Thanks for the heads up. Here is the Heard on the Street column from todays WSJ.
Heard on the Street
Compaq Deal May Mask
Problems in PC Business
By SUSAN PULLIAM and EVAN RAMSTAD
Staff Reporters of THE WALL STREET JOURNAL
Most of Wall Street hasn't stopped applauding since Compaq Computer
announced its record-breaking $9.6 billion merger with Digital Equipment
last month. Indeed, Compaq shares have soared nearly 25% since news
of the merger hit the wires Jan. 26.
But some analysts and investors say the DEC
deal, while potentially a long-term boon for
Compaq, could be masking problems in its
underlying personal computer business.
Merging with DEC will move Compaq into
higher-margin, bigger-box computers and
networks.
Some Compaq watchers say recent financial
transactions, including two transactions involving receivables in the third
and fourth quarters, suggest that Compaq is having a tougher time cutting
costs out of its PC business than it told Wall Street it would last summer.
Factoring of Receivables
In particular, some investors don't like the fact that Compaq factored, or
sold off, $732 million in receivables in the third quarter and a similar
amount in the fourth quarter. Such factoring transactions allow a company
to convert its bills payable by customers for computers already sold into
cash, albeit at a discount.
Compaq Computer
Business: Personal computers
Year ended
1997
1996
Revenue
(in millions)
$24,584.0
$20,009.0
Net Income
(in millions)
$1,855.0*
$1,318.0
Share earnings
(diluted)
$2.37*
$1.74
Latest quarter (Dec. 31, 1997)
Per-share earnings: $0.84 vs. $0.63
Average daily volume: 21,350,525 shares
Shares outstanding: 792.6 million
Trailing P/E: 30 Dividend yield: 0.2%
*Includes charge of $252 million or 32 cents a share for R+D and merger-related
costs.
Note: Share and per-share amounts haven't been adjusted to reflect a 2-for-1
stock split effective Jan. 20, 1998.
The transactions raised red flags in the minds of some investors and
analysts not only because they are unusual for a personal computer maker
but also because they lowered Compaq's costs for the period. The two
transactions also raised the company's "return on invested capital," which
is simply a fancy name for profitability that takes into account the costs of
carrying receivables.
In a recent report to clients, Donaldson, Lufkin & Jenrette analyst Kevin
McCarthy told clients that without the receivables deals, Compaq's return
on invested capital "would have been essentially flat over the past three
quarters instead of posting sequential improvement."
'Inflated Improvement'
With the factoring in the second half of 1997, Mr. McCarthy said,
"Compaq arguably inflated its improvement" in return on invested capital,
or ROIC, and another financial measure, days sales outstanding, which is
the average time it takes to be paid for a product. "This apples to oranges
comparison of these key yardsticks has some investors crying foul," the
DLJ analyst observed.
In an interview Wednesday, Earl Mason, Compaq's chief financial officer,
acknowledged the transactions helped profitability. "It helps ROIC," he
said. "Otherwise, we wouldn't do it." Mr. Mason also said the company
factored more receivables in the second, third and fourth quarters of last
year than it normally does.
But he added the Houston-based company only uses factoring when it can
get a "positive carry," earning more from the immediate cash received than
it must sacrifice in fees and discounts to the bank or company collecting
the receivable.
Wall Street has been following Compaq's return on invested capital closely
because the company has said it is one of the best measures of its attempts
to cut costs. Last summer, Compaq told analysts it would cut its costs of
doing business so much that return on invested capital would climb from
50% to "triple digits."
But without the factoring transactions, Compaq would not have even come
close to that goal, according to Mr. McCarthy.
Mr. Mason didn't dispute Mr. McCarthy's analysis but said it includes the
performance of Tandem Computers, the large systems maker Compaq
bought last summer. With Tandem excluded, Mr. Mason said Compaq's
ROIC reached 107% without the factoring transactions.
Lowering its cost of doing business is especially critical for Compaq. With
the surging popularity of $1,000 personal computers and price pressure in
the corporate market, Compaq -- like all PC makers -- is being forced to
cut its PC prices.
Without a more cost-efficient model for making computers, Compaq will
have a hard time competing with direct sellers such as Dell Computer.
Alternatively, its profit margins could fall. DLJ's Mr. McCarthy says the
difference "could mean a percentage-point drop in its net margin," now 5%
to 7% in personal computers.
Of course, Compaq's merger with DEC would reduce its reliance on the
low margin personal computer business, giving it entry into the higher
margin, server business. But some analysts aren't willing yet to overlook
questions about Compaq's underlying business, especially since there are
plenty of unanswered questions about how Compaq will integrate DEC.
"Compaq is faced with the task of integrating yet another acquisition.
Moreover, this integration comes at a time when Compaq is attempting to
reduce [distributors'] inventories of PC products, fundamentally alter its
manufacturing and distribution, deal with declining prices and avoid missing
product cycles in the fiercely competitive PC market. This seems like a
daunting task," Salomon Smith Barney analyst Richard Gardner told clients
following the deal's announcement.
Worries about whether Compaq was meeting its own goals in adopting a
more Dell-like business model began surfacing last fall, almost as soon as
the company began making promises to Wall Street.
Last summer, Mr. Mason not only promised higher returns on invested
capital but also told Wall Street that the number of weeks of inventory
Compaq would carry would be cut to about three from about 10. Soon
after, however, rumors began circulating that Compaq was "stuffing the
channels," a phrase used to describe the practice of selling lots of
computers near the end of a quarter to distributors in order to improve
results.
Compaq denied the rumors at the time. But it didn't help matters when one
distributor said its supply of Compaq PCs had grown, suggesting to some
investors that Compaq hadn't progressed as far as expected with the
transition to a build-to-order, or Dell, business model.
In the interview Wednesday, Mr. Mason said Compaq's distributors
missed a separate goal he'd set last summer for the distributors to be down
to only two weeks of inventory. The distributors, he said, feel that goal is
unrealistic, particularly with more advanced products. But he said the
company hasn't set new goals yet.
Some shareholders take a more benign view of the issue. "Compaq has
brought this on itself by setting goals that were too ambitious," says money
manager Kent Simons of Neuberger & Berman, one of Compaq's biggest
shareholders with about 14 million shares. Although Neuberger remains
bullish on Compaq, it recently had to sell some shares to keep its positions
under certain size limits within its funds. |
