Doubts about HP-Compaq's Financial Goal


With the Mar. 19 shareholder vote on Hewlett-Packard's $21 billion purchase of Compaq Computer just a day away, much attention has been turned to how the two companies might be integrated. So far, kudos have been heaped onto a 900-person team that has spent more than 500,000 hours on every imaginable detail -- from getting Compaq employees on the payroll to figuring out which sales rep will call on major accounts.

The team's biggest task: finding financial synergies. It has been dispatched to hit two targets: $2.5 billion in cost savings by 2004 and keeping revenues from shrinking more than 5%, as rivals swoop in to grab customers. If the merged company reaches these goals, HP Chief Executive Officer Carly Fiorina says HP's earnings per share would jump to $1.51 in 2003, up from $0.88 in 2001.

But some members of the integration team have doubts about the plan, BusinessWeek has learned. The problem isn't finding $2.5 billion in savings, which isn't a huge number for what could be a $78.8 billion company. Concerns center on the equation's revenue side. According to two members of the integration team and five former HP executives who have spoken with team members, the company may have underestimated the revenue loss it will experience in a number of areas, including home PCs and low-end servers. One team member thinks the combined company's revenues will slip 10% to 15%, rather than 5%.

"CHALLENGED." Why? The integration plan calls for closing down product lines where one company is weaker than the other. But shutting down some product families could also cause the revenues from those products to dwindle too fast. "I am very doubtful we'll be able to cut $2.5 billion in the right places without doing damage to revenues," says one team member. Says another: "The higher up you go [on the management organization chart], the more confidence there is in the 5% number. The lower down, the more challenged people feel. I think the numbers will be tough to achieve."

The question of revenue "slippage" is one of the deal's most controversial aspects, mostly because there are so many variables and so many unknowns. HP management insists that the combined company will lose no more than 5% of its revenues. And some integration team members agree, while others say it's too low.

Wall Street is similarly divided. Merrill Lynch analyst Steven Milunovich thinks HP will hit the 5% target. Others predict a bigger drop. Sanford Bernstein analyst Toni Sacconaghi and CS First Boston analyst Kevin McCarthy believe HP's revenues will dip 10% as a result of the merger, while Banc of America Securities analyst Joel Wagonfeld figures 7.5% slippage.

BETTER OFF ALONE? From an earnings point of view, every percentage point matters. Wagonfeld figures earnings-per-share will fall 14 cents for every additional 2.5% drop in revenue. By his math, a combined HP-Compaq that suffered a 10% revenue dip would deliver $0.68 EPS to shareholders in 2002 and $1.28 in 2003, compared to $0.89 and $1.56 if it hit the 5% mark. If the revenue drop is 15%, the combined company's EPS would be $0.43 and $1 in those years.

That's why too much revenue slippage would make this a bad deal for investors, Wagonfield says. A stand-alone HP, he figures, could earn $1.17 in 2002 and $1.60 in 2003. "If the negative impact to revenues were to be 10%, it would be very difficult for this merger to make sense -- unless there's over $3.5 billion in synergies," he says.

Nonsense, says HP's top brass. They point out that HP has beaten its revenue targets in recent quarters, so there's no sign of trouble. And they argue that the 5% figure is conservative. HP executives say they expect a 9.5% drop in their $44 billion hardware business. But that will be more than offset by no revenue declines in their $20 billion printer business and $13 billion computer services business. (Specifically, execs expect revenue slippage of 18% in home PCs, 11% in Unix servers, 8% in corporate PCs, 6% in Windows servers, and 5% in storage.)

DETAILED PLANNING. "We're right on track with where we want to be. We feel comfortable, in all respects," says Webb McKinney, the 32-year HP veteran who's leading the integration effort along with Compaq Chief Financial Officer Jeff Clarke. McKinney spoke with BusinessWeek on Mar. 12. HP and Compaq declined interviews on Mar. 15 and Mar. 18, when BusinessWeek contacted them for additional comment after gathering more reporting from integration team members.

To be sure, management has laid out a detailed plan for meeting its goals for both savings and revenue. Most of the $2.5 billion in reduced costs will come from eliminating overlapping corporate functions, from legal and marketing to human resources and sales management. Even the concerned members of the integration team praise the level of detailed planning that has gone on. And one integration team member disagrees that the 5% goal is too aggressive. "If I was [Fiorina], I would sign up for these numbers," says the team member. "It's not going to be a cake walk, but it's a reasonable plan."

Why aren't others so sure? The trouble, they say, centers on finding businesses that can be shut down gradually, without losing sales too fast. There are obvious candidates for the chopping block -- businesses that have either been losing money or have low growth prospects. Those include HP's Windows-server business, which has suffered double-digit operating losses in recent quarters, as well as its corporate PCs.

FASTER FALL? On the Compaq side, Unix servers are a candidate. Many of these businesses still bring in lots of revenue. While the plan is to gradually ease customers over to the other products -- say, HP's profitable home PCs rather than Compaq's money-losers -- insiders fear that those revenue streams could dry up too fast.

Take HP's $1.6 billion Windows NT server group. It has lost money and market share in recent years, while Compaq remains a leader in this segment. If HP said it was eliminating its unit, many customers might switch to rivals such as Dell or IBM. That could cause revenues to fall faster than the merged company could reduce expenses related to the business. In 2001, that $1.6 billion server business represented over 2% of the combined company's revenues. It has been shrinking since. Still, too big a sales drop would take a big bite out of the 5% target.

Increasing politics between the two companies may be taking other obvious candidates for elimination off the table. While insiders say the teams from Compaq and HP have worked together remarkably well, as the merger gets closer both sides are being more aggressive about protecting their people and product lines, say two integration team members and former HP execs.

LOBBYING PUSH. One possible example: Compaq's Alpha-based Unix servers. Inherited in its 1998 acquisition of Digital Equipment, these models have been poor sellers for Compaq. In 2001, Compaq said it would discontinue Alpha chip development and focus on machines based on Intel's Itanium chip. On the surface, that might make it an obvious candidate to be discontinued. But since Compaq still takes in big profits through high-margin service contracts with Alpha server customers, Compaq insiders are lobbying to maintain enough investment in the business.

Says one of them: "There are a lot of quid pro quo's being discussed. Each side is worried about getting the longest life out of what they bring to the table." At a recent analyst's meeting, HP executives denied that HP wanted to shutter the Alpha business.

Some may also be worried about their retention bonuses. One insider admits that he'll vote his personal shares for the deal, even though he doesn't think it's best for the company. The reason: He's one of 6,000 HP employees getting hefty retention bonuses -- $337 million in all -- if he stays with the post-merger company. "I know it's pathetic, but the old HP is gone," he says. "I'm giving up on the stock, and taking the cash. The bribe worked."

If other shareholders also approve the deal, the world will soon find out if the HP-Compaq integration plan will work as management has promised. By Peter Burrows in San Mateo, Calif.


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