To all
This was in the Microsoft Investor page today.
Compaq Eats Digital, But Who Gets Fat?
The No. 1 PC maker may suffer some indigestion from its rich feast, but Intel and Microsoft should be licking their chops.
By Jim Jubak
It's big -- no doubt about it. Compaq Computer (CPQ) announced last week that it will pay about $9.6 billion in cash and stock to buy Digital Equipment (DEC), creating the third-largest computer company in the world with $37 billion in combined revenue.
But does size matter? Will Compaq now crush PC competitors like Dell (DELL)? Or does IBM (IBM), currently trying not very successfully to play catch-up in the PC market, have the most to worry about? How will the new Compaq, armed with a product line that stretches from PCs to powerful servers, fare in battle against Sun Microsystems (SUNW) and Hewlett-Packard (HWP)? Are Intel (INTC) and Microsoft (MSFT) the true winners from this deal? (These are not irrelevant issues to me, since I own shares of Intel and Hewlett-Packard, and Investor is published by my employer, Microsoft.)
To sort out the winners and the losers, you have to start by understanding exactly what Compaq is buying and how the acquired pieces fit into what Compaq already owns.
Founded in 1957, Digital Equipment now has about half the revenue of Compaq -- a company founded just about 25 years later. During its glory days in the 1970s and 1980s, Digital dominated the minicomputer market. But the company was slow to adopt Unix, the operating system that came to dominate the workstation market, and never managed to become a serious player in the PC market. The company sold 1.2 million PCs in 1997 out of global industry sales of about 90 million machines.
But Digital isn't simply a smaller firm now than Compaq; it's also a very different kind of computer company. Compaq gets about 95% of its revenue from selling boxes that range from entry-level, sub-$1,000 PCs to powerful servers produced by the company's Tandem division (a 1997 acquisition), which handle millions of transactions at banks and stock exchanges. Digital, in contrast, gets about 45% of its revenue from providing service to corporate purchasers of the company's products and other computer-hardware and -software companies. Compaq and Dell, for example, both use Digital to run their product-support help desks. Of Digital's 55,000 employees, 23,000, or about 42%, belong to the service side. At Compaq, service employees make up only 18% of total headcount (6,000 out of 33,000 employees), and most of those came over in the Tandem acquisition.
This service group is the diamond that made the acquisition of Digital so attractive to Compaq. In one stroke, the Houston company gains the ability to go toe-to-toe with Hewlett-Packard and IBM on what are called enterprise sales -- and win a bigger percentage of these deals. The enterprise market is made up of corporations that want huge numbers of boxes -- from PCs to servers -- at a good price. But these customers also want to buy from someone who can hook up those computers into a network, who can troubleshoot the system to prevent it from going down, and who can fix it immediately when it inevitably does. Compaq has been intensely pursuing this market. But it's been tough sledding. Compaq doesn't offer the handholding that the superb service organizations at Hewlett-Packard and IBM can provide.
Adding Digital's service group won't just let Compaq sell more PCs to corporations. It will also give the company entry into the service business, one of the fastest-growing parts of the computer industry. Just look at IBM's income statement. In the fourth quarter, hardware revenue was essentially flat -- up 1% from the quarter a year earlier. But service revenue grew by 18%.
And it will also let Compaq sell more computer systems. Margins in the PC business are shrinking day by day. PCs are now pretty much a commodity, and consumers make their choices among competing vendors largely on price. The way to make a buck in the business is to produce as cheaply as you can, keep inventories as lean as you can, and cut distribution costs to the bone. Dell Computer has set the bar high in this event, triggering a wild scramble to stay competitive. That makes the larger margins on servers -- the machines that make up the backbone of computer networks -- and workstations a mouth-watering target. Enterprise sales usually include both PCs and servers, plus storage systems to hold all the data -- a business segment where Compaq already ranks second in the world. And it won't hurt the company's enterprise-system sales when it adds Digital's midline servers, which fill a big product hole at Compaq between the company's PC servers and the top-of-the-line machines added in the Tandem acquisition.
Compaq will probably shut down Digital's PC business -- it's totally redundant.
It would take a series of really major bungles to destroy Compaq's immense momentum.
That's the upside for Compaq, and it's certainly sizeable. But integrating the two companies so that those rewards actually fall to the bottom line won't be easy. Compaq will probably shut down Digital's PC business -- it's totally redundant. Compaq competitors such as Dell that now hire Digital to provide service will undoubtedly want to terminate those contracts. And meshing the two cultures -- one relatively lean and driven, the other rather bloated and demoralized by years of reorganization -- without losing precisely the employees who are most valuable to the company will take talented diplomacy. And let's just say that Compaq CEO Eckhard Pfeiffer isn't exactly known for his soft touch with people.
So here's how I handicap the race over the next year and for the long term.
