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Corporate PCs Turn a Corner, but Compaq's Test Is Meeting Bullish Guidance

It needs strong results in its storage and server segments to meet growth predictions.

It's good to be a turnaround story in a tough market.

The return of

Compaq's

(CPQ)

commercial PC business to profitability this year has fortified its reputation as a comeback stock. And that reputation will come in very handy Tuesday, when Compaq reports its third-quarter results after the close of regular trading.

CEO Michael Capellas will do his best on the company's conference call to attribute any potential weakness in the PC segment to the same mysterious forces responsible for the recent blowups in

Intel

(INTC) - Get Report

,

Dell

(DELL) - Get Report

and

Apple

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. The sell-side analysts recommending the stock also will note that the market's tough for everyone and that the turnaround story at Compaq remains in its early chapters.

So forget about PCs for now. Compaq's results will ultimately be judged by whether the company is able to maintain the guidance it gave in the second quarter. At the time, Capellas told analysts that Compaq would be able "to deliver strong, double-digit revenue growth in the second half of the year." If Compaq's going to get that sort of growth, it will need strong performances in two segments that are experiencing anything but "tough" conditions: storage and servers.

The lucre to be gotten from those markets is clear. Intense demand for those products has been giving industry leaders

EMC

(EMC)

and

Sun Microsystems

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extremely strong sales and earnings growth at a time when business at many technology companies is showing signs of slowing.

David Bailey, an analyst at

Gerard Klauer Mattison

, thinks the results from Compaq's servers should be strong. The third quarter represents the first full quarter of sales for the company's high-end, high-margin

Wildfire

Unix servers, and Compaq could get good growth in that segment, even if it were only selling those products to existing customers wishing to upgrade. In addition, says Bailey, Dell's reticence to go after the market for high-end Windows NT servers has opened the door for Compaq. (Gerard Klauer hasn't done recent underwriting for Compaq.)

Compaq's storage revenue, meanwhile, just needs to grow. It was flat last quarter, and that didn't look good alongside the smoking numbers being posted by companies like EMC and

Network Appliance

(NTAP) - Get Report

. "That's an exploding market," says

UBS Warburg

analyst Charlie Wolf. "I want to see if they're participating with revenue growth." (UBS hasn't done recent underwriting for Compaq.)

As for PCs, it's unlikely that segment will be particularly strong. Corporate demand appears slow across the board, and concerns about the consumer business were sparked last month when contract manufacturer

SCI Systems

(SCI) - Get Report

, of which Compaq is a major customer, told investors it was seeing weak demand for consumer electronics and PCs. This week's data from

International Data

and

Dataquest

suggest that Compaq lost market share in the third quarter; both research firms showed the company growing below the industry rate.

Compaq reassured investors last week that it felt comfortable with inventory levels for the third quarter. But that does nothing to quell fears that price cutting -- a time-tested way to get inventory down to a "comfortable" level -- hurt the company's profit margins. Compaq offered consumers rebates of between $200 and $250 during the quarter.

All the more reason to show strength in servers and storage. Even with the much-vaunted turnaround in Compaq since Capellas took the helm last year, the company's consumer and commercial PC segments posted very modest profits of $31 million and $62 million, respectively, in the second quarter.