OB & Thread:
Here's a Cowen & Co release that speaks to that a little - the Dream Team - they're not waiting for things to happen!:
CPQ: MAINTAIN STRONG BUY ON CPQ FOR $50 TARGET; BIG LEVERAGE IN 99 EPS
08:38am EST 10-Feb-98 Cowen & Co. (CHU, RICHARD)
Rating: Strong Buy (1)
===========================================================================
EPS Quarterly
EPS
CPQ w/DEC CYPE Q1 Q2 Q3 Q4
F96* 0.87 0.16 0.16 0.24 0.32
F97A 1.35 0.27 0.30 0.36 0.42
F98E 1.75 20X 0.35 0.40 0.45 0.55
F99E 2.25 2.50 14X
F00P 3.10 11X
1585MM shares; Market Cap = $55B; TTMRevs = $24.6B
*Quarters do not add; recast for TDM pooling
===========================================================================
Key Points:
1. DEC deal can significantly boost 1999 EPS, to about $2.50, w/ modest
assumptions re cost cuts.
2. Moreover, see 19-20%/annum top line growth, with leadership in NT-
based enterprise computing.
3. Overlaps minimal; integration challenges very manageable.
4. Maintain strong buy/1 rating with 12-15 month price target of $50, or
20X proforma 99 EPS.
Bottom line - Compaq will be a driver and beneficiary of two principal
dynamics a) consolidation of the global PC business, and b) increasing
importance of NT-based systems in the enterprise. The proposed acquisition
of Digital Equipment gives Compaq tier-1 enterprise services and support
capability, while giving it access to a range of important technology and
intellectual property relevant to enterprise NT strategies. Based on our
analysis, CPQ shares are compellingly attractive within the relatively
small group of peer "mega-cap" computer systems names. We are raising our
12 month price target to $50 (from $87, previously).
COMPAQ/DEC PRO-FORMA SUMMARY P&L
CPQ-ONLY CPQ w/ DEC
1997 1998E 1999E 1999E 2000P Comments
Revenues $24.6 $30.1 $37.3 $51.3 $61.5
% Change +23% +22% +24% +19% +20%
Gross Margin 27.5% 28.0% 28.4% 30.6% 30.7%
Operating 12.1 13.1 13.8 12.7 13.1 -Before $0.5-0.6B in
Margin cost synergies
and $0.2B in goodwill
amortization
Pretax 12.6 13.4 14.1 12.3 12.8
Margin
Tax Rate 32% 30% 30% 29% 29%
Net Income $2.1 $2.8 $3.7 $4.5 $5.6
Average 1569 1609 1635 1785 1800 -150MM additional
Share shares +$4.5B cash
EPS $1.34 $1.75 $2.25 $2.50 $3.10
1. Big Boost In Services/Support Plus Technology/Intellectual Property As
Compaq's strategic purview increasingly encompasses enterprise computing,
the pending acquisition of Digital Equipment provides Compaq with tier-1
enterprise services and support capability, while at the same time giving
it access to a range of important technology and intellectual property,
many pieces of which are likely to find more value and flourish under a
Compaq corporate umbrella than under Digital.
2. CPQ/DEC Emerges As De Facto Leader In Driving NT for Enterprise -- In
particular, the combined entity will emerge immediately as the mind-share,
support, and technology leader in NT-based computing for the enterprise.
Under a two-year old strategic partnership with Microsoft, Digital fields a
1,600-person Microsoft-certified NT-specialist support organization; the
extended partnership between DEC and Microsoft announced on January 28
promises to nearly double this to 3,000 by the end of 1999. Compaq's
identification with NT arises naturally out of its long-standing focus on
"Wintel" platforms and is a straightforward corollary of its position as
the largest X86-platform vendor. Digital's close identification with NT
dates back to the technical genesis of NT under the leadership of David
Cutler at Microsoft, who had previously been a key VMS architect at DEC,
leading to Digital management's early decision to strategically partner
with Microsoft. It is important to recognize that even though NT has
already won the mind-share war as the "politically correct" long-term
platform choice for the enterprise, it has by no means demonstrated the
robustness and scalability of, e.g., the Unix environment. In this
respect, technologies under development at effort at DEC can contribute
significantly to enhancing the robustness and scalability of NT -- these
include, in particular, Digital's efforts in clusters, generally, and with
Galaxy, its adaptive partitionable cluster software technology (see
discussion in our Perspectives on Digital Equipment, 9/23/97), emanating
out of the OpenVMS group, in particular.