I think Compaq will struggle as it digests the acquisition. I'd expect the hit to margins and the round of write-offs to surprise investors who think they've seen all the write-offs. And I'd expect that the benefits that management is hoping for will drop to the bottom line more slowly than they'd like. The Digital acquisition doesn't fill all the gaps in Compaq's enterprise strategy -- for example, Digital has only a minimal competence in applications. (Compaq has virtually none.) Digital's service group, while moving aggressively into the Windows world in the last few years, still carries substantial baggage from the days when Digital believed in proprietary operating systems. The frustration level could get pretty high at Compaq, and management is likely to take a misstep or two.
But Compaq has solid management and a strong culture that will take the company through the rough spots. And it would take a series of really major bungles to destroy the company's immense momentum. For example, Compaq is now jockeying with Hewlett-Packard for bragging rights to the No. 1 ranking in PC-server sales, a very profitable market that Compaq has targeted. In the days just after the announcement of the acquisition, Digital and Microsoft signed a deal that makes Digital the prime service contact for corporations that want to use Microsoft's NT operating system.
Everyone on Wall Street expects that NT sales will really take off later in 1998, when Microsoft announces Version 5 of the software. But even the current version, with all its flaws, is grabbing an amazing share of the server and workstation market. In fact, in 1997 sales of workstations equipped with Windows NT hit 1.3 million units, marking the first time that NT unit sales topped the figure (660,000) for workstations sold with the Unix operating system. Put it all together -- the No. 1 PC company, Digital's service group, and Microsoft -- and, well, Compaq ought to be able to sell some machines.
My take on Compaq's stock? Use any weakness this year to accumulate a long-term position. Buy on any signs of indigestion during the transition and hang on.
IBM should be worried -- even more so than Sun Microsystems and Hewlett-Packard. I think all three companies still have a substantial edge in service on even the combined Tandem/Digital group, but the game is a lot more even now. Compaq, which was already making inroads in the enterprise market, will become an even more aggressive competitor after Digital's service organization is folded into the package. Any of the full-service incumbents who think they can use their dwindling edge in that area alone to ward off Compaq are being foolishly complacent.
IBM is wracking up an embarrassing record of being late to market with new products in hot areas.
I don't see any signs of that attitude at Hewlett-Packard and Sun Microsystems. The two companies seem committed to fiercely battling Compaq on price and product. In the last month, for example, Hewlett-Packard has matched Compaq feature for feature, product for product, price cut to price cut. So has Sun Microsystems in the server business. IBM, however, is wracking up an embarrassing record of being late to market with new products in hot areas. In the most recent instance, Big Blue has lagged well behind Compaq and Hewlett-Packard in offering a line of computers selling for less than $1,000. I see Compaq's acquisition of Digital as a dagger pointed straight at the heart of IBM. If IBM can't respond to the challenge with more nimbleness than it's shown recently, this is not a stock I would plan on holding for the long term.
The deal also poses tough strategic questions for Dell Computer. Dell remains the low-cost seller in the PC business -- but it has no ability to provide service and therefore sells into the enterprise market at a serious disadvantage. The company stands at a crossroads. Continue to do what it has done so very successfully to date by concentrating on individual consumers and small businesses, and compete for those corporate sales where service isn't an issue. Or go into the service business. (Dell will probably want to replace its current arrangement with Digital anyway.)
My guess is that the company will stick to its knitting and continue on its present course. Check Dell's success in selling PC servers to see if this strategy is working. If the company can build sales in this high-margin business while pursuing its current business model, then investors in Dell can sleep easy.
At the risk of arousing extreme suspicion, I have to say the biggest winner from the acquisition may actually be Microsoft. I think a deal that combines one of the hardware companies pushing NT hardest with the service company specializing in NT should result in an acceleration of sales of Microsoft's operating system for computer networks. (It will also have the effect of making companies such as Hewlett-Packard push NT just as hard in order to stay competitive.) Lining up all those bruisers behind NT will certainly help sales of that operating system in the short run. But just as important, down the road it will grease the skids for Microsoft's reported plan to transform its operating-system business from Windows 98 to some future version of NT.
A similar logic makes Intel a winner in this deal, too. Before the announcement, Intel had enlisted everyone in the computer industry (with the exception of Sun Microsystems) in its effort to make the ever-more-powerful PC server -- with Intel inside -- the replacement for the Unix-based workstation. Now, with Compaq's acquisition of Digital, a large group of Digital's workstation users have joined the Intel processor camp; Compaq will make sure that those Digital users have a viable upgrade path, which means an Intel machine, and that their workstations can talk to the rest of Compaq's line of Intel machines.
I've left out quite a few players -- Gateway (GTW), Packard Bell, Micron Electronics (MUEI). The omission isn't an oversight. The Compaq/Digital deal has just pushed the speed of the consolidation going on in the PC industry up another notch. And I'm afraid that means that a very big truck is bearing down on these companies very, very fast. All but the most efficient and the most nimble -- Gateway, maybe? -- are going to wind up as roadkill in the rear-view mirror.
For these companies, this acquisition is and will be a very big deal.
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Comments?
long sun,
David |
