Dulane/Thread:
Another take on the CPQ/DEC get together with a slightly more cautious twist:
Perspective
IT Services-Core Topics
Event Summary
A Comprehensive Analysis of Compaq's Acquisition of Digital Equipment
Abstract: On January 26, Compaq Computer Corporation announced an agreement to acquire Digital Equipment Corporation for $9.6 billion, the largest acquisition in the history of the computer industry. The ramifications of this merger impact every corner of the IT industry. This Perspectives provides a Dataquest-wide analysis of the effects of this acquisition on the IT market, the competition, and on the future of Compaq and Digital Equipment.
By Dataquest Analysts
Introduction
This Perspective represents a Dataquest-wide effort to explore the significance and meaning behind Compaq Computer Corporation's acquisition of Digital Equipment Corporation. This acquisition is touted as the largest deal ever to take place in the history of the computer industry, thus catapulting Compaq to new heights as one of the world's top computer companies. The following pages explore the impact this merger will have on the industry, the competitive landscape, and the future of Compaq and Digital Equipment.
The Largest Acquisition in the History of the Computer Industry
On January 26, Compaq Computer Corporation and Digital Equipment Corporation announced, to a somewhat surprised public, that Compaq will acquire Digital Equipment. The deal, worth $9.6 billion, is the largest acquisition in the history of the computer industry. This announcement came amidst ongoing speculation that Compaq was talking with Digital Equipment, but many industry pundits would have bet that the resulting deal was for Digital Equipment's profitable services business, as opposed to the entire company. Under the terms of the agreement, Compaq will complete the purchase with a combination of stock and cash. Digital Equipment shareholders will receive $30 in cash and about 0.945 shares of Compaq common stock for each share of Digital Equipment stock. Compaq will issue about 150 million shares of Compaq common stock and $4.8 billion in cash. Estimates indicate that the acquisition cost works out to between $60 and $65 per share. Pending approval by Digital Equipment's shareholders and clearance under antitrust laws, Digital Equipment will become a wholly owned subsidiary of Compaq.
The true cost of Digital Equipment to Compaq, however, is much less. Digital Equipment, at the end of December 1997, had just over $2 billion in cash-making the net cash outlay only $2.8 billion and the 150 million shares representing 19 percent of Compaq's shares outstanding. This means that if Digital Equipment produces no earnings, Compaq's earnings per share would be diluted by 19 percent. However, if Compaq is successful in making whatever parts of Digital Equipment it keeps, as profitable as the rest of Compaq, there will be no dilution. As a result, Dataquest expects Compaq to act swiftly in realigning the parts of Digital Equipment it will keep and spinning off whatever remains.
Who Is the Biggest of Them All?
As part of its announcement, Compaq made the claim that once combined with Digital Equipment, the resulting company will be the second largest computer company in the world after IBM; Table 1, in some ways, supports Compaq's boast. In total revenue, Compaq combined with Digital Equipment comes in fifth place. Backing out noncomputer revenue is difficult at best. However, Dataquest's best estimate shows the combined revenue of computer-related products from Compaq and Digital Equipment to be second only to IBM. Table 1 and Table 2 present a breakout of this data.
Table 1
Total Worldwide Company Revenue 1996 and 1997 (Millions of Dollars)
Company 1996 1997
IBM 75,947 78,508
Hitachi 65,207 68,735
Hewlett-Packard 38,420 42,895
NEC 34,904 39,907
Compaq and Digital Equipment 34,572 37,646
Fujitsu 29,160 36,318
Note: All numbers are Dataquest estimates
Source: Dataquest (January 1998)
Table 2
Total Worldwide Computer Revenue 1996 and 1997 (Millions of Dollars)
Company 1996 1997
IBM 72,222 74,777
Compaq and Digital Equipment 32,593 35,800
Hewlett-Packard 31,559 35,449
Hitachi 34,174 35,325
Fujitsu 23,286 30,887
NEC 27,340 30,540
Note: All numbers are Dataquest estimates
Source: Dataquest (January 1998)
For Compaq to maintain its role as the second largest computer company, it must effectively integrate Digital Equipment's operations into its own with minimal cannibalization, while continuing to grow at its stated growth rate of 25 percent per year or better. Clearly, Compaq will not be able to keep all of Digital Equipment's market share in PCs and low-end servers, making the combined companies' revenue not completely additive. However, even with an assumed loss of 75 percent of Digital Equipment's PC revenue, Compaq is still ahead of Hewlett-Packard Company after backing out HP's test and medical equipment revenue (but not by much). In essence, the race for the No. 2 position in the computer industry is a dead heat between the combined Compaq and Digital Equipment, HP, and Hitachi. Fujitsu and NEC are not far behind.