3. Alpha, Far From An Anchor, Will Be A Big Plus For Compaq -- Upon the
completion of the strategic partnership agreement between Digital Equipment
and Intel (subject to government FTC review; slated to close some time in
Q2), Digital will transfer its Hudson Fab 6 along with its semiconductor
business unit operations (including Alpha fabrication, PCI chipsets,
StrongARM) to Intel for $700MM up front plus, we estimate $100MM annually
for the next 8 years, this latter figure representing a combination of
license/royalty payments from Intel to DEC and discounts. Digital
maintains all intellectual property rights on Alpha along with the related
Alpha/VLSI architecture development teams. Intel, in turn, has committed
to act as a foundry for Alpha, and will provide parts for the next
"several" iterations of the architecture, beyond, for example, the just
formally launched EV6 (or Alpha 21264) generation. We realize there is
speculation that Compaq may chose to kill Alpha. This doesn't make sense.
Foremost, with the just-announced 600MHz EV6 (ships initially on Digital's
0.35 micron technology, but is slated to take advantage of the 0.28 micron
at Hudson and, eventually, Intel's 0.18 micron technology) Alpha should
comfortably maintain a significant performance lead over competing
architectures slated to debut over the next 18 months. More importantly
perhaps, it is the only platform other than Intel x86 that NT runs on. In
this regard, Microsoft has just renewed its commitment that future
Microsoft NT server products will continue to be released concurrently on
Alpha and the x86 platform; Microsoft has also disclosed that it plans to
integrate Digital's proprietary FX!32 binary translation capability (allows
Alpha to run native Intel code) with the forthcoming 5.0 release of NT.
Even with the looming strategic importance of Merced and Intel's IA64
platform, the fact that Merced timing (widely believed to be H2:99) is
still some 18 months away and subject to potential delays remains a risk.
In addition, it remains unclear whether initial Merced implementation will
be optimized for anything other than high-end workstations and low-mid
range LAN server types of platforms. Accordingly, for Compaq, ownership of
Alpha could represents a tremendous value proposition as it attacks the NT
enterprise markets.
As shown below, Digital and the top two pure x86 plays (Compaq and Dell)
loom as the most obviously beneficiaries of NT in the enterprise; the
impending Compaq and Digital merger, all else being equal, drives the new
Compaq's future enterprise systems mind-share among NT centric sites to
over 30%, leapfrogging IBM and HP.
4. "Legacy" Issues Presented By Digital Are Manageable -- Some observers
have noted that in acquiring DEC, Compaq saddles itself with having to
manage legacy businesses, precisely the sort of boundary conditions that
will inhibit its strategic degrees of freedom, the same sort of challenges
faced by Hewlett-Packard and IBM. These relate to, for example, the
handling of the DEC OpenVMS base (numbering some 400,000+ users) and the
issue of Alpha.
* VMS revenue dependency already small. Foremost, despite the very
large installed base, DEC's VMS related systems revenues have declined
significantly; we estimate these at approximately $100MM+ annual rate in
VAX/VMS systems plus some $500MM run rate in Alpha systems running VMS;
combined, they represent little more than 20% of DEC's mid-range server
revenues.
* VMS/NT Affinity programs a plus. Competitors will no doubt attack
Digital's VMS base as they always have. However, under Compaq, with a
redoubled strategic commitment to NT, we suspect that the so-called VMS/NT
Affinity program, which provides specific tools for integrating OpenVMS
environments with NT, will give Compaq/DEC a strong shot at capturing NT
migration dollars.
5. Enterprise Unix Opportunities Are A Bonus -- Although Digital is at
best a distant #4 in the enterprise Unix markets (behind Sun Microsystems,
Hewlett-Packard, and IBM), because of the impending DEC/Intel Alpha deal,
it is now in an interesting position to capitalize on Unix transition
issues that may be looming at its competitors. Specifically, Digital has
committed to take its 64-bit Unix platform onto Intel's IA-64 architecture.
