Merrill Lynch (Painter) opinion to follow this one (Salomon Bro's)
K.
CPQ: Reinitiating Coverage of Compaq Computer
04:42am EST 1-Dec-97 Salomon Smith Barney (Richard Gardner)
--SUMMARY:
--Following the merger of Smith Barney and Salomon, we are reinitiating
coverage of Compaq Computer.
--We rate the shares 2H. The previous Smith Barney rating was 3H.
Improved asset mgmt and strong cash flow has driven P/E expansion since '96
The next important step will be to tackle channel inventories
Recent channel checks suggest that channel inventory reduction has not begun.
In general, Compaq is the most diversified of the pure PC plays
With Tandem, CPQ's product line spans high-end server to low-end consumer
Strong growth at the high-end should help CPQ weather desktop price decline.
--EARNINGS:
FYE 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year
Actual 12/96 EPS $0.32A $0.30A $0.48A $0.63A $1.74A
Previous 12/97 EPS $N/A $N/A $N/A $N/A $N/A
Current 12/97 EPS $0.53A $0.60A $0.71A $0.81E $2.67E
Previous 12/98 EPS $N/A $N/A $N/A $N/A $N/A
Current 12/98 EPS $0.69E $0.76E $0.87E $1.02E $3.33E
Previous 12/99 EPS $N/A $N/A $N/A $N/A $N/A
Current 12/99 EPS $N/A $N/A $N/A $N/A $1.14E
--FUNDAMENTALS:
Current Rank........:2-H Price 11/28/97......:$62.43
Prior Rank..........: Target Price........:$85.00
P/E 12/97...........:23.4X 52 Wk Price Range...:79.56 - 28.40
P/E 12/98...........:18.7X Proj. 5yr EPS Grth..:N/A%
Return on Equity 96.:N/A% BookValue...........:$11.52
LT Debt-to-Capital..:N/A% Dividend............:$.12
Revenue 1997........:$24787.00 mil Yield...............:.1%
Shares Outstanding..:792.00 mil Convertible.........:No
Mkt. Capitalization.:$49444.56 mil Hedge Clause(s).....:
--OPINION:
Compaq is the most diversified of the pure PC plays in terms of geographic
reach, customer base and product line. Compaq has led worldwide PC unit
shipments since December 1994. Compaq currently holds the number one
worldwide share in desktops and servers with 12% and 30%, respectively, and
the number three share in notebooks with 10%.
At the beginning of 1996, Compaq embarked on an asset management crusade
which sourced $2.1 billion in cash through reductions in operating assets.
During this period, Compaq reduced internal inventories from 56 days to 29
days and more than doubled its return on invested capital from 18% to 41%.
Reductions in internal inventories lower Compaq's inventory carrying costs,
but CPQ is still exposed to four to six weeks of channel inventory which is
fully price protected and can usually be returned to Compaq if it does not
sell. Due to its direct, build-to-order model, Dell does not incur these
costs or risks. Compaq will not be able to price competitively with Dell
(all else equal) until channel inventories are reduced.
With build-to-order and channel configuration, Compaq is attempting to
coopt the most important features of Dell's direct model: build-to-order
and the ability to customize systems. Part of BTO/CTO has been the
reduction of channel inventories. Tandem positions Compaq well for
the emergence of NT clusters. Clusters are essential for the continued
movement of Windows NT server and industry standard hardware into mission
critical environments. Tandem's ServerNet hardware interconnect technology
will give Compaq a time-to-market advantage over other NT server vendors.
More importantly, Compaq's development work with ServerNet will probably
accelerate the standardization of NT clustering technology.
Average selling prices for Compaq's base server, desktop and notebook
models have declined significantly for several quarters. In the US consumer
market, sales of value-line $1,000 desktops have risen from less than 10%
of the market several quarters ago to between 25% and 30% in the June
quarter. We expect that $1,000 systems will continue to increase as a
percent of the total consumer market. However, we view this as a positive
for Compaq because it can produce these $1,000 systems profitably. We
believe Compaq will benefit disproportionately from the health of this
sector with its strong brand name.
Average selling prices have declined significantly within Compaq's
commercial desktop line also. However, as the prices of base configurations
have come down, Compaq has managed to sell more options which keep the
overall price and margin stable.
We do expect to see continued declines in corporate desktop pricing, not
because of any wholesale move toward thin clients but rather because of
component cost reductions. However, we believe strong growth at the high
end of Compaq's product line will provide a shield from such declines. As
we said before, Compaq has the broadest product line of any PC vendor, and
has demonstrated an ability to respond quickly to shifts in market
preferences. For example, Compaq moved quickly to take advantage of growth
in both the Intel-based workstation market and the low-end consumer market.
Compaq deserves credit for recognizing the opportunities presented by these
markets.
The re-entry of the large, vertically integrated Japanese and Korean PC
vendors into the US market deserves careful scrutiny. To date, however, the
competitive impact of these moves has been limited--none of the Japanese or
Korean companies, in our view, has demonstrated an understanding of the
factors necessary to compete effectively in the broader PC market. The
expansion of their product lines, their willingness to compete on price and
their ability to quickly bring new products to market will indicate a more
aggressive stance by these foreign competitors.
The larger competitive threat for Compaq, in our view, comes from other
large US vendors like Dell, Hewlett-Packard and IBM. Hewlett-Packard and
IBM have also begun build-to-order, configure-to-order and channel assembly
initiatives. IBM has been employing channel assembly for more than a year
with its desktop line, and will soon begin configuring servers and
notebooks in the channel. Hewlett-Packard is just beginning channel
assembly this quarter in its commercial desktop line but has clearly
outlined its intention to compete aggressively in the worldwide PC market.
Compaq shares have experienced significant multiple expansion since March
1997 both in absolute terms and relative to the S&P. In March, the shares
were trading at slightly more than their historical average of 11 times
forward twelve month earnings; Since then, their multiple has surpassed 20
times. Relative to the S&P, the shares have historically traded at a 20%
discount. Now they are trading at a 20% premium. We believe this multiple
expansion is justified based on Compaq's increasing returns on invested
capital and the resulting growth in free cash flow. In light of this
multiple expansion, we conducted a simple discounted cash flow analysis to
shed light on the growth assumptions implicit in the current valuation of
the shares. Our discount rate is derived using the capital asset pricing
model, a risk free rate of 6.3%, a beta of 1.5 and a market risk premium of
4.5%. The resulting discount rate is 13.1%. According to our analysis, the
current price of Compaq shares actually includes fairly conservative
forecasts for year to year growth in free cash flow. Given our discount
rate, we can arrive at the current valuation of the shares using a
perpetual growth rate 8% in free cash. Compaq's revenue goal is $50 billion
by the year 2000 without acquisitions. This implies compound annual revenue
growth of 26%. If Compaq can grow earnings and free cash flow at the same
rate via further reductions in operating assets (and 9.5% thereafter), this
implies substantial upside to the fair valuation of the shares.
Based on our belief that Compaq will continue to improve returns on
invested capital and source large amounts of cash through reductions in
operating assets, we believe that the shares will continue to trade at a
premium to the S&P 500. We believe that the shares could experience further
multiple expansion during the coming year as returns on invested capital
rise. With a multiple of 22 times and our forward twelve month earnings per
share estimate of $3.89 twelve months forward, we establish a twelve month
price target of $85. |