A key benefit for Compaq is Digital Equipment's core enterprise business, which occupies a market position that Compaq has been unsuccessful at penetrating because of its Intel-based architecture. However, Digital Equipment's Alpha business is the clear technical leader in large computing system hardware, but it has been unsuccessful in a marketing sense. Compaq can take the Alpha systems business and dramatically accelerate it through Compaq's powerful sales and marketing skills. If it succeeds, the prize will be large-Table 2 indicates that there is plenty of money in this particular pot.
How Does the Acquisition Impact the Competition?
Prior to the acquisition, Compaq competed against IBM's and HP's products. Today and in the future, the battle will be waged over solutions that Dataquest defines as the strategic bundling of products and services. IBM is still by far the world's largest computer company. However, its hardware revenue is dominated by aging legacy systems such as S/390 mainframes, AS/400 midrange systems, and its UNIX-based RS/6000 products. The inevitable maturation of Windows NT should have a profound effect on IBM's ability to keep its business from shrinking. Compaq's acquisition of Digital Equipment puts increasing pressure on IBM to decide whether to aggressively pursue a Windows NT-based product and services strategy as have HP and Compaq. If IBM continues to shy away from a similar strategy, its customers may become fodder for HP and Compaq's growth. The ultimate key challenge for Compaq is to create its own solutions methodology, thus moving away from a products-only strategy.
As for PC companies, Compaq has moved significantly ahead of its traditional competition. Dell Computer Corporation must decide whether to become a computer company or stay a very efficient channel for PC products. A major risk for PC and other systems vendors is that Compaq, IBM, and HP will become the primary product and service suppliers for end users. Customers may not see the need to include more than three vendors on their short lists. This may have force other competitors to become niche solution providers.
How Will the Acquisition Impact Products and Technologies?
A Dataquest analyst made the analogy that "the merger of these two enterprises and cultures will be like two galaxies colliding: slow to happen, and some worlds may collide and be destroyed." This comment reflects the multitude of perceived product overlaps within Compaq, Tandem, and Digital Equipment. Understandably, these redundancies will be remedied-the perceived outcome is the eradication of certain products and technologies. Perhaps the more interesting question is which products and technologies have enough brand and market value to succeed under the new Compaq regime. Dataquest briefly explores these questions by product and technology type.
Workstations
With the workstation market in a period of major transition, Compaq's acquisition of Digital Equipment has the potential to significantly change the balance of power. Although it is relatively new to the workstation business, Compaq has shown itself to be one of the movers and shakers in the rapidly growing Windows NT workstation market. By comparison, Digital Equipment has not been doing as well-not only losing market share in the stagnant UNIX market, but more importantly losing ground in the Windows NT segment where it was one of the early leaders. Digital Equipment workstation customers stand to gain from Compaq's leadership and momentum. Almost immediately, Compaq can challenge HP more effectively for the No. 1 position in the Windows NT market segment by pooling the market share of both companies (Compaq and Digital Equipment).
Compaq also gains significantly on the technology front with a technically credible UNIX offering. The most significant impact of this could be in the graphics area. Until now, Compaq has had no graphics strategy of its own, relying upon third-party cards while HP and Intergraph have been able to differentiate their Windows NT product lines with proprietary high-end graphics capabilities. Along with Digital Equipment's workstation business, Compaq has gained the high-end graphics technology from Megatek, which Digital Equipment acquired in 1996. Compaq has the opportunity to add the fruits of this venture to its workstation business potentially filling one area of weakness.
Servers
The issues dealing with the operating system of choice take place most predominantly in the server space. Compaq supports Windows NT, SCO UnixWare, and Novell's NetWare; Digital Equipment provides Windows NT and its proprietary UNIX, as well as systems based on VMS. The third element of the new company, Tandem (acquired by Compaq in June 1997), has its proprietary NonStop Kernel (NSK), a small investment in UNIX, and Windows NT. Also there is a mix of processors (that is Intel, Alpha, and MIPS) within the new company and the operating system decision goes jointly with the chip selection.
