"Compaq's Fourth Quarter: Better Than You Think"
From Individual Investor
iionline.com
Compaq's Fourth Quarter: Better Than You Think
Caroline Jones
CEO's are coming to love the earnings game that Wall Street plays. Deliver earnings that are well ahead of expectations, and watch your company's stock price rise. On Wednesday, Jan. 27, Compaq Computer's (NYSE: CPQ) Eckhard Pfeiffer must have been pleased to deliver a dose of good news on the earnings front.
After a difficult first half of 1998, Pfeiffer was able to crow that the company being back on track, delivering $758 million in profits in the fourth quarter. That $0.43 per share profit was a mighty 16% ahead of consensus estimates. Much of the gain, though, came from a lower-than-expected tax rate through the utilization of Digital Equipment's tax loss credits.
And true to from, Compaq's shares got a nice pop at the open to $51. Considering that the stock traded at just $24 in October, investors seemed to be getting behind the stock in a big way. But by 10:30 AM EST Wednesday, the shares slipped to $48. By late afternoon the shares fell below $47. Shares recently traded for $46.88.
To be sure, the company's earnings were complicated and difficult to decipher. The company's erratic operating results for the previous four quarters and the addition of Digital for the first fully accretive quarter make comparisons guesswork at best. But frankly, it surprises us that the shares didn't continue climbing
Momentum on the PC Front
Compaq showed strong sales momentum this quarter with PC sales to the channel up 31% year-over-year. More importantly, however, is whether consumers are buying the product or whether Compaq was tempted once again to stuff the channels and inflate earnings. The good news is that sales out of the channel were up a huge 43% and channel inventory levels remain sound at just under four weeks, although this was up slightly sequentially. The average selling price declined 5% sequentially, a refreshing change from the precipitous falls earlier in the year. So all looks intact on the PC front. Now over to Digital.
Digital Integration Progressing
Digital was accretive for the first full quarter and contributed to a higher gross margin of 26.4% up from 24.9% sequentially. That 150 basis point jump should signal a trend that will continue over the next few quarters. Services revenue increased 10% year-over-year and now contributes 16% of the total. Enterprise sales are growing quickly and now contribute 40% of revenue (including services). Overall, Digital's results and the integration of the company were impressive.
Earnings
Overall Compaq's revenue grew 48% and net income grew 14% year-over-year, while earnings per share increased $0.01 to $0.43. However, results are confused by unusual gains from a lower tax rate and charge reversals, which contributed approximately $0.05 per share.
In addition, quarter four 1997 results were inflated due to channel stuffing, making both 1997 and 1998 reported EPS figures artificially high. It is more relevant to consider the quality of earnings (1998 is clearly superior) and sequential improvements, which reveal that Compaq is back on track.
One concern: The risk of a slowdown in PC sales in the second half of 1999. People may stop buying technology just before 2000 -- in fear of the Y2K problem -- would quickly deflate the stock.
Future Catalysts
Three things in particular should drive further gains. For starters, Compaq's move to mimic Dell Computer's (NASDAQ: DELL) direct sales model should help boost market share. Secondly, the Alta Vista spin off has the potential to be very profitable for Compaq, given the continued demand for Internet IPOs. Thirdly, stable component costs and strong demand should ensure a smooth and predictable earnings outlook. Lastly, a move to slash 20 percent of the work force should help Compaq expand operating margins.
Bottom Line:
Admittedly, at 26.2 times consensus 1999 EPS of $1.79, the shares are no longer a bargain. Despite a shortfall in 1998, Compaq execs have historically showed a knack for boosting earnings strongly. Per share earnings grew at a 48% annual clip until the recent slowdown. With the aforementioned drivers in place, analysts may soon start focusing anew on Compaq's bright long-term earnings outlook. By then, $60 or $70 price targets may take hold.
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