Stonehenge & thread:
Good Stuff on CPQ was E-mailed to me. Looks like this acquisition was a steal! When this is widely out there this baby will fly.. oh mama!
Subject: CPQ: Move Over Bonny. Move Over Clyde. You're History. (First Boston)
Bob Hiler)
CPQ: Move Over Bonny. Move Over Clyde. You're History.
08:24am EST 2-Feb-98 Credit Suisse First Boston (Charles Wolf,
BUY / FOCUS LIST
Compaq Computer-(CPQ)
Summary
Move over Bonny. Move over Clyde. You're history. In its
acquisition of Digital Equipment, Compaq raises theft to a new
level. After Compaq liberates the cash sloshing around in DEC's
balance sheet, the cost of the acquisition could fall to $3.5 billion,
less than four times DEC's projected 1999 NOPAT. Contrary to perceptions,
the acquisition should create substantial value. Once the deal
closes, our price target could rise from $42 currently to $48
even in the face of a significant decline in Compaq's
projected growth rate. Compaq remains a Buy and Credit Suisse
First Boston Focus List selection.
Summary and Investment Recommendation
A ton of ink has been spilled in analyzing the strategic
implications of Compaq's announced acquisition of Digital
Equipment. What's been ignored are the financial implications
of the deal.
DEC's balance sheet-in particular its working capital-contains
a huge cash hoard just waiting to be liberated. And if
history is any guide, Earl Mason, Compaq's chief financial
officer, will liberate it. Our analysis indicates that if
Mason can simply bring DEC's days outstanding of accounts
receivable and accounts payable and DEC's inventory turns into
line with Compaq's, he should be able to reduce the cost of
acquisition from $9.4 to $3.5 billion. The latter amount is
less than four times-that's right, four times- DEC's projected
NOPAT in 1999.
We do not attempt to estimate the cash Compaq might generate
by restructuring DEC's fixed capital. In particular, we have
not factored in the $700 million which could be realized from
DEC's sale of its Alpha processor manufacturing facilities to
Intel. So our estimate of the cash locked up in DEC's balance
sheet is probably low.
And there's more! Our target price analysis indicates the
acquisition should add about $6, or 15%, to our current $42,
12 month price target. The combined company should grow more
slowly-at 18.5% over the next five years vs. the 25.0% growth
rate forecast for Compaq alone. But significant increases in
NOPAT and EVA created by the acquisition should more than
offset the slower growth of the combined company.
Some investors focus only on reported earnings. We have good
news on that front as well. Although Mason has indicated the
deal should be accretive by December, our analysis suggests it
could be immediately accretive if Compaq's restructuring
actions are as dramatic as we expect.
We continue with a Buy on Compaq rather than a Strong Buy
because the stock does not have to be bought today. It is
unlikely to show significant appreciation until the cash flow
implications of the deal are appreciated. And this could take
some time.
The Cash is Sitting There Just Waiting to be Liberated
Our analysis follows the forecasts in our January 28, 1998
Compaq broadcast, but extends our income statement and balance
sheet forecasts through 1999. These are shown in Tables 1
through 6.
With respect to DEC's income statement, we make three
assumptions:
(1) Compaq can buy components at prices which average 10% less
than DEC's because of its purchasing clout.
In 1997, for example, Compaq's cost of goods amounted to $17.8
billion, almost four times DEC's $4.6 billion cost of goods.
The assumed 10%+ reduction in component costs is consistent
with Compaq's cost advantage over Gateway, whose cost of goods
sold was slightly greater than DEC's in 1997.
(2) Compaq can reduce DEC's head count by 10,000 people after
the deal closes in mid-1998.
At an assumed salary of $50,000 per person, this translates
into annual savings of $500 million before taxes, which Compaq
should realize beginning in the September quarter. At the
same time Compaq must make severance payments, which we assume
will amount to one year's pay, or $500 million in total. In
short, Compaq does not realize a cash benefit from the layoffs
until the second half of 1999.
(3) We use Compaq's 30% tax rate, conservatively assuming that
Compaq obtains no benefit from DEC's $1.2 billion of tax loss
carry forwards.
DEC's working capital contains untold cash riches. With
respect to working capital, we make three assumptions:
(1) Compaq can reduce the days outstanding of DEC's accounts
receivable from 75 at the end of 1997 to 45 (Compaq's current
level) by the end of 1999.
