Let's talk about this rather...
COMPAQ: NOT A BAD STORY AND NOT A BAD PRICE
03:01pm EST 19-Mar-99 J.P. Morgan (KUNSTLER, DANIEL)
March 19, 1999
J.P. MORGAN SECURITIES INC. - EQUITY RESEARCH
Compaq Computer (Market Performer)
NOT A BAD STORY AND NOT A BAD PRICE; BUT 1Q DUST STILL NEEDS TO SETTLE
Earnings Per Share
----- ----- ----- ----- -----
12/98 12/99 12/00 1Q/99 1Q/98
----- ----- ----- ----- -----
Current $0.53A $1.81E $2.28E $0.33E $0.01A
Previous $1.90E $2.30E $0.43E
We spent the morning of March 18th with four of CEO Eckhard Pfeiffer's
direct reports: CFO Earl Mason, John Rose head of the enterprise
business, John Rando, head of the services division, and Mike Winkler
who runs the corporate non-server PC business. The company is still
being buffeted by the shifting winds of the PC business, which seem
to be particularly unsettled by the PC equivalent of an El Nino
effect in the first quarter. While Compaq traces current sluggishness
to a fall-off of demand from small and medium businesses in January
and February - possibly because of the transition to Pentium III and
the ripple effect on pricing of existing Pentium II models -- other
evidence, like Dell's (DELL/$42.25/Market Performer) revenue miss and
Hewlett-Packard's (HWP/$74/BUY) frank confession of weak sales of its
Vectra series, suggests some flattening of overall demand for
corporate desktops. We have pointed to a number of reasons why the
extrapolation of the strength in PCs over the last two years into
1999 is hazardous: there are no big operating system releases this
year to push hardware upgrades, Y2K in our view has a neutral effect
on demand, and the easier market share gains available to the major
players may have already been reached. So Compaq's 1Q travails are
not terribly surprising to us. On the positive side, we came out of
our meeting yesterday with the distinct feeling that Compaq's cost
structure is considerably more competitive than it was as recently as
a year ago and, perhaps most importantly, that market share ambitions
notwithstanding, pricing discipline could well prevail over the
course of the year. The onus is now on Compaq - and others like Dell
- to focus investor attention on measures the company is taking to
protect EPS consistency under a variety of circumstances affecting PC
revenues. In addition, for Compaq, we feel that the multi-platform
enterprise strategy is beginning to take form, but still has a number
of contradictions to iron out before it can be portrayed as a
solutions provider with no other agenda. With regard to the stock,
the price is certainly more compelling having declined some 38% from
its year-to-date peak of $51.25, and we definitely see some upside in
PC margins should pricing discipline hold, further expense
improvements, and a honing of the enterprise strategy. Nevertheless,
we believe that investor confidence in the corporate PC space has
been shaken, particularly in light of the exuberance voiced by the
major vendors, Compaq included, up until January. Compaq is certainly
a candidate for consideration at this valuation, but we are
maintaining our Market Performer rating in light of a still very
uncertain outcome for 1Q.
Here are the highlights from our discussion yesterday with management,
interlaced with our interpretation.
1. For Compaq to meet its revenue target for the quarter can best be
described as a stretch goal. While the latter part of February did
pick up, we don't get the sense that Compaq was able to make up for
much of the earlier lost ground. This means there is a lot of
pressure on March. Having said that, we are also hearing that pricing
is still pretty disciplined in the PC business, which should help
margins and there is the possibility of Compaq pulling more expenses
out this quarter to help them at least come close to consensus
earnings, particularly now that they have been brought down. Pricing
discipline is a hot button issue for us. Dell has threatened to take
pricing down in view of its "excess" gross margins in its last
reported quarter, and HP has made similar references to pricing
"flexibility." The saber rattling is now a month behind us, and we
have seen no overt acts of pricing belligerency. The bad news is that
by shying away from an aggressive market share push, the loftier
revenue targets may have to be brought down. The better news is that
EPS and cash flow are more likely to be protected. We are not
advocating that market share ambitions be abandoned - indeed, with a
move by corporate buyers toward single-vendor procurement of PC
products this could be very hazardous - but rather that some
tempering of revenue goals for the sake of EPS protection is not a
bad idea. Compaq's remaining chore is to gently re-condition
investors to accept a slight change in tack.
2. Our meeting with John Rose left us feeling that Compaq is
sincerely willing to guide the enterprise business toward support for
multiple platforms, including both NT and Unix, and to enjoy the
profit potential from the proprietary platforms like VMS. (After all,
IBM's (IBM/$177.65/BUY) AS 400 and HP's 3000 proprietary businesses
may not be growing, but they are certainly highly profitable.)