Inasmuch as Digital Unix is a "little-endian" implementation (unlike
Solaris and HP-UX which are both "big-endian"), software vendors writing to
Digital Unix face a far easier transition from RISC to Intel architectures
than in transitioning with other versions of Unix. This was an element
(along with others) in Sequent's recent decision to move to Digital Unix as
its platform of choice, over Sun's Solaris, which until recently had been
widely expected to be the choice until the Digital/Intel deal was
announced. We continue to believe that HP faces non-trivial challenges in
the Unix arena, not only vis-.-vis Sun, its most visible competitor, but
also prospectively, versus Compaq/DEC, who together offer significant
critical mass in x86-based platforms. Although Compaq has not formally
discussed the direction of its Unix strategies, we would be very surprised
if Digital Unix did not surface as the Unix platform of choice for Compaq.
6. Post Purchase Consolidation, We Can See $2.50 EPS For 1999 And Nearly
20%/Annum Top Line Growth Next 3 Years -- We have had to make a number of
arbitrary assumptions in our pro forma calculations of what the combined
Compaq/Digital will look like on a post-merger purchase consolidation
basis. First of all, we assume that the transaction closes at the end of
the June quarter. Second, we have not assumed usage of Digital's existing
$1.2B in tax-loss carryforwards beyond what would have been applicable to
projected DEC earnings. Third, we have assumed no meaningful top-line
revenue synergies, although these should be plentiful, especially in NT
markets. Finally, we note that the projected combined bottom line will be
most sensitive to two variables, namely, (a) the amount of purchase good-
will that will be generated in the acquisition (in turn, a function of how
much Compaq can write off up front) which will be a major factor in
determining annual amortization charges, and (b) merger synergies
achievable on the cost/expense side. For purposes of our analysis, we have
penned in the following:
- Annual amortization charges of $200 million (whether this equates to
good will of $2 billion to be amortized over 10 years or $3 billion over 15
years is largely academic); we think this assumption could turn out to be
conservative. Assuming that the $9.5 billion purchase price generates a
purchase premium on the order of $4-5B, we suspect that upwards of as much
75-80% of the premium will be written off by Compaq as in-process charges
at the time of the acquisition close.
- First full year cost/expense synergy of just over $500 million,
requiring a headcount reduction of roughly 7,000 (at $70-80K per head). We
think this assumption is potentially very conservative, given that the
combined CPQ/Digital operating expense base totals nearly $10 billion;
viewed alternatively, including COGS, the pro-forma cost base for the
combined company will surpass $40B for 1999. Our assumed cost synergy
would represent just over 1% of the projected cost structure for 1999.
- Digital deal with Intel closes at the end of June quarter -- The
DEC/Intel Alpha transaction is currently on a track to close sometime
during the June quarter, barring major snafus with the FTC. Digital has
just announced the completion of the sale of its Network Products business
unit to Cabletron this week for $430 million.
7. Deal Could Be Slightly Dilutive In 1998 But Add $0.25 To Compaq 1999
EPS -- As detailed on the next page, we calculate that were the deal to be
completed at the end of the March quarter, it would most likely be
immediately accretive for June quarter EPS (43> pro forma versus our
current 40> estimate) given that the June quarter is by far the seasonally
strongest at DEC. As it stands, we expect modest dilution in Compaq's Q3
(seasonally weak for DEC) offset by an accretive Q4. For all of 1998, on a
purchase basis, we assume a modest 2> drag (in H2), counting DEC operations
just for the September and December quarters. For 1999, we calculate that
Compaq's pro-forma EPS would lift to $2.50 on revenues of just over $51
billion (up some 19% apples-apples versus 1998). While gross margins would
widen to 30.6% (260 basis points higher than our current pre-DEC estimate
for Compaq), operating margins would decline somewhat to 12.7%, versus our
current Compaq-only operating margin of 13.8%.
