From the May Issue of Money Magazine:
money.cnn.com
HP/Compaq: A toothless merger
Together or apart, Hewlett-Packard and Compaq are mediocre.
April 18, 2002: 4:35 PM EDT
By Michael Sivy, MONEY Magazine
NEW YORK (MONEY Magazine) - Ambition. Intrigue. Betrayal. The merger of Hewlett-Packard and Compaq Computer has had more plot twists than a soap opera, and a cast of characters that's no less dramatic.
Carly Fiorina, H-P's celebrity CEO, has staked her career on one of the largest tech deals ever attempted. Her nemesis, Walter Hewlett, son of one of the company's founders, movingly laments the passing of the firm's former greatness. Milling around them are institutional investors who've been switching sides like characters in an Elizabethan revenge tragedy.
Despite Hewlett's continuing opposition, the merger is probably unstoppable. But it won't fundamentally change the outlook for H-P -- or for competitors such as Dell and IBM. The sad fact is that the combination is far less consequential than it looks. Both H-P and Compaq are mediocre companies that lack viable strategies. Whatever gains they achieve will come chiefly from cost-cutting. They might as well be drug companies with weak product pipelines that merge and combine sales forces. That tactic may give earnings a boost but doesn't create any new drugs.
If this assessment sounds too harsh, just take a critical look at the benefits the deal confers. The first is scale. The sales of the two companies will total nearly $80 billion, making the new firm nearly as large and diverse as IBM. The second is cross-selling. Both product lines can be offered to the combined customer base. Most important of all, H-P and Compaq hope to slash overhead by more than $2.5 billion a year (or 63 cents a share). But the merger doesn't seem capable of bringing the kind of transformative change that creates a new dynamic entity out of two stagnant ones. The combined companies will probably just lose ground more slowly than they would had they remained separate.
As large as the new company will be, it still won't match IBM's heft -- even though Big Blue isn't looking so tough at the moment. The computer services that H-P and Compaq offer, for instance, have less potential for big sales to corporate customers. Cross-selling isn't likely to be a huge moneymaker either, because of product overlap and tech standards that aren't entirely compatible.
The biggest weakness, though, is that the deal's success depends chiefly on cost reductions. Companies rarely cut their way to greatness. Moreover, H-P still won't be able to produce PCs as cheaply as Dell can, which probably means a continuing loss of market share.
Value-conscious investors may be intrigued by the deal. At $18, Hewlett-Packard (HWP: Research, Estimates ) shares trade at less than 17 times this year's estimated earnings. But that valuation assumes the deal progresses without serious setbacks. Historically, though, two out of three mergers have failed to achieve their financial targets on time.
Shortfalls and delays resulting from tech mergers are particularly disruptive. Since product cycles for new technology can be as brief as 18 months, a merger that bogs down even briefly can cause a company to fall seriously behind competitors. Uncertainty may also encourage corporate customers to migrate from H-P and Compaq to IBM and Sun Microsystems.
Here's the bottom line: It will take six months for investors to determine whether the new company is achieving its financial goals. Even if it does, the merger won't significantly boost earnings for almost two years. And there's a significant chance that the company will fall far enough behind schedule to hurt the share price.
The final question for investors is whether H-P's competitors look any better. The fact is that the entire computer group is less appealing than some other tech sectors right now. Like H-P and Compaq (CPQ: Research, Estimates ), Gateway has been losing market share. But it's in even worse shape since it's smaller and has a narrower product line. Sun, which specializes in servers, also has some long-term merit, but has been losing money and will have negligible earnings this year.
Over the next five years, however, Dell and IBM have brighter prospects. Dell's strengths are readily apparent. As the lowest-cost major producer of PCs and other computer hardware, Dell can consistently underprice rivals. The result has been steady gains in market share, which are likely to continue. But at $27 a share, Dell (DELL: Research, Estimates) trades at 36 times earnings for the current year, so it isn't a conspicuous bargain.
Personally, though, I'm inclined to favor IBM (IBM: Research, Estimates ). In the most recent issue of MONEY Magazine, I recommended the stock at $103, before lousy first-quarter results knocked the price down 15 percent. Despite the setback, however, IBM's long-term strengths remain impressive.
The company's product mix isn't dependent on consumers and skews instead toward higher-margin hardware, software and services for corporations. Weak corporate tech spending is hurting results right now but should recover before year end.
At a current price of $88 a share, IBM is trading at 21 times earnings for the current year and 18.5 times 2003 estimates. So even if Big Blue's earnings growth doesn't quite keep up with Dell's, its P/E is almost 50 percent lower. For patient investors, that valuation looks like a tempting bargain. |
