April 12, 1999
Compaq Profit Warning
Raises Serious Questions
By GARY MCWILLIAMS
Staff Reporter of THE WALL STREET JOURNAL
Though Compaq Computer Corp. blames weaker-than-expected sales in saying that first-quarter profit will be less than half of Wall Street's projections, some analysts are questioning the PC maker's ability to manage competition while melding operations with Digital Equipment Corp.
Compaq, which in February warned of slackening demand for its PCs, said Friday that heightened competition and disappointing sales of its most-profitable computers will result in net income of about $250 million, or 15 cents a share, for the quarter, Compaq said.
Company Profile: Compaq Computer
That is well below the already-lowered consensus estimate of $560 million, or 32 cents a share, held by Wall Street analysts. Revenue was projected at $9.4 billion, $100 million to $400 million below analysts' projections.
The warning, which came after the markets closed, triggered a sell-off of computer stocks in after-hours trading. Traders reported heavy selling of Compaq at $26 to $27 a share, which had closed at $30.9375 in New York Stock Exchange composite trading Friday. Intel Corp. and Dell Computer Corp. also traded as much as $4 below their closing prices.
Compaq's disclosure shocked many analysts who had come to believe that the company's income was on track, and several pointed to the integration of Digital Equipment, which Compaq acquired in June. "The company has overstated the DEC synergies," said analyst Ashok Kumar of US Bancorp Piper Jaffray Inc.
"Compaq said there was lower demand; everything we see says different," said analyst Charles R. Wolf of Warburg Dillon Read. Indeed, a day before Compaq's announcement, rival Dell called PC demand healthy, across all geographic, product and customer segments.
Instead, said Mr. Wolf, "there are two issues here: integrating DEC and the misguided steps the company took last fall" to sell directly to businesses. He said he believes Compaq's need to add dealer incentives for products intended to be sold directly has contributed to margin declines.
In an interview Sunday evening, Compaq Chief Executive Eckhard Pfeiffer insisted the profit woes were because of what he described as an about $600 million shortfall in expected sales during the period.
"Everyone is building expectations on certain market-demand growth. If it [demand] comes in at a somewhat lower level, the competitive reaction leads to price cuts that are deeper or more frequent. We had both these factors in the last quarter," Mr. Pfeiffer said. "This should not be completely blown out of proportion." He said the company will continue to look for ways to improve production and delivery, address margin improvements and complete its absorption of Digital Equipment. Financial results will be released April 21.
The timing of this latest problem couldn't be worse for Mr. Pfeiffer, who has been struggling to turn around the Houston PC maker's fortunes for better than a year. This week, he opens a weeklong customer gathering designed to showcase Compaq's products and operations. He has invited about 4,000 executives from its biggest customers, including Ford Motor Co., Nippon Steel Corp., and Nestle SA, to hear how Compaq products and service can help them adapt to the changes spurred by the Internet.
Instead, he is apt to face questions over the miscues in his own business that rivals have used to outmuscle Compaq. "To come out on the ninth of April and announce you've missed the quarter by 50% represents a huge credibility problem," said Ciaran T. O'Kelly, managing director of equity trading at Salomon Smith Barney Inc.
The profit woes suggest sales of big computers acquired through the acquisitions of Digital Equipment and Tandem Computers continue to fall, analysts say. Sales of the high-priced machines, which carry gross margins at least double that of PCs, aren't salvaging the PC margins drop. Compaq's product gross margin is expected to be about 22.5% for the quarter, similar to Dell and Gateway Inc., which don't offer minicomputers.
Analysts say the shortfall is likely to expand the cutbacks now under way and force a re-evaluation of its direct-sales efforts. "Compaq claimed all along it wouldn't be structurally disadvantaged once DEC got absorbed. Now we may see them challenging that assumption," says Louis J. Mazzucchelli Jr., analyst at Gerard Klauer Mattison.
In its statement, the company said it "will continue its aggressive drive" to cut costs and operating expenses "in the face of a very competitive market."
Compaq's juggling of sales through dealers and through its own telephone and Internet-sales operation also could come under new scrutiny. Two weeks ago, Compaq disclosed it would make its five-month-old Prosignia PC line, designed for direct sales via the Internet and telephone, available through retail stores. The move only complicated the company's distribution, critics say. "If you want to make sure you're getting the best Compaq price, you have to shop four [sales] channels," Mr. Mazzucchelli says.
A year ago, Compaq similarly warned of below-par sales during the first quarter. It had operating losses during the first half of the year as the company was forced to provide sales incentives on as much as $500 million in excess dealer inventories.
This time, dealer inventories aren't anywhere near as high. Analyst Don Young of PaineWebber Inc. estimates resellers hold four weeks of sales on their shelves, compared with 12 weeks a year ago. However, the timing and size of Compaq's profit miss suggests the company was required to make significant price concessions on those inventories, Mr. Young said.
He believes the impact of selling even a small amount of discounted PCs could ripple across the industry. He said if demand doesn't accelerate by midyear, price competition will worsen as companies try to hold on to their market share.
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