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Technology Stocks : Compaq -- Ignore unavailable to you. Want to Upgrade?

To: PCSS who wrote (95534)	2/28/2002 8:16:46 AM
From: PCSS	Read Replies (2) \| Respond to of 97611

MORE of G-S's HWP Alert: Hewlett-Packard hosted its semi-annual analyst meeting and laid out its merger integration plans with Compaq in great detail. While HP's overall argument was unchanged, it provided enough detail to suggest that the earnings accretion expected in the first full year following the merger could be met with some room for upside. Our thoughts are as follows: 1) HP'S TARGET OF $2.5B IN ANNUAL COST SAVINGS LEAVES SOME ROOM FOR UPSIDE. HP provided more detail on where the combined entity expects to derive its $2.5B in cost synergies (see the table below). Areas where cost savings may come quickly after the merger closes include layoffs across various non sales staff, and in R&D for personal computers. In contrast, reductions in duplicate IT investments (estimated savings of $200M) and Unix R&D are likely to take longer, with some of these related cost savings not likely to be realized until FY04. @@@@@ Category EBIT impact Administration -new IT investment $200M -labor $425M COGS -purchasing $300M -server manufacturing $100M -pc direct $100M -cost of services $100M Indirect purchasing $250M Sales $475M R&D $425M Marketing $125M Total $2,500M One area where we think HP's assumptions may be too conservative is in manufacturing procurement, where the assumption is 1% in synergies or roughly $300M in EBIT. Given the high volumes of the combined company's PC and server businesses, synergies in this area may turn out to be higher. If HP achieves 2-3% in synergies, which other merged entities been able to realize in the past, or roughly $600-900M in EBIT, this could add an additional $0.07-$0.14 to EPS on top of the $0.48 of net benefits to earnings per share already expected. 2) REVENUES POST-MERGER COULD ALSO END UP BEING BETTER-THAN-EXPECTED. There are two potential sources for better than expected revenues once HP's merger with Compaq is complete. --The revenue shrinkage from the combined company could end up being less than the expected 5%. This view is based on HP's and Compaq's revenue loss of 2% and 3% respectively for the most recent quarter compared with original expectations at the time of the merger announcement, a period presumably of great uncertainty. With two-thirds of the expected revenue loss coming from the lower-margin PC space, revenue shrinkage will have less impact on earnings. --There are also likely to be revenue synergies that are currently not in the numbers. Among the more important opportunities are Compaq selling HP printers with its PCs, and HP selling Compaq's midrange storage with its servers. Since HP's printers, including consumables, and Compaq's storage carry higher than corporate margins, they further add to earnings. 3) WE ARE MORE INCLINED TO SIDE WITH HP ON KEEPING PRINTERS WITHIN THE COMPANY. Although both the company and Walter Hewlett argue that printers are central to their thesis, we are more persuaded by the HP argument. Walter Hewlett's argument is that printers should be spun out and run as a standalone company. This seems to have resonated with a few investors. Our view is that HP's Board of Directors, which has considered and rejected this possibility several times in the past few years, would reject it again. There are powerful financial and business ties between printers and other parts of HP's business and, if anything, these ties are growing, not shrinking. We continue to see benefits from having a product group such as PCs to sell printers with. Even more, HP's ambitions to move further up the commercial publishing space necessitates that it build a direct sales and support organization, leveraging both its IT services group as well as its enterprise offerings. 4) HIGHER VOLUMES AND COST SYNERGIES COULD ENABLE HP TO COME CLOSE TO ITS TARGETED 9% OPERATING MARGINS IN ENTERPRISE COMPUTING IN FY'03. Even in an improved economic environment, we see a standalone HP still behind market leaders in key areas in servers and storage. With Compaq, the company gains access to several market leading businesses in NT servers and midrange storage, enabling HP to dial back its own efforts in these areas. This should provide HP with a more reasonable chance to boost its profitability in enterprise computing and reverse what has been a sizable drag on earnings. The swing here could take enterprise-computing earnings from a $0.10 loss in FY 2001 to an approximately $0.40 profit in FY 2003. 5) VALUATION STILL ATTRACTIVE AT CURRENT LEVELS. At roughly 17X our calendar 2002 EPS of $1.15, HP stock is trading at a discount to the S&P 500's 26X and close to the midpoint of its pre-bubble trading range. The deal is expected to close around the middle of CY 2002 and if the company's assumption of substantial accretion in the first full year after the merger is correct, the current First Call mean of $1.35 for HP could move up by 12% to $1.51 for the combined company, yielding a P/E of approximately 13X. Our own EPS estimate for FY 2003 is $1.40.