K-- as of YESTERDAY Smith Barney maintains it's target price on CPQ---------------- OF 20.00
--SUMMARY:--Compaq Computer--PCs
*Compaq held a press conference in New York yesterday to unveil a new
corporate client (aka desktop) and a new "busines-to-employee" web portal.
*The new client, the iPaq, is smaller, less expandable and less expensive
than today's typical corporate desktop. Many "non-essential" components
have been eliminated to reduce raw materials costs (and increase Compaq's
margins). To reduce manufacturing and fulfillment costs, Compaq will offer
just four configurations and little or no price protection.
*Although the iPaq's 17-19% lower avg price will place pressure on
commercial desktop revenue growth going forward (if cannibalistic), the
more important consideration is that 1) reductions in materials costs, 2)
design-for-manufacturability and 3) lack of price protection should allow
Compaq to make a profit on this product.
--EARNINGS PER SHARE--------------------------------------------------------
FYE 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year
Actual 12/98 EPS $0.01A $0.02A $0.07A $0.38A $0.48A
Previous 12/99 EPS $0.16A $(0.10)A $0.07A $0.15E $0.28E
Current 12/99 EPS $0.16A $(0.10)A $0.07A $0.15E $0.28E
Previous 12/00 EPS $0.17E $0.20E $0.27E $0.36E $1.00E
Current 12/00 EPS $0.17E $0.20E $0.27E $0.36E $1.00E
Previous 12/01 EPS $N/A $N/A $N/A $N/A $N/A
Current 12/01 EPS $N/A $N/A $N/A $N/A $N/A
Footnotes:
--FUNDAMENTALS--------------------------------------------------------------
Current Rank........:3H Prior:No Change Price (11/10/99)....:$22.25
P/E Ratio 12/99.....:79.5x Target Price..:$20.00 Prior:No Change
P/E Ratio 12/00.....:22.3x Proj.5yr EPS Grth...:15.0%
Return on Eqty 98...:21.0% Book Value/Shr(99)..:6.67
LT Debt-to-Capital(a)N/A% Dividend............:$N/A
Revenue (99)........:47105.00mil Yield...............:N/A%
Shares Outstanding..:1585.0mil Convertible.........:No
Mkt. Capitalization.:35266.3mil Hedge Clause(s).....:
Comments............:(a) Data as of the most recently reported quarter.
Comments............:
--OPINION:------------------------------------------------------------------
*Reiterate Neutral and $20 target.
THE NEXT GENERATION CORPORATE DESKTOP: THE iPAQ
Analysts and investors will be tempted to refer to the iPaq as a network
computer, a netPC, a windows terminal or an Internet terminal. In
reality, the product is all of the above and we prefer to think of it
simply as the next generation of corporate desktop. Although Compaq (and
HWP earlier this week) has billed the product as an Internet appliance or
a device best suited for employees needing limited functionality, the
fact is that the product contains a very robust configuration with plenty
of local storage and should be suitable for all but the most demanding
corporate network citizens.
Having said this, the iPaq includes significant modifications over
Compaq's current corporate desktop offerings in the areas of 1) chassis
design, 2) upgradeability 3) breadth of available configurations, 4)
fulfillment, 5) platform stability and 6) price. See below.
1) Chassis - The iPaq sports an innovative, small form factor chassis
with just 25% of the footprint of a typical corporate desktop. All models
include a hot swap bay suitable for an LS-120 drive, CD-ROM, DVD-ROM or
extra hard disk drive (each model includes an internal 4, 8 or 14GB hard
drive). The chassis is designed for easy access to memory slots.
2) Upgradeability - Memory is the only upgradeable/expandable component
in the iPaq; there are no PCI or ISA expansion slots. iPaqs come standard
with 64MB of memory, but support up to 512MB. Compaq has billed the iPaq
as "Windows 2000-ready" despite its standard 64MB configuration--we
suspect that the standard configuration would have been at least 96MB had
DRAM prices not doubled since July. We believe Compaq's decision to
eliminate PCI/ISA expansion slots reflects the reality that corporate
customers rarely add any new hardware to their desktops aside from
additional memory.
3) Configurations - Compaq will offer the iPaq in just two microprocessor
configurations (500MHz Celeron and 500MHz Pentium III) and four total
configurations. Each microprocessor configuration will be available in a
"legacy-free" version whereby most peripherals are connected to the PC
via universal serial bus (USB) and a "legacy-lite" version which also
includes parallel, serial and PS/2 ports. Offering just four
configurations will allow Compaq to better manage raw materials and
finished goods inventories--REDUCING INVENTORIES IS THE SINGLE MOST
IMPORTANT STEP THAT COMPAQ MUST TAKE TO REGAIN COST LEADERSHIP (AND
PROFITABILITY) IN THE COMMODITY DESKTOP MARKET.
4) Fulfillment - The simplicity of the iPaq design and the limited number
of configurations should reduce the amount of time it takes Compaq to
manufacture the product which, in turn, decreases the need for channel
partners to stock buffer inventories. With this in mind, Compaq does not
intend to offer price protection on the iPaq. This is a significant step
toward regaining PC cost leadership (Dell and Gateway do not offer and
therefore do not incur any price protection costs).