Dataquest foresees that Compaq will opt to keep Tandem's high-end systems and operating system while at the same time maintaining Digital Equipment's UNIX variety. There may be an opportunity to migrate the NSK operating system to an Intel design in the future, but it is well after the turn of the century. The Alpha solutions gain credibility with Compaq's endorsement and can provide a path from IA 32-bit to the Merced technology. The real test of strengths will be the price/performance ratings of the processors and operating systems after Merced is stabilized and Microsoft's next generation matures.
Personal Computers
Through the first three quarters of 1997, Compaq sold roughly as many PCs every month as Digital Equipment did the entire period. This underscores the fragility of the Digital Equipment PC business as part of a much larger Compaq. Although Dataquest believes that Digital Equipment brings valuable technology and engineering to the table, these attributes will be more effectively leveraged in Compaq branded PCs. Therefore, Dataquest ultimately foresees the death of Digital Equipment branded PCs.
As customers' short list of vendors becomes dominated by IBM, HP, and Compaq, this may force other computer vendors (PC and otherwise) to target niche markets. Ultimately, this standardizes and simplifies the desktop, leading to a real commodity market where vendors must search long and hard to add significant value and differentiation. Whether customers will accept single vendor solutions is an open question.
As for the mobile portion of the PC business, there are no immediate magic bullets-it is truly a draw between the mobile technology of Compaq or Digital Equipment. Dataquest believes, however, that the acquisition may allow Compaq to finally get a shot at obtaining the kind of flagship product that instantly defines the entire line and its potential. Additionally, Digital Equipment design engineers and marketers have a chance to join a mobile team that has been one of the top three in the world for the past few years. Compaq has been vying for the top spot on the mobile PC vendor heap for almost as long as there have been mobile PCs. The addition of Digital Equipment's products and skills will help Compaq compete more effectively.
Microprocessors
Digital Equipment's Alpha chip will afford Compaq the chance to penetrate and grow its business in the data center environment.. It raises Compaq to the elite ranks of HP and IBM as a provider of a full suite of systems and services, and allows Compaq to let the PC business evolve into a box-delivery component of its overall system strategy. Compaq's server growth will no longer be limited by any perception that Compaq is just a PC company, and the opportunity to mate the advanced Alpha servers with Compaq's marketing and sales skills could lead Compaq to significantly higher overall margins by the end of the decade. Therefore, after the dust settles, there is a third major contender for the enterprise systems market as Compaq joins HP and IBM.
What's the Impact on IT Services?
The addition of Digital Equipment's services business to Compaq fills an immense void that has kept Compaq from becoming a significant player in the enterprise computing market. Compaq's distinct lack of a service business (especially in terms of field personnel), even with its acquisition of Tandem last June, had a "pigeonhole" effect on it as a product company. It could offer great technology that was admissible for workgroup computing, but would never fly in the enterprise because of the company's lack of mission-critical services infrastructure and IT integration and management skills. Compaq attempted to minimize its lack of robust enterprise services by crafting partnerships with Digital Equipment and Unisys. However, IBM and HP continually attacked this leveraged support model in competitive bid situations, even though they too used partners.
The addition of a direct service business is a major boost for Compaq. It now has a chance at the enterprise and may be able to give IBM and HP a run for their money, provided the integration runs smoothly and there is an increased focus on providing solutions.This move also places more distance between Compaq and its PC competitors, particularly Dell and Apple. Compaq can now go to market competing on product and service while most others will not be able to compete at this level in the services arena.
In terms of skills and resources, Digital Services Division consists of 22,000 service professionals split between its three service business units. These business units and the specific skills sets contained therein are as follows:
n Multivendor Customer Services (MCS): This group accounts for 66 percent of fiscal 1997 service revenue ($3.8 billion). MCS delivers hardware service, support, and maintenance services, as well as multivendor availability and management services that focus on providing technical expertise in UNIX and Windows NT for mission-critical environments. Compaq leverages the MCS organization as a global service partner. Overall, the MCS group will be challenged to maintain its vendor neutrality as a vendor-to-vendor service partner.
n Network and System Integration Services (NSIS): This group accounted for 24 percent of fiscal 1997 service revenue ($1.4 billion). It has competencies in application solutions for mail and messaging, Internet/intranet services, electronic commerce, and manufacturing and telecomm industry solutions. Strong technology solutions have also been built around NT. Compaq made an initial foray into the network business with its acquisition of Thomas Conrad and Networth several years ago. To date, Compaq has not figured the nuances in delivering service for networks versus delivering services for desktops. This NSIS group will help better define Compaq's role as a network integrator.
n Operations Management Services (OMS): This group accounted for 10 percent of fiscal 1997 service revenue ($0.6 billion). Service offerings include operations support for distributed client/server environments, including desktop systems infrastructure management, application operations management, and Internet/intranet management. The services and skills in OMS will enable Compaq to offer life cycle management services to its customer base.