With a modestly higher percentage of international sales than
Compaq, DEC is hostage to longer payment terms in some
countries. However, Mason has been successful in reducing the
days outstanding of Compaq's receivables, in part through
factoring; and we see no reason why he cannot do the same with
DEC's.
(2) Compaq can increase DEC's inventory turnover ratio from
6.3 times at the end of 1997 to 13.0 times by the end of 1999.
Superficially, this appears difficult. But Compaq has more
than doubled its inventory turnover ratio to 13.5 times over
the past two years; and through more efficient supply chain
management and its new build-to-order initiative, it hopes to
reach 25.0 times by the end of 1999. Moreover, since DEC
ships a much larger fraction of its products directly to
customers than does Compaq, the opportunities to move to a
build-to-order model and faster inventory turns are much
greater at that company.
(3) Compaq can increase the days outstanding of DEC's accounts
payable from 20 at end of 1997 to 42 by the end of 1999.
This is a no-brainer because DEC controls its payment
schedule. Why it's only 20 days is a mystery.
Table 7 shows that Compaq could capture almost $6 billion in
cash from the actions outlined above.
At the end of June 1998 when the deal closes, DEC should have
a cash balance of $2.3 billion and excess cash of $1.8
billion, assuming it operates with two weeks of cash.
After a 30% tax benefit, severance payments cost Compaq $350
million.
In the second half of 199, DEC generates $1.7 billion of free
cash flow from an increase in NOPAT and reductions in working
capital. This amount jumps to $3.5 billion in 1999.
Compaq's net cost of acquiring DEC falls from $9.4 billion to
$3.5 billion, less than four times the DEC's projected 1999
NOPAT. This is a good deal, if there ever was one.
The Acquisition
Creates Significant Shareholder Value to Boot
One of investors' concerns with Compaq's acquisition of DEC is
that the growth rate of the combined companies would slow from
the pace anticipated for Compaq alone. That's because DEC has
shown little, if any, growth in recent years. Assuming that
Compaq will grow at 25% and DEC at 0% over our five year
forecast period, the merged companies would grow at an 18.5%
rate, as shown in Table 8.
Nonetheless, the Compaq/DEC combination creates significant
shareholder value, as shown in Table 9. Using the 18.5%
annualized revenue growth rate, our price target model
indicates a fair price of $48, up from $42 for Compaq alone.
To capture Compaq's recovery of the cash locked in DEC's
working capital, we assume that invested capital will actually
decline 2.5% annually to $7.8 billion in 2003, the horizon
year in our forecast. This latter amount is still about $2
billion higher than the combined companies' projected invested
capital at the end of 1999, shown in Table 6.
We also assume that Compaq/DEC can increase its operating
margin to 13.0% from Compaq's 12.5% stand-alone operating
margin. In view of the fact that DEC's 34% gross margin is
over six percentage points higher than Compaq's, the company
should be able to convert a small portion of this increment
into a modestly higher operating margin quite easily.
Despite the lower revenue growth rate, the Compaq/DEC
combination generates a higher price target for two reasons.
On the one hand, the combination produces a NOPAT stream which
is larger in absolute dollars than Compaq's alone. On the
other hand, the stream of EVAt = NOPATt - the cost of capital
x invested capitalt, grows faster than revenues. That's
because invested capital is itself declining.
Compaq's current share price implies that investors are
anticipating only an 11% revenue growth rate for Compaq/DEC in
combination with a 10% operating margin, as shown in Table 10.
And the competitive advantage period implied in Compaq's price
is a mere three years.
The decline in Compaq's competitive advantage period from four
years as a stand-alone company to three years suggests the
market's initial response to the DEC acquisition is totally
inconsistent with the strategic benefits it should provide.
Once the acquisition is completed, Compaq will be able to
offer a full line of servers, ranging from departmental
servers running Windows NT through mid-range enterprise
servers running DEC UNIX to high-end fault tolerant Tandem
servers running transaction intensive applications.
In addition, Compaq will finally have a world-class service
and support organization.
The ratio of enterprise value to normalized free cash flow
provides a simple but compelling way to value Compaq cum DEC.
Compaq's enterprise value is currently $47 billion. As shown
in Table 6, the combined companies should generate $4.3
billion of NOPAT in 1999. Assuming the growth in NOPAT equals
the growth in capital, Compaq is currently valued at only 11
times 1999's normalized free cash flow. To place this in
perspective, Dell is currently selling at 28 times 1998
estimated free cash flow.
KAD |
