Inacom's Slide Sprinkles Cold Water on PC Distributors' Merger Hopes

The stock slides 32% just a day after a rally on a deal with Compaq.
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The verdict on the

Compaq

(CPQ)

-

Inacom

(ICO)

deal took a while to come in, but when it did, it hit the Street with a thud.

After running up Tuesday, Inacom shares Wednesday gave up their gains and then some as investors worried that the deal, in which Compaq acquired Inacom's hardware business for $370 million, left them holding the bag. The negative reaction may put further consolidation between traditional PC manufacturers and computer distribution companies on hold, say analysts. That means bad news for the distributors, many of whose stocks have languished amid fierce competition and sliding margins.

Like at First Sight

At first glance, Inacom investors liked the arrangement, and Inacom stock rose 20% Tuesday in heavy late-day trading. But by Wednesday morning, shareholders were reading between the lines and reconsidering, even as stocks mostly recovered from Tuesday's drubbing. Inacom shares dropped 32% Wednesday to close at 7.

"I bought some Inacom last night thinking I was going to get rich, but I was wrong," says Paul Schupf, a New York-based money manager.

Sharp Reversal
Inacom shares' about-face following Compaq deal

Source: BigCharts

"It is not clear that the direct capabilities that Inacom has are the right approach for Compaq," writes

PaineWebber

analyst Don Young in a report on the deal. "The operation of Inacom as a subsidiary with operations physically separated from Compaq's Texas manufacturing is an unproven approach that none of the direct competitors employ." (Inacom's plants are in Indiana, New Jersey and California.)

Young goes so far to write that Compaq should have acquired

Gateway

(GTW)

or

Micron PC

(MUEI)

instead. (Young has a neutral rating on Compaq and does not cover Inacom. His firm has done no Compaq underwriting.)

The Eye of the Beholder

Before the deal, Steve Milunovich, a hardware analyst with

Merrill Lynch

, told

TheStreet.com

that Inacom, as well as some of its undervalued brethern, were becoming attractive takeover targets.

Milunovich said

CompuCom

(CMPC)

, trading at 4 1/2, is another candidate, and analysts are now saying No. 3 PC direct seller Micron PC could be attractive to companies such as

Hewlett-Packard

(HWP)

, Compaq or even

IBM

(IBM) - Get Report

. All three PC giants are looking to move more of their business away from the retail channel and into direct sales, which sport better gross margins -- a key indicator for PC stocks. A Micron representative declined to comment. Milunovich has accumulate ratings on H-P and Compaq, a neutral IBM rating, and does not cover Inacom or CompuCom. Merrill has done recent underwriting for H-P, but not for the others.

Schupf says Inacom investors are having second thoughts because investors are feeling misled. "Previous management had been saying the real key to this business was their IT installation business," explains Schupf. "But since Compaq paid $370 million for just its reselling PC business and Inacom only has a $450 million market cap, it's pretty obvious they haven't built up any IT momentum."

The Whole Shebang

Inacom CFO Thomas Fitzpatrick says shareholders should look at the whole Compaq deal. "We also are getting $420 million in revenue over the next three years from Compaq," says Fitzpatrick, who estimates Inacom will receive this much in a revenue-sharing deal. "That will substantially improve not only revenue results but gross margins as well going forward."

This new IT business, which was expected to give Inacom better profit margins, was one of the main reasons its stock rose to 40 two years ago. But it hasn't been close to that level since. Schupf says he bought Inacom yesterday because he thinks new management -- CEO Jerry Gagliardi started two months ago -- may be able to focus more on IT now that Compaq will control the hardware distribution end. Schupf holds no position in Compaq.

Whether or not Gagliardi can use Compaq's cash to pay off debt and generate some long overdue IT momentum is not what brokerage firms may be thinking right now, however. Instead, investment bankers may be musing that the poor response to the Inacom announcement may very well dry up the well for future deals in the computer distribution arena.