Nonetheless, we still feel that Compaq's strategy is riddled with
conflicts which the company has yet to resolve. For example, Compaq
is promoting the idea of vaulting into a top tier position in Unix
while protecting its status as Microsoft's (MSFT/$173/BUY) preferred
ally and the spearhead of NT into the upper echelons of the
enterprise market. Claims of having the most "NT- friendly" Unix are
a little vague, and may even compound the sentiment that Compaq's
embrace of Unix is equivocal. John Rose argues that Unix leader Sun's
(SUNW/$114/BUY) opposition to NT is more categorical than Microsoft's
unfriendliness to Unix, and he has a point. Also, Compaq's leverage
with independent software vendors whom the company can push to
develop for its Unix (called Tru64-bit) has a compelling ring to it,
because of the volumes of Intel (INTC/$122/BUY) servers the company
ships (coming up on a cumulative 3 million units). However, customers
do reward focus and a clear sense of direction on the part of their
technology suppliers over a mixed message; this is one of the reasons
why Sun has prevailed over HP in Unix, and why Compaq's position with
regard to Unix should be less apologetic to NT than it currently is.
After all, Compaq has not retreated from competing with Intel in
microprocessors. The other thrust in the enterprise strategy is to
emphasize the "value proposition," read competitive pricing in
enterprise products, including servers and storage. True, pricing
storage at a small fraction (Rose threw out the figure of 1/6th) of
what EMC charges on a per megabyte basis will buy business
particularly in the primary market, i.e., Compaq's server customers.
EMC's experience would indicate that pricing is not an effective
wedge in very storage-centric mission-critical applications. The same
holds true in high-end servers deployed as part of mission-critical
infrastructure.
3. Another curious thing is the Alpha strategy. It is very gutsy. In
short, Compaq is betting that Merced will be delayed significantly
beyond the introduction of a 64-bit NT platform, giving Alpha an
opening as the only 64-bit microprocessor architecture supporting
64-bit NT when it comes out. That's quite a gamble, and could set
Alpha's market position back if they are wrong. The other aspect of
the gamble is that Microsoft can stick to a development schedule for
a 64-bit version of NT; the delay in getting Windows 2000 out the
door might give rise to legitimate skepticism. Having said that, the
actual investment Compaq shoulders to support Alpha is small. John
Rose used the figure of 5% of R&D, putting the total at less than
$100 million per annum, which is commensurate we believe with Sun's
annual commitment to its Sparc microprocessor design effort.
4. Notwithstanding our uneasiness of this quarter, we are satisfied
with the basic PC strategy. Compaq has taken a lot of cost out of the
system, and while they still offer price protection up to four weeks,
the actual volumes of channel inventory are low enough for the contra-
revenue exposure to have been brought way down. We are also hearing a
lot less about convoluted channel relationship models, and more of a
go with the flow approach, now that the cost structure has been
brought down. Of course, the channel is suffering but Compaq's
position is to let consolidation happen in the channel without
interfering beyond supporting the channel's thrust into services.
5. The services business is very straightforward and, given a free
rein, has accelerated its growth over the past year. The approach
here is to focus on a broad customer reach and on technologies where
Compaq has specific expertise, like in NT integration, corporate mail
and messaging systems, and PC up-time management. The more menial
service products are left to the channel who can earn good margins on
them, and the high-end professional consulting to Arthur Anderson and
others whom Compaq would prefer not to alienate. While the growth
rate may trail IBM's service model, we think that by sticking to its
service knitting, Compaq can keep its service margins in the 30%
range, which does represent a good premium. Our prior estimate for
the current quarter is too high, and we have brought it down to
reflect the revenue shortfall in January and February. We are
lowering our EPS estimate for the third quarter and fiscal 1999
from $0.43 and $1.90 to $0.33 and $1.81 respectively. Similarly, our
fiscal 2000 estimate has been tweaked downward from $2.30 to $2.28.
While we see some sequential improvement in gross margins thanks to
the stable pricing environment, the lower than anticipated revenues
do have some impact on overhead absorption, so our gross margin
assumption has been throttled back somewhat. The highlights of
forecast are shown below. While we are poised to be more positive on
the stock in the wake of yesterday's session, we are retaining our
Market Performer rating until we gain more visibility into the
outcome of the quarter and the root causes of the pressures on PC
revenues.
Table 1: CPQ Model Assumptions
P&L Line Item 1Q/99E 1999E 2000E
Revenues ($MM) $10,033 $44,413 $53,663
Gross Margin(%) 28.0% 29.1% 29.6%
SG&A as a % of Revenue 14.8 14.0 14.0
R&D as a % of Revenue 4.7% 4.7% 4.8%
Operating Margin (%) 8.5% 10.4% 10.9%
Tax Rate (%) 32.0% 32.0% 32.0%
EPS (Diluted) $0.33 $1.81 $2.28
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