Barrons: (apologies if it has already been posted)
Compaq Makes a Big Move -- and Shareholders Cringe
When Compaq Computer announced its proposed $9.6-billion merger with Digital Equipment Monday, few people were surprised that the Houston-based PC manufacturer was involved in a big deal. But the actual partner raised some eyebrows.
Rather than buying Gateway -- a deal it was rumored to be exploring last summer went in the other direction, jumping into the enterprise computing services business against the likes of IBM and Hewlett-Packard. But in doing so, Compaq could be taking on more problems than it's solving. Enterprise-computing may be a hot business, but it's highly competitive and margins are tight. And the rest of Digital Equipment's businesses may give plenty of headaches over the next year or so. In fact, analyst Michael Kwatinetz of Deutsche Morgan Grenfell downgraded the stock immediately following the merger announcement. "While we think the merger will benefit the company in the long term, in the near term -- the next six to twelve months -- it exposes them to a lot more risk," said Kwatinetz. The analyst believes Compaq may end up losing customers as it tries to integrate the two companies. Moreover, he expects to take a "very large charge" that could end up in the "hundreds of millions or maybe even billions[dollar]" range. Compaq was drawn to Digital's extensive services business, which provides solutions for big companies in areas ranging from the Year 2000 problem to high-performance networks to electronic messaging. The union would make Compaq the strongest sales and services company supporting Microsoft's Windows NT operating system, the company's CEO, Eckhard Pfeiffer, said during a conference call Monday.
The services business is becoming increasingly valuable as big companies looking to upgrade to the newest electronic gadgetry are gravitating toward "one-stop shops" that can offer both the products themselves and the means to put all this new technology together.
Compaq executives were predictably quick to cite the "very complementary strengths" of the two organizations. ("Synergy," anyone?) But the deal -- the largest merger ever in the computer industry -- could prove a misstep by high-flying Compaq. "I'm not sure whether the acquisition will help Compaq strategically," says Stephen Dube, an analyst at Wasserstein Parella Securities. (Investors apparently share those concerns: After the announcement of the cash and stock transaction early Monday, Digital Equipment stocks soared a whopping ten points -- or about 22% -- to 55 7/16, while Compaq's shares fell 2 3/4 to 29.)
The reason? Along with Digital's services business, is also
taking on other businesses whose prospects are decidedly duller.
Specifically, Digital's proprietary 64-bit Alpha microprocessor used on higher-end systems -- as well as its special version of the UNIX operating system designed to run on the Alpha chip -- could face stiff competition from none other than Intel. Intel will be coming out with its own 64-bit processor, called Merced, in 1999. And Intel's alliance with Sun Microsystems to run Sun's Solaris operating system on Merced should further entrench the chip juggernaut in the enterprise computing market. With such a dominant force lined up against it, Alpha faces an expensive, uphill battle -- one that many analysts think Compaq/Digital can't win.
Meanwhile, Digital's efforts to sell personal computers either direct to customers or through the retail channel haven't exactly set off fireworks.
"There's been no revenue growth in the PC side of [Digital's] business, and a lack of momentum in the Alpha side of the business," according to Ashok Kumar, an analyst who follows Compaq from its home state of Texas for Loewenbaum & Company.
This is important, since those two areas constitute most of Digital's
product sales, which in turn represent about 55% of the company's 1997
revenue of approximately $13 billion. (Some industry observers already had begun to fear that earnings of computer makers like Compaq might come under pressure as they book a higher percentage of sales from computers costing less than $1,000, whose margins are much lower.)
And while Digital's services business should help Compaq get a foothold in the enterprise computing market, that business also has low profit margins. "It's a gamble," says Frank Gens, an analyst for International Data Corp. "They're trading off profit margin for growth by buying into a business model that has lower profitability." In fact, Gens expects Compaq to take charges against earnings during the next several quarters as it writes off some underperforming businesses, cleans up Digital's balance sheet and makes Digital's sales force more efficient. "It will be a major challenge to meld the two cultures," he observes.
It could also be a challenge for investors, who have been richly
rewarded for holding <Compaq stock., one of the big success stories in 1997 with gains of about 73%. The stock currently trades at about 19 times 1998 earnings forecasts, about in line with First Call's median five-year projected earnings growth rate of 20%. That means there's no room for any disappointments resulting from the merger, particularly since the economic crisis in Asia already has technology investors more than a little jumpy.
Compaq's representatives didn't return phone calls, but in a press
release announcing the merger, Pfeiffer said: "Digital's focused
enterprise strategy [and] improvements in operational performance make this a timely choice for us." In his conference call, Pfeiffer pledged Compaq would give Digital's Alpha chip "full support."
The merger with Digital also could have potentially interesting
consequences for one of Compaq's biggest competitors, Dell Computer. IDC's Gens believes it could put Dell between a rock and a hard place, since the wildly successful Austin, TX-based direct-sales manufacturer will be one of the few major players left without major exposure in enterprise computing.
Here's the rub: If Dell doesn't bolster its exposure to enterprise
services, it could lose product sales to competitors that offer "one-stop shopping" since providing services can often give product manufacturers a foot in the door. But if Dell decides to follow Compaq and buy its way into enterprise computing with a big acquisition of its own, its margins could take a big hit that would be only amplified by its emphasis on direct sales. Such a big move would be "a major shock to Dell's business model that could impact its margins dramatically," Gens believes.
Dell spokesman T.R. Reid said the company "already provide[s] customers with services that influence their buying decisions" and, for now at least, generally won't be offering what he called "higher-end, esotericservices."
For the time being, that should reassure Dell shareholders, who have
seen the shares climb over 180% since last year, making it one of the best performing stocks anywhere. But ultimately, this Compaq/Digital deal could hurt the major players more than it helps. |
