COMPANIES & FINANCE THE AMERICAS: Fiorina comes a step closer to making the connection: Shareholders face big decision on deal, write Louise Kehoe and Scott Morrison:
Financial Times; Mar 7, 2002
By LOUISE KEHOE and SCOTT MORRISON
On Tuesday afternoon, senior executives of Hewlett-Packard crowded into Carly Fiorina's office.
With Institutional Shareholder Services minutes away from issuing its long-awaited recommendation on HP's Dollars 22bn bid for Compaq Computer, the room was bursting with anticipation.
Everyone knew that a negative opinion from ISS, a proxy advisory group whose clients hold an estimated 23 per cent of HP's shares, would all but doom the controversial merger.
As the dozen or so executives gathered around a television to await the verdict, the telephone rang. It was one of HP's proxy solicitors. The staff gathered around Ms Fiorina's speakerphone to hear a disembodied voice announce that ISS was backing the deal.
A cheer went up and relief swept the room. HP's bid for Compaq had been given an important confidence boost ahead of a shareholder vote on March 19.
But if there was any desire to crack open the champagne, the HP executives knew better. The company may have won over ISS, but 20 per cent of HP shares are already pledged against the deal - and HP still needs to convince many investors to back its plan.
Nevertheless, the ISS verdict has radically changed the tenor of an extraordinary proxy battle. All but written off by her critics, Ms Fiorina now appears to have a fighting chance of staging one of the greatest comebacks in corporate history.
She may also win the opportunity to put into practice her vision of transforming HP from a respected company that had lost its edge into an information technology powerhouse.
HP is the archetypal Silicon Valley start-up, formed in 1938 by Bill Hewlett and David Packard, who worked in a rented garage building electronic instruments.
In the 1970s the group diversified into computing, but made its most important breakthroughs in printer technology just as the personal computer revolution was taking off in the 1980s. That enabled HP to claim leadership in the printer market, a position it has never let slip.
However, HP has since acknowledged that while its printer business was booming, its computer operations were struggling to be profitable. Worse, HP failed to capitalise on the internet revolution, allowing competitors to steal a march at the height of the dotcom frenzy.
The forces of computer industry consolidation have been mounting against HP for several years as its strongest competitors gained market share and weaker players fell away. In most of the main market segments, HP plays third or fourth fiddle to rivals including Dell Computer, IBM and Sun Microsystems, as well as Compaq.
As Ms Fiorina is all too aware, it is becoming impossible to compete profitably from such a position.
In a recent interview with the Financial Times, she bemoaned the situation, noting that 36,000 of HP's 88,000 employees worked in business units that are unprofitable.
The combination with Compaq, she argues, would make HP number one or two in almost every part of the computing hardware market.
Ms Fiorina also claims that greater scale would also benefit HP-Compaq as the industry shifts, gradually but inexorably, towards commoditisation - meaning that competitive advantage is gained mainly through operational efficiencies. She also expects to reduce component costs, for example, as HP and Compaq combine their purchases.
The vast rise in the amount of data generated in the information technology era has also dramatically increased the need for storage systems, a sector in which HP is weak. Compaq, on the other hand, is much more focused in this area, and has become a challenger to EMC as market leader.
If there is one element missing from the planned merger, it is the rapidly expanding - and highly lucrative - services market.
Ms Fiorina likes to compare a combined HP-Compaq to IBM, which is dominant in high-level consulting and outsourcing services. But critics point out that only one-third of HP-Compaq's revenues from services would come from consulting, with the remainder in lower-margin support services.
The merger would also fail to address HP's shortcomings in software, a business in which IBM achieves profit margins of about 80 per cent - though more acquisitions would be necessary to bolster the enlarged HP's consulting and software operations.
However, if the solution to HP's problems is to combine with another computer giant - a premise that remains contentious - it is difficult to think of anyone better than Compaq. The companies' product lines match fairly well, albeit with some overlap. HP's strengths in mid-range servers and consumer PCs complement Compaq's strengths in low- end servers, high-performance computing and business PCs.
Nevertheless, the risks involved in such a big combination are huge, and the history of computer industry mergers is hardly glittering.
Compaq's acquisitions of Digital Equipment and Tandem Computers in the late 1990s might have been good strategic moves in theory, but proved disruptive in practice. Arguably, Compaq would never have offered itself for sale to HP had those acquisitions worked.
Even ISS, while backing the HP-Compaq merger, says that Walter Hewlett - an HP board member and son of the late Bill Hewlett - "makes a credible case that the risks associated with the merger are real and mate rial" as he wages an acrimonious proxy battle against the deal.
But what are the alternatives to Ms Fiorina's plan? Mr Hewlett was initially reluctant to address this issue, but eventually offered his "focus and execute" strategy, with three main points.
In printing and imaging, Mr Hewlett argues that HP should increase investment in new areas such as digital photography and commercial printing equipment. He also suggests HP should consider spinning out the unit to maximise shareholder value. HP should also reduce its emphasis on PCs, he says, restructuring the business to maximise profits rather than market share. Mr Hewlett also advocates small, targeted acquisitions in enterprise hardware, software and services.
The obvious advantage of this strategy is that it is less risky in the short term - perhaps the next three years. This was clearly an issue for the Hewlett and Packard heirs, whose family foundations together hold more than 18 per cent of HP.
But it might be argued that Mr Hewlett's strategy provides no long-term answer to the fundamental problems in HP's computer business.
And while spinning out the printing business is popular in some circles, it is not clear what value the unprofitable operations might have as a standalone company.
Institutions holding 57 per cent of the stock and retail investors owning another 25 per cent may or may not share Mr Hewlett's perspective.
Ms Fiorina and Mr Hewlett will have two weeks to sharpen their arguments. Investors will then decide whether HP tackles its challenges with a bold, if risky strategy - or whether it adopts a more conservative approach, but one that could fall short in the long run.
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