An alternative view to the negativity expressed in the Barrons and Forbes articles is offered in this cover story in the more widely read Business Week.
Barry
From the 2/9/98 issue:
businessweek.com./premium/06/b3564001.htm
COMPAQ'S POWER PLAY
How the Compaq-Digital deal will reshape
the entire world of computers
Since taking over the world's largest maker of personal computers six years ago,
Compaq Chief Executive Eckhard Pfeiffer has regularly sent shock waves through
the
PC business. Back in 1992, the Houston-based PC maker slashed prices by up to
32%, sending competitors scrambling to lower costs and match Compaq Computer
Corp. Last year the German-born executive set the consumer-PC business on its
ear
with a line of home computers priced below $1,000, again forcing rivals to react
swiftly or lose out on one of the fastest-growing segments of the PC business.
Get ready for another shakeup--only this one will reach far beyond the PC crowd and
into every corner of the $700 billion computer world. On Jan. 26, Pfeiffer and Digital
Equipment Corp. Chief Executive Robert B. Palmer concluded four days of intense
negotiations by shaking hands on a record-breaking $8.7 billion acquisition. When
completed in June, the deal will be the largest in the annals of the computer
industry--topping AT&T's $7.4 billion purchase of NCR Corp. and IBM's $3.5 billion
buyout of Lotus Development. It will create a new computer colossus with some
$37.5 billion in revenues, second only to giant IBM in computer sales.
NEW LANDSCAPE. The import of this mega-merger, though, goes far beyond
computer rankings. By acquiring Digital, Compaq is catapulted from the upstart,
wild-and-woolly PC generation into the high-tech big leagues of companies that
supply
the world's most complex and critical information systems. Compaq's product
offerings will now span the computing landscape, from $649 handheld computers to
superpowerful $2 million fail-safe computer servers. More important, the company
will command Digital's vaunted service and consulting staff of 22,000 people, who
know their way around the computing back offices of the world's largest
corporations--customers Compaq has been striving to reach, with modest success,
for the past three years.
Compaq's timing couldn't be better. The merger comes just as corporations are
grappling with wrenching change in their computing options and the way they do
business. The move away from mainframe-style computing to cheaper, powerful
servers tied to banks of PCs is accelerating as companies buy new equipment to
ward
off potential software problems posed by the year 2000. At the same time, the race
is
on to figure out how to link a mish-mash of corporate networks to the Internet for
speedy access to customers and suppliers. Compaq will now be able to offer
solutions
on all fronts--low-cost, powerful computing systems, along with a cadre of
consultants to install and maintain the high-tech gear.
Suddenly, the 16-year-old company has the key pieces to reshuffle the tech deck.
Compaq is expected to bring its low-cost, take-no-prisoners PC economics into the
high-end computing markets that IBM, Hewlett-Packard, and Sun Microsystems
have
long dominated. Compaq's lean operations, for instance, require it to spend just 15
cents for every $1 in sales, far below Hewlett-Packard and IBM, which spend 24
cents and 27 cents, respectively, for every $1 they add to the top line. ''This is an
example of a New Economy company growing up to replace a company that
dominated in an earlier era,'' says John T. Chambers, chief executive of Cisco
Systems Inc., the No.1 supplier of networking gear.
Even PC highfliers Dell Computer Corp. and Gateway 2000 Inc., long accustomed to
running no-frills operations, can't assume it's business as usual. Now, their biggest
competitor just upped the ante by adding a service and support team that will give
business customers the velvet-glove treatment. This deal, says Pfeiffer, will ''force
others to rethink their positions.''
Indeed, Compaq's sheer muscle and broad new reach may put it on a par with the
industry's two agenda-setters: Microsoft Corp. and Intel Corp. Today, Microsoft calls
the shots with its Windows software, which runs on 87% of desktop machines, while
Intel's microprocessors claim 89% of the world's $21 billion computer processor
market--a duopoly dubbed Wintel.
Now, Compaq, already the biggest seller of Windows software and Intel chips in its
PCs, could be the flag bearer that pushes Wintel technologies upstream in servers
for
heavy-duty computing jobs--everything from inventory management to complex
financial databases. A crucial ingredient: Digital has one of the largest trained sales
and
support staffs for hawking Microsoft's powerful Windows NT, which is Microsoft's
linchpin for moving into the lucrative $30 billion corporate-software market. In the
past, customers gravitated to Compaq's aggressively priced products but often
would
use a service company like Digital because of its superior systems-integration
skills,
says Microsoft Chairman William H. Gates III. ''This gives them the best of both
worlds,'' he says.
