Packard

(HWP)

. Ingram declined to give precise figures on current inventory levels.

But there may be more to the story. According to David Goldstein, president of Dallas-based research firm

Channel Marketing

, it's not unusual to see overall inventories decline over a year's first half. "Seasonally, at the end of the second quarter, inventories are usually down vs. the first quarter," he says. "But when you look at the number of weeks of inventory this year versus last, it's higher than a lot of folks would like it to be."

Low-End PC Price War Coming

Fears about rising inventories made headlines last week, when

eMachines

(EEEE)

warned that poor demand for cheap PCs would cause it to lose 30 cents to 33 cents a share in its second quarter. That demand problem had inflated the company's inventory to five to six weeks, says President and CEO Stephen Dukker. What's more, Dukker claimed inventories of low-end PCs were also rising at Compaq and Hewlett-Packard. "As discounting begins," he says, "that will pull in dramatically."

In other words, get ready for a price war in the low-end PC market.

To Goldstein, the discounting of low-end PCs that Dukker presaged could be one explanation for the seeming variance between the Gardner and Compaq positions. "Over the last several weeks, there has been tremendous price cutting on the part of companies like Compaq and eMachines to move some inventory through the channel," he says. "The inventory in the channel is recent. It's the result of recent price cutting. That got

PCs out of

Compaq's warehouses and into the channel."

Price cutting has already helped Compaq move "tens of thousands of units over the last three weeks," according to Goldstein. Compaq didn't return a call seeking comment.

But Price Cutting Could Hurt Margins

In the meantime, investors in the PC sector must wait for the sound of dropping shoes.

Goldstein stresses that even though inventories look high, "they're not alarmingly high." But aggressive price cutting could put pressure on Compaq's margins. In his note, Gardner wrote that Solly was reviewing its earnings-per-share and revenue estimates for Compaq. And GKM's Bailey -- who, it should be noted, thinks there are more important issues at Compaq than short-term inventories -- suspects the company "might come up a little short" of its revenue estimates. "And that's not a good sign," he says. "This is a difficult turnaround."

Analysts expect Compaq will earn 21 cents a share in the second quarter and $1.08 a share for the year, according to

First Call/Thomson Financial

.

Meanwhile, H-P maintains that its inventory is under control. "We are not having the same problems," says spokesman Steve Pavlovich. "We feel very good about inventory in both the retail and commercial channel. On the commercial side, we have about three weeks, and in some lines even less than that." Pavlovich says that he wasn't sure about inventory levels on the retail side, but says that "three weeks or less is fair. We've had a number of questions on this subject, and our PC folks are feeling good about the situation now."