Waiting for a Compaq Comeback


By Margaret Popper These days, tech stocks are for optimists. Sure, they're cheap, but any hopes for a decent return on investment depend heavily on an improving economic environment. Yet if you're a investor with a longer-term perspective, willing to buy a few promising tech stocks and hang on, it's likely that you'll be patting yourself on the back sometime in 2002, when the economy has righted itself and information technology spending begins to rebound.

Take Compaq (CPQ). That's right, the same personal-computer company that's been in the news for losing market share to Dell (DELL). With its most recent cost-cutting initiatives and its global positioning in businesses outside of PCs, Compaq may be better set up than its rivals -- including Dell -- to exploit the economy's rebound. There's another factor to consider: Investors barely reacted to the company's earnings report on July 25, a fact which has only enhanced the attractiveness of the stock. At its current share price of around $14.50, Compaq might be a tech stock that could deliver substantial upside by August 2002.

True, Compaq experienced a 17% year-over-year revenue decline in the second quarter. But the success of its cost-cutting programs is evident in that the company still met its 4-cents-a-share earnings target. As Chairman and CEO Michael Capellas said in the July 25 earnings conference call, "We delivered on our commitments to improve the company's business model and build momentum behind our services and solutions-led strategy." In fact, the company made staff and inventory reductions that should permanently shift Compaq's distribution structure to a direct-sales model that is more comparable to Dell's.

DIRECT APPROACH. Perhaps the most important aspect of the restructuring was the fact that $500 million of Compaq's $700 million inventory reduction in the first half of 2001 was inventory at Compaq's resellers, also known as "channel" inventory. In other words, it appears that Compaq is moving toward eliminating channel inventory and selling products directly -- a strategy that has made Dell a favorite on Wall Street.

Over the past six months, this effort has reduced the company's sales base from about $50 billion to about $35 billion. In the second quarter alone, the inventory adjustment took five percentage points from revenue growth. But the smaller size is a more profitable one, according to Jeff Clarke, Compaq's chief financial officer. "The restructuring has resulted in a permanent change in the way Compaq is doing things," says Eric Rothdeutsch, analyst at Robertson Stephens. "In the U.S. it has made a big improvement in its bill-to-order system so that products move faster from the [time of the] order [until they get] to the end-user. It's closing the [competitive] gap between Compaq and Dell."

Improving its inventory model is key if Compaq wants to bolster its fortunes to compete with Dell. While Dell's 13% market share makes it the world leader in PC sales, Compaq follows close on Dell's heels with a 12% share, with IBM holding the third slot with an almost 7% share of the global PC market, according to Robertson Stephens' Rothdeutsch. Compaq lost half a percentage point of market share to Dell in the second quarter, according to management.

GUARDED OPTIMISM. It's not just pressure from Dell, however, that has hurt Compaq's so-called access business -- selling desktops and handhelds to consumers and commercial customers -- in 2001. The industry is suffering from the slower growth that naturally accompanies a maturing business -- and that's not going to change, according to Richard Chu, analyst at SG Cown Securities. Chu sees market saturation on both the corporate and consumer sides. In his view, businesses' appetites for tech spending are sated after the Internet boom and fears of a Y2K computer meltdown. And on the consumer side of the business, the households that are likely to want -- and to buy -- PCs in the near term already have them.

Compaq management believes that, once corporate IT budgets loosen up, companies will be open to upgrading their desktop technology. The reason: Accounting rules allow for a three-year writeoff of the cost of computer equipment and Y2K equipment, so all that gear will have been fully amortized this year. As for consumer spending, back-to-school purchases usually cause a revenue bump in the third quarter. But increasing layoffs nationwide could curtail that spending. Still, all in all, Compaq predicts that the third quarter will see improvements over the access business' $155 million second-quarter loss. The division's $3.8 billion in revenues were 22% lower than the same quarter in 2000, in part due to the reduction in so-called channel inventories.

Even if the long-term industry outlook for PCs is weak, Compaq is much more than just a PC maker. Of its $8.5 billion in revenues for the second quarter, 55% came from non-PC-related business. Of course, in the short term, these businesses also have their issues. "Dell doesn't have storage, services, and high-end servers," observes Robertson Stephen's Rothdeutsch. "But since these are part of what got hit by the overall IT cutback, the slowdown has had a double impact on Compaq." Yet Rothdeutsch believes these products could be key to Compaq's future.

PAIN NOW, PROFITS LATER? The fastest-growing business line is services -- essentially systems consulting and outsourcing services that compete with those offered by the likes of IBM (IBM). Global services, which account for 23% of total revenues, grew 7% in the second quarter of 2001, vs. the same quarter a year earlier. And it's a business with 14% operating profit margins. The goal is to grow services to more than 30% of revenues. Compaq has reached that target in Japan, the U.K., and Switzerland, but to hit it in the U.S. will require better economic conditions than we currently enjoy.

Another 32% of Compaq's revenues come from what the company refers to as its enterprise computing business -- selling servers and storage capability to business clients. With revenues down 21% and profits down 44% year-over-year for the second quarter, this division has been hit far harder by the downturn in capital spending than the services division. And Compaq profits also have suffered from the hit to sales the company took in clearing out inventory held by resellers during the first half of 2001.

With pain could come gain, however: Compaq stands to benefit hugely when the economic recovery finally kicks in. "Enterprise computing will be a fast grower when IT spending turns," predicts Rothdeutsch. "And there will be some big spending in the second half [of 2002] because companies can only hold off for so long. They've cut their IT spending to the minimum this year." When sales are growing at a more normal pace, enterprise products have even higher margins than services, he says.

WIDE RANGE. The consensus among analysts is that Compaq will achieve sales of $8.5 billion and earnings per share of 7 cents in the third quarter, and sales of $36 billion with EPS of 36 cents for 2001, according to First Call data. In 2002, analysts predict sales will grow almost 7% to $38.4 billion, while earnings increase a whopping 86% to 67 cents a share, thanks to this year's restructuring. Analysts' 12-month target prices range from $15 to $35 a share.

"Risk/reward on the shares remains attractive at 0.6 [times] revenues," wrote Kimberly Alexis, analyst at Prudential Financial in a July 26 report on Compaq. That's pretty darn cheap, in her estimation. The only problem is that there are likely limited catalysts for achieving significant revenue growth in the near term, the report says. But for investors who might be thinking about the longer term, $14.50 a share may yet prove to be a very reasonable price for a stock like Compaq. Popper covers the markets for BW Online in our daily Street Wise column


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