8. Every Incremental $100MM In Cost/Expense Synergies To Drive Additional
$0.05 in 1999 EPS -- The proposed merger could drive significant further
leveraged upside to our EPS estimates. As summarized below, every
incremental $100MM in additional cost synergies that can be achieved on an
annualized basis drives roughly $0.05/share in incremental earnings for
1999. Similarly, every $50MM reduction in goodwill amortization charges
equates to an additional $0.03/share in 1999 EPS. Given the sizable
combined present pro-forma headcount of 85,000, we think there is
significant opportunity for Compaq to attain substantially more aggressive
cost savings than we have assumed. Compaq and Digital management have thus
far refused to acknowledge that any such cuts may be in the works, pending
the finalization of the deal, understandable in light of concerns that
disclosure of cuts, pending a clearer identification of action to be taken
could increase the risk of unwanted personnel losses. Industry commentary
has speculated on the possibility of layoffs at Digital of 10,000 or more;
we think this is not an unreasonable expectation. Such reductions would
have been difficult to implement at Digital on a standalone basis without
damaging the top-line revenue picture even further; under a Compaq
umbrella, such revenue risks may be mitigated considerably.
1999 PRO -FORMA EPS: SENSITIVITY ANALYSIS
Assumed Headcount Reduction*
Annual 5000 7000 9000 11000 13000
Amortization
$250MM $2.40 $2.47 $2.53 $2.60 $2.66
200 $2.43 $2.50 $2.56 $2.62 $2.69
150 $2.46 $2.52 $2.59 $2.65 $2.72
100 $2.49 $2.55 $2.62 $2.68 $2.75
50 $2.52 $2.58 $2.65 $2.71 $2.78
*Drives estimated $75-80K/head.
9. Can See 19-20%/Annum Revenue Growth In 1999 And 2000 -- Our analysis
suggests that Compaq, on a post-merger basis, can post revenue growth in
the 18-20% range, to roughly $51 billion in 1999 and $61 billion by the
year 2000. (See detailed analysis on page 7). Specifically, the PC (i.e.,
desktop, portables and consumer) mix, even with assumed share gains, is
expected to decline sharply, from approximately 63% in just reported 1997
results, to just 44%, post the DEC merger, by 2000, when revenues from
systems and servers are slated to rise to about the same level (i.e., 44%),
with 12-13% of the mix stemming from services. We think these projections
are realistic, even against a backdrop of essentially zero reported growth
at Digital recently, for the following reasons: (a) DEC results have been,
and will continue to weighed down by discontinuations, but this effect
should normalize within a year; (b) Digital, with the Intel deal behind,
under a Compaq umbrella can be expected to regenerate modest growth
momentum in Alpha, and c) the drag from the continuing decay in traditional
DEC maintenance (eroding at 7-10%/year) will be increasingly offset by
growth in multi-vendor services and systems/network integration, both of
which segments have been showing good growth momentum of late and should
flourish even more under Compaq's ownership.
10. How Serious Are Integration Risks And Challenges? Obviously, Compaq
will have to execute impeccably in its integration of Digital, a non-
trivial challenge, given that the size of the acquisition. The fact that
the management has been ostensibly able to pull off the integration of
Tandem smoothly is encouraging, but not an assurance that it can do the
same with DEC. In addition, observers have commented specifically on the
differences in "cultures" between Compaq and DEC as potentially a major
barrier to successful integration downstream. We certainly don't wish to
minimize these challenges. Nonetheless, at least two points are worth
making in defense of the notion that these integration challenges are
likely to be very manageable ones. First, other than the PC business
itself, there is virtually no overlap between the two companies; this makes
it plausible that Digital can in fact be run as a separate wholly-owned
Compaq subsidiary for the foreseeable future (i.e., next 12-18 months) with
no compelling reason to achieve immediate integration of field sales
efforts right off the bat, as was the case with Tandem. Second, investors
should recognize that the senior Compaq management team is replete with
former Digital Equipment senior executives who are not likely to be under
any illusion about what they are buying into. Specifically, these include
CFO/SVP Earl Mason (formerly Digital finance staff and ex CFO of Europe),
SVP John Rose, head of the systems business (was General Manger of
Digital's PC business) and Enrico Pesatori, President of Tandem (until as
recently as mid-1996, #2 at Digital under Bob Palmer ), who is likely to
play an instrumental role in the integration process. In short, this
management team at Compaq under the no-nonsense execution umbrella of CEO
Eckard Pfeiffer, comes close to being the "dream" team for executing an
acquisition of Digital Equipment. |