The integration of Digital Services into Compaq is, in theory, like finishing a puzzle-almost. Dataquest perceives certain weaknesses in Digital Equipment's services business that may directly translate into lost opportunity for Compaq. Specifically, Dataquest cites its lack of a mature applications integration practice as a major hole in Digital Equipment's capabilities. These skills are essential for a major play in the enterprise. As both companies are aware of this distinct lack, there is a chance that there may be additional acquisitions down the road.
Once the integration process gets under way between the two companies, Dataquest foresees a potential culture clash between product-oriented Compaq and the Digital Equipment's services business. Although Compaq's executives understand the need for services, there is a distinct lack of understanding about how to shift from a product to a solutions model. Compaq needs to make a concerted effort to leverage the knowledge and expertise housed within Digital Equipment in order to effectively make this transition. Compaq may very well end up integrating into Digital Equipment's service culture rather than the other way around. Dataquest believes Compaq's best bet is to let current Digital Services management remain in full control of services.
The existence of a Compaq/Digital Equipment service partnership prior to the acquisition may help move the integration process along. In fact, Compaq stated that talks between the companies first began because of the services partnership. However, there's a concern that Compaq will continue to be quite focused on the capabilities offered by Digital Equipment's Multivendor Customer Services (MCS) business unit, which are quite product support oriented. Compaq needs to expand its services vision and leverage the outsourcing and network services skills housed in Digital Equipment's other services units.
Lastly, there are several looming questions-the answers will directly impact the success of Compaq's merger with Digital Equipment and their future success as a unified company. Some of these key questions are as follows:
n How will Compaq manage its channel relationships given that it now has a direct service capability?
n Will Digital Equipment be able to sustain its reputation and viability as a multivendor service provider given that it is now a Compaq-owned company?
n Does Digital Equipment bring the right mix of service expertise that Compaq needs to deliver enterprise solutions to the Fortune 1000?
n How will Compaq integrate the Tandem and Digital Equipment professional services capabilities?
Dataquest believes that most of the elements are in place for Compaq to compete squarely in the demanding enterprise services arena. However, it needs to take a hint from IBM and HP: lead with solutions, not just products.
What's the Impact on the Channel?
The potential for product channel conflict is technology dependent. Clearly in an open technology market such as PCs, channel conflict is a key issue because a reseller can make the decision to switch brands if it is concerned that it is competing for business with the vendor. With Digital Equipment's PC business expected to be merged into Compaq's business, this should not be an issue-particularly since Digital Equipment's existing business is almost exclusively indirect.
Further up the technology curve, segmenting between direct and indirect channels is more difficult; it is a question that companies such as HP and Digital Equipment have struggled with, especially as WinTel technology has encroached into the workstation and midrange computer spaces. If technology is proprietary and demanded by users, then a vendor can operate through both direct and indirect channels. More difficult for vendors is how to stop and separate sales organizations from competing against each other. HP's solution is to put both sales organizations under the same umbrella. Compaq will need to move in this direction.
Channel relations regarding service could be a touchy subject, as Compaq now has direct service capabilities. However, considering Compaq's recent redesign of its Authorized Service Provider (ASP) program around customer requirements and satisfaction, and Digital Equipment's multivendor services accomplishment of integrating services at point of product purchase, there will be plenty of service opportunity for the channel. Current business partners focused on the services side of the equation have compelling reasons to stay the course or even upgrade their relationships with both companies.
Compaq needs the channel's support. Even with the Digital Services Division under its belt, the company still needs the channel's core competencies such as broad customer reach and custom software expertise. HP and IBM have recognized this and it is reflected in their channel strategies. The Digital Equipment acquisition puts Compaq in a more powerful position when dealing with the channel, but there are alternatives that resellers can choose. Resellers will be watching Compaq very closely in the coming months.
What's the Impact on Sales and Marketing?