Compaq has said that it will drop ship the iPaq directly to
customers/resellers from its Houston manufacturing campus upon receipt of
an order. We believe that Compaq will leverage the
configuration/lot-size-one fulfillment capabilities of co-located
wholesale distributors (Ingram Micro, Tech Data and perhaps others) in
fulfilling iPaq to customers. The use of distributors will be transparent
to the customer, just as it is with Compaq's DirectPlus
telesales/Internet channel.
5) Platform Stability - In recognition of the fact that PC roll-outs
sometimes span 12-15 months in large, multi-national corporations, Compaq
has decided to guarantee availability of all iPaq configurations for at
least 12 months. While this fulfills a critical need for customers, it
will also accelerate desktop average selling price erosion because the
price of an existing configuration will decline significantly during a 12
month period and Compaq will not have the offset of graduating customers
to each successive new performance level that comes to market.
6) Price - The use of Intel's integrated 810e chip set, the removal of
expansion slots and legacy ports and improved inventory management all
contribute to the iPaq's 17-19% price discount to equally configured
Deskpro and Prosignia models (see chart below). While the iPaq will ramp
slowly as a percent of Compaq's corporate desktop mix next year, the ramp
will accelerate the decline in Compaq's corporate desktop average selling
price. Unless sales of iPaq are additive to CPQ's commercial desktop mix,
this will place pressure on top line growth. From an EPS perspective,
however, any commercial PC product with positive operating margins will
be accretive (Compaq reported a $169M operating loss in its commercial PC
products division during 3Q99).
----------------------------------------------------------------------
iPaq Legacy Free iPaq Prosignia 320
----------------------------------------------------------------------
Processor 500 MHz Celeron 500 MHz Celeron 500 MHz Celeron
Memory 64 MB 64 MB 64 MB
Hard Drive 4.3 GB 4.3 GB 6.4GB
O/S Windows 2000 Windows 98 Windows 98
Base Price $499 $549 $1120
CD ROM $65 $65 standard
17" CRT Monitor $299 $299 $65
upgrade to 128 MB $125 $125 $100
----------------------------------------------------------------------
Total Price $988 $1038 $1285
----------------------------------------------------------------------
----------------------------------------------------------------------
iPaq Legacy Free iPaq Deskpro EN
----------------------------------------------------------------------
Processor 500 MHz PIII 500 MHz PIII 500 MHz PIII
Memory 128 MB 128 MB 64 MB
Hard Drive 8.4 GB 8.4 GB 6.4GB
O/S Windows 2000 Windows 98 Windows 98
Base Price $799 $849 $1478
CD ROM $65 $65 standard
17" CRT Monitor $299 $299 standard
upgrade to 128 MB -- -- $72
----------------------------------------------------------------------
Total Price $1,163 $1213 $1550
----------------------------------------------------------------------
THE NET, NET ON THE iPAQ...
We have said for some time that Compaq cannot maintain its dominant share
in the worldwide commercial desktop market without cost leadership. We
are encouraged by today's iPaq announcement; the significant cost
reductions in this product suggest that Compaq is enacting the reductions
in materials/manufacturing/fulfillment costs necessary to regain cost
leadership. However, we remind investors that the iPaq does not come to
market until 1Q00 and will represent a small proportion of Compaq's
commercial desktop mix during 1H00.
The net, net is that we need to see similar cost reduction measures
across the entire commercial desktop product line before we call a turn
in Compaq's commercial PC fortunes. We believe that Compaq should merge
the Deskpro and Prosignia lines to reduce the breadth of its commercial
desktop product offerings. This, in turn, will allow the company to work
more closely with fewer suppliers, simplifying the management of raw
materials inventories. As with the iPaq, fewer SKUs within other desktop
lines will also reduce the risk of mismatched demand and obsolescence
charges (price protection). CEO Michael Capellas stopped short of
announcing specific product rationalization initiatives, but did suggest
that product line simplification is a top priority. We believe such
initiatives are already underway.
YEAR 2000
Capellas commented that October order patterns have been very consistent
with prior years' patterns. In other words, Capellas does not believe
that Year 2000 has negatively or positively impacted Compaq's business
thus far in 4Q99. Capellas did, however, cite uncertainty with respect to
shipments later in 4Q. Net, net, although the order book remains intact,
Capellas admits that it is difficult to ascertain the impact that Y2K
lock-downs may have later in the quarter.
Our most recent checks with Fortune 500 resellers in the U.S. suggest
that demand was below expectations for the entire month of October. We
remain cautious on Fortune 500 PC demand during 4Q99 based on the results
of these checks. While we realize that corporate resellers are losing
share to Dell and IBM in the Fortune 500, we believe the magnitude of the
downtick in the reseller channel is too pronounced to be explained
entirely by market share loss.
INVESTMENT CONCLUSION
Despite signs of cost reduction efforts within the commercial PC
division, we reiterate our Neutral rating on Compaq shares. Due to 1)
evidence of negative Y2K demand impact in the corporate reseller channel
during October, 2) the adverse margin implications of rising component
costs, 3) product availability issues fueled by the Taiwan earthquake,
and 4) the persistence of Compaq's high-cost position in commercial PCs,
we do not believe that Compaq has reached a true inflection point yet.
Our price target remains $20.
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