Or three worlds. The Microsoft-Intel-Compaq troika could be a hugely powerful
combination that gives NT the oomph it needs to edge out the huge numbers of
mainframes and Unix servers that corporations now rely on to run their businesses.
Already, NT has captured 40% of the server market, with unit sales up a huge 80%
from last year.
In essence, the three companies may well wind up acting like a virtual corporation
lined up against IBM, Sun, Silicon Graphics, and the like. While Microsoft spends a
hefty 17% of sales on research and development and Intel spends 9.4%, Compaq
invests a measly 3.3%. Even after the merger, analysts expect Compaq will be able
to
keep its R&D costs to just 4.6%, thanks to Digital's decade of downsizing. That
makes it possible for the Houston computer maker to undercut competitors across
its
product line, from bargain-basement PCs to powerful servers. Says Pfeiffer: ''We
want to do it all, and we want to do it now.''
But first Compaq must digest Digital, which promises to be one of the biggest
challenges Pfeiffer has faced to date. For years, Compaq has prospered through its
single-minded focus on selling Wintel machines. Now it vows to turn itself into a
one-stop shop, selling Wintel, as well as Digital's proprietary VMS computers and
Unix machines--both used for big computing tasks. That means Compaq will likely
face a massive sales reorganization as it melds its PC sales group with Unix sales
reps.
That's no small thing. Just this November, HP finished merging its Unix and PC
sales
staffs into one integrated force--a two-year effort that changed the jobs of 5,000
people. ''It was big for us, and it will be orders of magnitude greater for them,'' says
William V. Russell, HP's server chief.
Then there's the task of folding Digital's 54,300 employees into Compaq's
considerably smaller 33,000-strong workforce. Worse, this must be done by
companies based some 2,000 miles apart. To be sure, Compaq is credited with the
smooth $3 billion acquisition of Tandem Computers Inc. last June. But Tandem, a
Silicon Valley maker of high-end computers, had just 7,000 employees, and they
weren't as demoralized as Digital's workers, who have weathered years of layoffs,
losses, and flip-flop strategies. ''Compaq could really get locked up in an execution
nightmare,'' says Silicon Graphics Chief Executive Rick Belluzzo, who until recently
ran HP's computer business.
And, face it, big tech mergers have a lousy track record, chiefly because it's so
tough
fusing differing product lines and corporate cultures. ''Compaq will have to spend
the
next two years integrating and reinventing,'' says Edward J. Zander, Chief
Operating
Officer of Sun Microsystems Inc. ''We'll spend it innovating.''
Rivals dismiss the deal as only the final chapter in Digital's long decline. ''We
don't see
DEC in the marketplace very much at all,'' says HP's Russell. ''We don't even track
our win rate against them anymore.'' Dell Computer Corp. CEO Michael S. Dell,
whose company now uses Digital for customer service, says the merger is more
likely
to balloon Compaq's operating costs than its sales. ''Companies with higher cost
structures do very poorly,'' he says.
Still, it's hard to bet against Pfeiffer. Under the 56-year-old CEO, Compaq's run has
been phenomenal. Revenues are up 500% since 1992 and show no sign of
slowing--they're expected to climb 26% this year, to $31 billion, even without
Digital.
Last year, Compaq sold 10.1 million PCs worldwide, up a stunning 43%--more than
double the industry growth rate. ''If you look at the overall market, there were 11
million more PCs sold than in 1996, and Compaq picked up 30% of that,'' says
analyst
Ashok Kumar, of Loewenbaum & Co. Among rivals, none matches Compaq's
sizzling
pace--certainly not IBM, whose sales rose an anemic 3% last year. Not even Sun,
whose revenues shot up 21% last year.
NEW RESPECT. In almost every business it has entered, Compaq has driven rivals
to
distraction. Three years after it charged into the home-PC business, Compaq's
sales
are running neck-and-neck with Packard Bell NEC Inc., the market leader. Packard
Bell held a 31% share of retail PC sales to Compaq's 29% during October, according
to researchers Audits & Surveys Worldwide. Even in segments with well entrenched
suppliers, such as engineering workstations, Compaq has marched in unimpeded.
