From The Motley Fool: must read for DELL and CPQ investors.
Compaq Bear's Den
by Louis Corrigan (tmfseymor@aol.com)
Investors need to know what they're buying. However,
Compaq is no longer a known quantity.
Looking at FY97 results, I see a computer giant that
delivered $24.6 billion in sales (up 23%) and $1.35 in
earnings per share (up 52%), excluding non-recurring
charges. Its PC sales grew at around 63%, or four times
faster than the industry overall. Meanwhile, gross
margins rose from 25.8% to 27.5%. Operating margins
before taxes and charges jumped to 12.3% from 9.7%.
Meanwhile, its acquisition of Tandem boosted the
enterprise business to 37% of sales in the fourth
quarter, helping to counteract margin pressure in the
desktop business.
Such terrific numbers sent Compaq shares soaring from
under $15 at the end of `96 to nearly $40 by September.
But since then, the stock has been crushed due to
dismal results in the increasingly competitive PC market
and a whole lot of uncertainty about what the purchase
of Digital Equipment Corp. (DEC) will mean for Compaq.
First quarter revenues increased just 8% as the
company finally had to admit that much of the inventory
it had pushed into the reseller channel in the latter half of `97 was still there. The
result was some very bad news: EPS fell to $0.01 versus $0.28 in the year-ago period,
as gross margins fell to 18% from 26.9%. Second quarter results are expected to be
merely break-even because the company has been forced to slash prices and even
halt some production. While inventory held by resellers at the end of the second
quarter should be around 4 weeks versus 10 weeks earlier in the year, that's still a lot
in a marketplace that is keying off of Dell's build-to-order model.
Compaq had promised a rapid implementation of its own build-to-order
manufacturing last summer, but it so botched that initiative that its inventories
actually soared. Yet, while Compaq is fighting Dell, it's also using the DEC deal to
refocus its business around services, system integration, and all the other stuff that
transforms hardware into "enterprise computing" and "information technology."
That sounds fine, but let's check out the pro forma combined financial statement for
FY97. DEC would have pumped up Compaq's revenues to $37.6 billion, but EPS of
the combined firms would have actually dropped to $1.10.
That doesn't take into account the pending $5.4 billion restructuring that will claim
17,000 jobs and no doubt enhance future results. Still, Compaq's core business has
suffered from slowing sales, shrinking margins, and rotten execution. The company
is now looking to refocus its operations by acquiring a business that won't add to
profits unless Compaq executes like crazy.
Investors should all but ignore current analyst estimates; they're little more than
guesses. Compaq may have found the future of computing, but until it shows it can
deliver, why rush in? Here are the main reasons this one-time star has dropped from
the A list to the D list.
Disclosure: On January 21, CEO Eckhard Pfeiffer said he expected a "strong 1998"
with "improve[d] profitability." Right! Everybody and his brother was already
worried about Compaq's excess inventories, and the firm was six weeks away from
pre-announcing the first quarter disaster. Management refused to be straight with
investors. On other occasions, Compaq has told money managers material
information without bothering to tell the public. Companies with poor execution and
poor disclosure are the kind you want to avoid.
Demand: Worldwide growth in PC sales has slowed from 15% last year to just over
10% in the first quarter to maybe 9% in the second quarter. With everyone looking
to capture market share, price competition is intense, underscoring the necessity of
low-cost manufacturing.
Dell: Given the above, build-to-order rules because the value of inventory drops 1%
per week. Dell has about a week's inventory while Compaq has four weeks of
channel inventory plus several weeks of in-house inventory. So, until Compaq
executes to precision, Dell has a significant price/profit advantage.
DEC: This deal poses more than an integration challenge; Compaq is going to use
DEC to remake its own business model. Compaq now has 25,000 technicians plus
10,000 direct marketing/sales personnel who are supposed to help it build
relationships with customers, thus pumping up service revenues and helping the
firm win jobs it otherwise might have lost. However, Compaq will now be competing
against many of its current partners, from information technology consultants to its
channel resellers. That usually spells trouble.
Distractions: Compaq just launched a $300 million branding campaign with a
beautiful but idiotic 12-page spread in the Wall Street Journal. These ads (like those
run by Seagate and Oracle) are a waste of money because they don't focus on
actually selling products. Besides, those pull-out ad sections just get tossed
anyway. Pfeiffer also thinks Compaq should blow money investing in cable and on
various Web start-ups to help accelerate demand for faster, higher margin PCs. But
Compaq simply doesn't have the margins of Microsoft or Intel, so it just can't afford
such extraneous ventures. Add this kind of stuff to the task of taming DEC, and
Compaq seems a long way from what should be its major concern -- improving
manufacturing efficiency.
The question is, what business model will thrive in today's computer marketplace?
Compaq is moving from being primarily a manufacturer to being all things to all
customers. This strategy should lead to continued revenue growth, but its effect on
margins is unclear. Meanwhile, Dell is focusing on one goal: being the most
profitable computer manufacturer on the planet, partly by managing its assets
exceptionally well and partly by migrating its business into the server market rather
than down into the under $1,000 box market. Dell is happy to rely on partners for all
the other stuff.
While there's nothing wrong with developing new competencies, it's tougher than
focusing on improving your core competencies. I see Compaq fooling around on the
former while Dell keeps working hard at what it does best, which includes preparing
to kick Compaq's butt while Pfeiffer et al. have their backs turned.
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