Wall Street Wants More Data on Compaq's Reseller Incentives

The PC giant's plan to reward resellers threatens to distort financial results, some say.
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Compaq

(CPQ)

, which is currently seeking salvation from Wall Street, may have to come clean on one more issue.

As the dust settles over Compaq's dramatic

ouster of Eckhard Pfeiffer as its CEO last month, it appears that the world's leading PC seller fell victim to its own hubris. Pfeiffer had a bold plan: $50 billion in revenue by the end of 2000. To get there, however, Compaq was forced to offer bigger incentives to resellers to order its products despite lackluster demand, say analysts and money managers familiar with the company.

It is the level of these incentives -- through an accounting measure known as contra-revenue -- that led to Pfeiffer's downfall. Like other PC companies that push their products through a reseller to customers, Compaq has for years credited its resellers when it lowers prices to move products through the channel. This way, if Compaq grosses $10 billion in revenue in a quarter, for example, but has allocated $1 billion in contra-revenue, the net revenue for the quarter will appear as $9 billion on its accounts.

The level of contra-revenue accounting has long been a mystery to money managers and analysts, forcing them to guess how much Compaq was compensating its resellers. The contra-revenue allocation is not divulged during conference calls, nor is it noted on the company's filings to the

Securities and Exchange Commission

. As Compaq begins laying out a strategy to recover its position, lowering the high level of contra-revenue will be one of the biggest obstacles facing the company.

"

Contra-revenue always has been one of my issues with management," says Randy Befumo, an analyst at

Legg Mason Fund Adviser

. His firm's funds own positions in

Gateway

(GTW)

,

Dell

(DELL) - Get Report

and Compaq, according to the latest filings from

Technimetrics

. "It just adds more risk to a Compaq investment."

Compaq's contra-revenue, which should really be looked at as price credits to resellers in the quarter after the products were sold, was distorting the company's revenue on an incremental basis. Contra-revenue "should be under incremental cost of sales on the balance sheet," says Mark Specker, an analyst with

SoundView Technology Group

. He argues that Compaq's problem was that its contra-revenue was a multiple-quarter event, while every other company's accounting moves are normally confined to a single quarter or "intra-quarter" event.

Many companies also use reserves to credit resellers for moving their products when they cut prices. Compaq isn't doing anything outside the legal confines of the

Financial Accounting Standards Board

. But ever since the company's first-quarter profit of $281 million fell almost 50% below expectations, many on Wall Street are demanding that Compaq divulge more information.

"The problem is we just don't know how contra-revenue changed," says Specker, who rates Compaq a buy. (His firm has done no Compaq underwriting.)

Compaq's contra-revenue war chest first caused concern in early 1998, when CFO Earl Mason told analysts the company's contra-revenue account had hit $1 billion toward the end of 1997. That, say two analysts, made Wall Street focus on this secretive account for the first time.

In the first half of 1998, Compaq was stuffing the channel, or offering incentives to resellers to order more computers even if demand did not justify such a move. Compaq's channel had swollen to 11 weeks of inventory by early 1998, according to

BancBoston Robertson Stephens

analyst Dan Niles. Comfortable inventory levels are about a month, according to Compaq. (Niles has a buy rating on Compaq, and his firm has done no underwriting for the company.)

As the company faced falling PC prices, Compaq's contra-revenue hovered at 20% of gross revenue in the first quarter last year and 18% in the second quarter, according to one Wall Street analyst who requested anonymity. That puts contra-revenue at $1.15 billion for the first quarter and $1.05 billion for the second quarter, according to this analyst. A Compaq spokesman declined to comment on this issue.

Although other PC companies such as

IBM

(IBM) - Get Report

and

Hewlett-Packard

(HWP)

also set aside funds to compensate their resellers, their reserve levels lag Compaq's, according to analysts interviewed for this story. "Our inventory levels have typically been a minimum of eight to 10 days lower than Compaq's," says Larry Sennat, H-P's Personal Systems Group communications manager. H-P also doesn't break out its price protection reserves, which are debited against gross revenue, according to an H-P spokeswoman. Calls to IBM about its contra-revenue were not returned.

Faced with the wrath of Wall Street in early 1998, Mason promised the Street that the company would reduce the channel inventory levels. That meant more price cuts, but that made the goal of reducing contra-revenue difficult.

"Until Compaq got to a point where the company could lower levels of inventory, management couldn't lower price protection rates" offered to resellers, says Joel Pitt, a

Credit Suisse First Boston

analyst who covers PC distributors. (CS First Boston has done no recent Compaq underwriting.)

Compaq also had to go slowly on plans to move to a direct model. More than 85% of Compaq's PC revenues are still made through the indirect channel, but management is intent on raising its direct sales to 30%, according to

VARBusiness

, a channel trade publication.

Compaq's relationship with its partners, especially its major distributor,

Tech Data

(TECD) - Get Report

, soured. "The impression we got after the February PC road show in Texas was that channel distributors and resellers could do business with IBM, but Compaq was creating an image of being an unfaithful business partner," says one analyst who visited the company and requested anonymity.

Mason, who left Compaq when CEO Eckhard Pfeiffer resigned April 18, didn't return calls seeking comment. He now is CEO of food distributor

Alliant Foodservice

. Alan Hodel, Compaq's senior manager of public relations, says contra-revenue is an integral component of its sales effort. Interim Chief Executive Ben Rosen and CFO Ben Wells declined to comment on the issue.

In the fourth quarter of 1998, Compaq posted strong numbers -- a 48% jump in revenue -- by pushing a lot of PCs into the channel in December at inflated prices, says SoundView's Specker. But the PCs were not moving and by late February 1999, demand for Compaq PCs was

worse than expected. Compaq missed analyst estimates by 15 cents a share and revenue by $400 million. One analyst told

TheStreet.com

that Compaq is still stuffing the channel. If so, the contra-revenue levels are unlikely to decline.

The lack of disclosure of contra-revenue "does little for investor confidence," railed

Goldman Sachs

analyst Rick Schutte in an April 21 report to clients. Quarterly contra-revenue levels, he said, are often more than $1 billion, and they seesaw wildly from quarter to quarter. "In our opinion, contra-revenue should be disclosed so that investors can get a better understanding of the nature of any earnings improvements and/or disappointments," his report stated. Schutte has a market perform rating on Compaq, and Goldman has done no Compaq underwriting.

Schutte is not alone in his demand for more openness. "Last year, the reserves were used because inventory levels were so high -- I understand that," says a disgruntled Wall Street analyst. "Now I have no idea what they are doing with all that contra-revenue reserve and it bugs me."