February 5, 2001
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Taking $tock:
Compaq Could Be A Worthy Investment
PCs accounted for 48% of revenue, but only 10% of profit
By William Schaff (bschaff@bayisle.com)
Back in 1992, I listened to Compaq executives boldly set their sights on becoming the No. 1 PC vendor in the world. They did, but I don't hear them touting it much anymore. Instead, they talk about how half of sales comes from servers, software, and services for the business market. And that's an accomplishment worth crowing about.
Don't get me wrong: PCs are still very important to Compaq (CPQ--NYSE), representing about 48% of revenue (30% business PC and 18% consumer). However, 52% of revenue in the fourth quarter of last year came from the enterprise business, which includes services. In addition, 54% of sales came from outside North America. The focus on global, corporate accounts has helped ease the pain of weakening U.S. consumer PC sales.
Fourth-quarter business PC revenue was up 11% from the same quarter in 1999, but flat from the prior three months. Consumer PC sales grew 3% for the year, but Compaq gave up market share to focus on profitability. The company should benefit from large companies deploying Windows 2000 this year, as well as businesses' adoption of handheld devices such as its iPaq product. Compaq shipped more than 200,000 iPaqs in the fourth quarter, which ended Dec. 31, and had a backlog of 300,000 orders at the quarter's end.
But the more important story is locating the profits, and the PC business isn't the place to look. The enterprise and services group represents 90% of Compaq's operating profit. That's right. PCs brought in 48% of revenue and 10% of operating profit. Do the math.
CEO Michael Capellas has, and he knows the more Compaq pushes into enterprise and services, the higher its profitability. Capellas has been around for almost two years, and he's delivering this message to Wall Street. And Wall Street is starting to listen.
The company has established itself as a leading enterprise hardware and services vendor. It's focusing more on industry-standard servers for most mainstream applications while keeping the more proprietary Alpha servers for high-end applications. In the fourth quarter, enterprise revenue grew 20%, led by a 24% year-over-year growth in industry-standard servers and 17% year-over-year growth in proprietary servers. Storage products grew 17%. Storage should continue to grow, while services should recover from a poor showing in 2000.
Unfortunately, Compaq's fortunes aren't independent of the economy. Its high-growth server business may see the expected results in revenue, but in a weakening economy will undoubtedly see the onset of price wars at the low end, pushing down profit margins. Also, a weakening economy would hurt small-business spending and large companies' capital budget programs. Any reduction in capital expenditures by businesses will slow down sales. In this environment, Compaq has to keep its eye on profits, not sales.
In its fourth quarter, Compaq reported operating earnings per share of 30 cents on total revenue of $11.53 billion. Of that, $9.78 billion, 85%, is product sales, and the balance is service revenue. Product gross margins were 22.8%, while service gross margins were 28.4%, for a combined gross margin of 23.5%. The company also took a huge writedown, $1.8 billion, mostly for CMGI stock acquired from the sale of Alta Vista, thus doing its penance for dot-com pricing mania.
Compaq has improved margins through restructuring and productivity gains, and they're expected to continue improving. Gross margins are projected to improve again, reaching 24% to 25% this year. Compaq continues to hang onto its hybrid approach of direct and indirect sales for its PC business, insisting that's the best model, though the financial support is dubious when compared with Dell's direct sales model for consumers.
Management is forecasting an earnings per share of $1.17, and I think the number could easily be more than $1.20, meaning Compaq's price of around $23 looks good. If it reaches my fair value target of $30 by year's end, Compaq would turn out being an investment decision worth bragging about.
William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. |