Neither Compaq nor Digital Equipment has as yet determined the overlap between accounts. Digital Equipment's MCS organization is already supporting many Compaq environments-all signs indicate that Compaq intends to preserve this vendor neutral asset. Digital Equipment's product and service top accounts map closely in Fortune 1000 market segments. Its services business has helped Digital Equipment penetrate Fortune 2000 and middle market segments with little overlap on the product side. Digital Equipment's strengths are in middle market and global enterprise organizations. Compaq views its markets slightly differently. Compaq clearly plays in the small office/home office segment and in what it labels the small/medium business, middle market, and global/mission-critical enterprises.
In terms of sales resources, Digital Equipment has about 1,000 dedicated service sales specialists worldwide who prospect for and close the company's service business. A number of these dedicated service sellers line up to strategic accounts and sell to end users as members of Digital Equipment's Enterprise Sales Force (ESF) account teams. They also include channel sales representatives who sell to, through, and with partners. ESF staffs about 2,000 people worldwide and sells the company's technology products; it segments into three types of selling orientations. One group is assigned to about 500 strategic corporate accounts, another group has a territory responsibility covering from 2 to 25 accounts, and the rest are devoted to prospecting for new business and generating leads for Digital Equipment's partners.
A potential concern however, before the acquisition and now, is the lack of sufficient consultative selling talent in both companies. Compaq's model is indirect through partners, with limited experience in the business solution sell at the top of the enterprise. Digital Equipment's only real engagement managers are in the OMS business and are already stretched. Pockets of excellence exist within Digital Equipment's service sales organization, with considerable talent in networks, business-critical support, migration, mail, and messaging. However, the new entity will require a prudent sales retention, conversion, and recruitment effort designed to bring the enterprise selling talent to a level commensurate with the new and considerable enterprise capabilities.
The new value proposition is one of client choice of highly engineered products and technology platforms, superb service capability, true global distribution and service infrastructure, and a wealth of experience in managing complex distributed computing environments. This proposition gives the combined salesforce some powerful new selling opportunities that cannot afford to wait six months or even one year.
Dataquest Perspective: What's the Bottom Line?
Overall, Dataquest regards Compaq's acquisition of Digital Equipment as a positive move. Critical synergies exist that will greatly improve both companies' future positions and bring added value to existing and future customers. In the short term, Compaq will continue as it has been: driving NT over UNIX and proprietary systems, and leading the world selling PCs. Further down the road, Dataquest foresees significant product, technology, and service implications as a result of the acquisition.
One of the primary overlaps between companies is in the personal computer market. It is likely that Digital Equipment's PC business will be subsumed totally under the Compaq brand because of overlap and limited brand equity. Digital Equipment's mobile PC business will also be absorbed, but the company's pioneering work in low-profile large-screen products could combine with Compaq's solid mainstream devices to allow the combined company to dislodge Toshiba from the No. 1 slot. Dataquest believes that Compaq will retain Alpha and Digital UNIX because they have the strategic implication of expanding Compaq's reach into the enterprise-that is until Intel's IA-64 architecture delivers a compelling alternative to the market (not until 2001 at the earliest) and NT matures. The combination of Tandem's NonStop Kernel, Alpha and Digital UNIX, and Compaq's PC contribution create a powerful technology engine that will allow the combined company to compete against a wide variety of competitors.
On the services side, Compaq has historically been penalized for its lack of a substantial services business. With the acquisition, it gains a service giant, 22,000-people strong with global capabilities. Dataquest anticipates some form of a culture clash between the two companies as Compaq struggles to make room for services in its product world. Despite the addition of a formidable services business, Dataquest questions whether Digital Services has the precise array of services required to provide full solutions to enterprise customers. One of Digital Equipment's key weaknesses is its lack of application integration skills that are quickly becoming a requirement given the burgeoning enterprise resource planning market. Because both companies seem to be aware of this deficiency, Dataquest can't help but wonder if there are other acquisitions waiting in the wings.
Taken as a whole, the ultimate challenge will be the integration of products and technology with services. Compaq's goals of becoming one of the top three computer companies in the world and reaching $50 billion in revenue by the millennium, are largely dependent on its success at solutions selling. Dataquest perceives that most of the working materials are in place to make the new Compaq a full solutions provider, with the exception of data center and application integration skills. Aside from these holes, Dataquest anticipates a success-filled future for Compaq as an enterprise player.
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