Just
a year after shipping its first PC-based workstations, it held a market-leading 16%
share, leapfrogging Hewlett-Packard, Intergraph, and IBM. Meanwhile, Compaq has
held the lead in PC servers since 1993.
Now, Compaq will cast an even bigger shadow. Analysts say Sun will have to speed
up investments in customer services, a notoriously weak area for the $8.6 billion
computer maker (page 96). ''We typically viewed Compaq as a supplier in the
middle
tier, not for our big transaction systems,'' says Monsanto Corp. Chief Information
Officer Patrick Fortune. ''Now, within one company, we can have that whole line.''
The deal also is bad news for HP. Given Digital's problems and HP's ascent in the
PC
business in recent years, HP has carved out a position as the only soup-to-nuts
supplier to challenge IBM for the biggest corporate customers. Should Compaq
resuscitate Digital's computer business, HP would face a competitor with a product
lineup not unlike its own--but with a history for slashing costs and forcing margins
down industrywide. ''This puts a strong new player into the mix,'' admits HP CEO
Lewis E. Platt. ''We'll be watching with interest and won't let any time pass before
we
respond.''
IBM, the company Compaq must now surpass to become No.1, may be forced to
revisit lagging PC operations. Until now, IBM has fended off efforts to match the
sector's cutthroat pricing by linking PC sales with services. ''This may be a wake-up
call for IBM,'' says a consultant close to both companies. Further evidence of IBM's
declining share of home-PC sales came on Jan. 28, when retailer Tandy Corp.
announced it would no longer sell IBM PCs, opting for an exclusive 3-year Compaq
deal. With IBM's sales dragging behind the PC industry's worldwide 15% growth
rate,
it could be forced to match Compaq's ultrathin hardware margins. That will likely
require IBM to take additional steps to lower its manufacturing and distribution
costs,
they say. IBM declines comment.
Even Dell, the master of cheap PC assembly and delivery to corporations, can't
blithely ignore the bulked-up Compaq. Dell will no doubt remain the lowest-cost PC
maker--its overhead amounts to just 11.6% of sales vs. Compaq's 15%. But the
move
to networked computing and the rush to tap into the Net are prompting more
companies to seek advice--not just machines. IBM's service business, for example,
has ballooned from $2 billion to $19 billion in the past seven years. This trend
could
force Dell to invest heavily in a service and support team, raising its overhead
costs.
''Dell will have to fight fire with fire,'' says analyst John B. Jones Jr. of Salomon
Smith Barney, ''or change the game.''
Changing the game is Pfeiffer's specialty. By tackling Digital, the computer world's
longest-running tough-luck story, he is again flaunting conventional wisdom. He's
betting that PC economics, where huge volumes make up for slim margins, can
make
Digital a winner. ''What we realized before anyone, is the unlimited potential of the
PC,'' says Pfeiffer.
That became clear to him in 1991 when he took over a bloated Compaq, slashed the
workforce by 12%, and depth-charged prices on Compaq's PCs. The result: Compaq
reset the competitive landscape, forcing PC rivals to whack costs and squeeze
efficiencies out of manufacturing. Those that couldn't make the grade, such as AST
Research Inc. and Apple Computer Inc., lost market share and were sidelined.
MARGIN MAGIC. Four years later, Pfeiffer disproved the notion that home PCs
were money-losers. He further tackled costs and brought consumer marketing and
retail skills to the computer maker. Last year, Pfeiffer drove the concept to new
heights. By using low-cost chips, outsourcing assembly, and tightening sales
policies,
Compaq released a $799 PC with the same 11% gross margin as its most
expensive
home computer.
To get these tough jobs done, Pfeiffer has shown he's willing to do just about
anything--even go up against Intel and Microsoft. Take the recent sales explosion in
sub-$1,000 PCs, a segment Compaq jump-started late last year. At the time, Intel
didn't offer a low-cost processor that would make it possible to sell a no-frills
machine and still make money. Pfeiffer didn't wait for Intel to come around. He cut a
deal with Cyrix Corp. and, more recently, Advanced Micro Devices Inc. to use their
Intel-clone chips.
Absorbing Digital will put such skills to the test. Digital, after all, is no plum. The
company recently swung earnings into the black with a $75 million profit for the
quarter ended Dec. 27. But its $13 billion in revenues are the lowest since 1990.
