Article for CPQ fans
BitStream: Rocky start to Compaq-DEC marriage
If the deal goes through, it will be a bumpy first year as Compaq restructures DEC operations, hacks away at costs and revamps strategy. Analyst Report
By Bret Rekas
No objections were raised during the five-month engagement, and now
Compaq Computer (CPQ) and Digital Equipment (DEC) are about to
wed. On Thursday, Digital shareholders will formally vote on the
proposed merger. And as highlighted in "Digital Developments," it will be
astonishing if the deal does not receive the required 2:1 approval
required to consummate the transaction.
Digital's business has been deteriorating and the company no longer
possesses a dominant position in any major market segment. The
terms of the agreement currently value DEC at about $8.6 billion, or
67% of trailing 12-month sales. Compaq will pay roughly $57 -- $30
cash plus 0.945 shares of Compaq -- for each Digital share. Compaq's
effective cost, however, is only $42 per share because Digital's net cash
position (including the recently completed sale of Fab 6 and its
semiconductor operations to Intel) is about $15 per share. Although the
purchase price is significantly less than the nearly $200 per share
Digital was accorded in 1987, it represents a substantial premium to the
$35 Digital was trading at just weeks prior to the merger announcement.
CPQ+DEC=?
The combination of Compaq and Digital is not a case of simple
arithmetic. Upon the completion of the merger, Compaq will not
suddenly become a $36.5-billion entity. Once Compaq officially
assumes control by the end of the second quarter, the process of
dismantling Digital will begin. Compaq will be occupied with the
consolidation and assimilation of Digital's operations for at least a year.
Compaq is expected to incur two sizable extraordinary charges
associated with the DEC acquisition during the June quarter. There will
be a restructuring charge of $1.5 billion to $2 billion and a one-time
charge of nearly $3.5 billion for in-process R&D.
The Digital acquisition was primarily motivated by Compaq's desire to
quickly establish a worldwide service organization. Consequently, the
22,000 employees who comprise Digital's service organization and
account for 43% of DEC's worldwide employee population of about
51,700 are most likely to be spared in the restructuring. About half of
Digital's remaining 30,000 employees, however, will probably be
displaced as Compaq attempts to eliminate redundancies and rapidly
reduce Digital's bloated cost structure. Digital's operating expenses are
32% of sales; compare that with IBM's 27.5% and Compaq's 15.2%
operating expense ratio.
The most obvious target of Compaq's anticipated cost-cutting efforts is
Digital's PC business, which will probably be eradicated. Compaq is the
leading PC company worldwide, while Digital isn't even among the top
10. Digital's PC sales, which account for about $2.2 billion, or 17% of
trailing 12-month revenue, are up only 10%.
Another likely casualty of the restructuring and rationalization efforts is
Digital's worldwide sales and marketing organization. Bruce Claflin, who
headed Digital's sales effort, has already announced he will not remain
at Compaq following the completion of the acquisition. Compaq is
unlikely to completely eviscerate Digital's sales force since it enhances
Compaq's direct-sales capabilities, but Compaq will probably trim the
ranks and focus on improving sales-force productivity and reduce costs
by selling more Digital product through its own global reseller network.
Questions about Alpha
Since 1990, Digital's revenue has been virtually stagnant at $13 billion to
$14.5 billion annually, but Digital's operations are unlikely to initially
contribute $13 billion to Compaq. In fiscal 1997, revenue declined 10%
to $13 billion and trailing 12-month revenue is down 3%. Digital's service
business, which accounts for 45% of revenue, has been contracting
since 1993 due to the deterioration of Digital's systems business.
Digital's Multivendor Customer Services, which provides computer
system maintenance and support services, generates 65% of DEC's
service revenue and is also the highest margin service business.
Unfortunately, 60% of the maintenance and support contracts are still
associated with Digital's deteriorating hardware sales. Compaq's
imminent involvement has prompted computer systems companies like
Dell (DELL) that previously used Digital's service organization to provide
customer support, to switch to alternative service providers like Wang
(WANG) and Unisys (UIS).
Although Eckhard Pfeiffer and Compaq have pledged allegiance to
Digital's Alpha microprocessor, it is unclear if Compaq's endorsement
will revive Alpha's anemic sales. Alpha system sales, which account for
$2.2 billion, or 17%, of Digital's trailing 12-month revenue, are down 5%.
Historically, Compaq has been exclusively a Windows/Intel company
and will have to convince customers it is committed to Alpha.
Although restoring
growth will be a
challenge, Compaq
should be able to
significantly cut
costs. The benefits
of the anticipated
restructuring and
expense-reduction
efforts, however,
are unlikely to be
realized before
1999.
Although an implementation of Microsoft Windows NT supports Alpha,
less than 20% of Alpha systems ship with Windows NT. The six-month
delay of Intel's IA-64 architecture is unlikely to persuade customers to
deploy NT on Alpha. Digital UNIX is the primary operating system
running on 50% of Alpha systems and OpenVMS ships on the
remaining third of Alpha systems. It will be difficult for Compaq, which
has never been perceived as a UNIX solutions vendor, to create a
credible UNIX-on-Alpha strategy and successfully compete against Sun
Microsystems (SUNW) and Hewlett-Packard (HWP).
Cost-cutting is the key
The evolution from "just another PC company" to a true enterprise
computer systems company will be difficult, and digesting Digital clearly
presents Compaq with a number of significant obstacles. Compaq will
probably be unable to immediately reverse the deterioration at Digital. To
renew growth, Compaq must simultaneously integrate DEC's operations
and develop strategies to effectively compete in unfamiliar markets with
formidable competitors.
Although restoring growth will be a challenge, Compaq should be able to
significantly cut costs. The benefits of the anticipated restructuring and
expense-reduction efforts, however, are unlikely to be realized before
1999.
If Compaq can avoid losing its focus as it struggles to assimilate Digital
and establish a presence in new markets over the next 12 months, it
could become more than just another PC company.
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