And
Digital has suffered $5.9 billion in cumulative losses since 1991. Addressing the
company's low morale and leisurely release of new products will be Pfeiffer's first
priority. There are signs Digital's culture may be waking up to what's ahead. At a
meeting last week, a Digital manager asked the correct pronunciation of Pfeiffer's
first
name. ''Aggressive,'' came the response from a co-worker.
Pfeiffer has a plan, as well as a reputation. ''We believe we can apply a lot of the
management abilities we've shaped very successfully in the last two years--be it
asset
management or combining some functions,'' he says. ''There's lots of leverage
there.''
Pfeiffer, however, won't reveal any restructuring plans until the merger officially
closes in June. But analysts say he will likely pare Digital back to two pieces: a
systems and software unit and a services business.
That means Compaq may jettison Digital's remaining software and peripheral
product
lines. Analysts also are betting he will fold Digital's lackluster notebook and PC
operations and sell off some businesses, such as Digital's storage unit, to recoup a
part of its purchase price. The result: Digital's workforce could shrink to about
45,000, from 54,000 currently, say experts.
Analysts agree the acquisition can deliver significant new revenues. ''You have to
ask
how much of Digital's growth has been limited by its financial uncertainties,'' says
technology analyst William C. Conroy of the Houston-based brokerage Sanders
Morris
Mundy Inc. ''There may be some nice pickups'' from customers' faith in Compaq, he
says. Indeed, Compaq Chief Financial Officer Earl L. Mason says Digital will
contribute to earnings within a year.
Achieving that goal will require a sizable hike in revenues from Digital's business.
Compaq expects Digital's $5.8 billion service group to play a big role in that.
''There is
a very big multiplier effect,'' says a source close to the merger talks. ''That's where
IBM is using frontline services to drag big-iron sales along.'' Compaq's willingness
to
pay a nearly $2.5 billion premium to the company's Jan. 23 market cap reflects the
conviction that Compaq's management can rapidly expand sales to Digital's 20,000
customers.
What made the deal happen now? Talks between the two companies had been on
and
off over the past three years. In mid-1995, when the two first began negotiating,
Digital's stock was depressed to $42 and its market cap less than half its $13.8
billion
in sales. At the time, the Digital board was unwilling to consider a sale, believing its
shares were undervalued and Compaq would likely gut the company, according to a
source close to the talks. Then last December, when discussions resumed, Palmer
was joined in the negotiations by outside Digital director Frank P. Doyle, a retired
General Electric Co. executive.
Doyle, who had played a key role in brokering the October sale of Digital's
chipmaking operations to Intel, swayed the board in favor of a sale this time. ''He
helped the Digital board wrestle with the economic consequences of a stand-alone
strategy,'' says a source close to the talks.
ROSE'S RAIDS. There also was a new team evaluating the deal for Compaq. Pfeiffer
assigned CFO Mason and Enterprise Computing Group Senior Vice-President John
T.
Rose, who oversees Compaq's corporate-computing efforts. They have the
background for the task--both are former Digital executives. They spent weeks
evaluating Digital's products, customers, and finances. Rose's ties have helped
land
former Digital executives at Compaq, including vice-president for enterprise
marketing
Robert Fernander and vice-president of Compaq's networking division, William R.
Johnson.
A gregarious manager who began his computer industry career at IBM and later ran
Digital's PC business for seven years, Rose will be on the hot seat to make the
deal
work. ''He's been the champion. This [acquisition] affects his ability to compete in
the
marketplace. More than anybody else, he's the guy Eckhard and the board are
looking
to say why this is the right target,'' says a Compaq insider.
Pfeiffer is looking to another former Digital manager to get the business contributing
to profits by the end of the year. Under CFO Mason, who joined the company in
1996, Compaq has become a cash machine intensely focused on boosting return on
invested capital. Since the start of 1996, Compaq has trimmed inventories by 27%
even as it added nearly $10 billion in revenues. Compaq now turns over inventories
14
times a year, up from nine times at the end of September. The payoff from that
ultrafast turnover: Compaq generated $6 billion in cash since the start of 1996.
Not bad returns for what is largely a low-margin PC business. Now, consider the
potential impact of that operating style on big-ticket packages of servers, networks,
software, and services. That's the landscape Pfeiffer now sketches for a
dramatically
bigger Compaq--and the world of computers.
By Gary McWilliams in Houston, with Ira Sager in New York, Paul C. Judge in
Boston, and Peter Burrows in San Mateo, Calif.
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