Risky Business

Wall Street and customers question the viability of the HP-Compaq merger.

Leaders of two of the worlds largest computer companies contend their proposed megamerger will produce a winning combination. But Hewlett-Packard Co.s Carly Fiorina and Compaq Computer Corp.s Michael Capellas have a lot of convincing to do before the deal goes through.

Following HPs announcement last week to buy Compaq, there was no shortage of skeptics: Wall Street gave a collective thumbs down to the move, as was evidenced by the dramatic sell- off of both companies stock; industry analysts said the move carries with it a lot of risk; and reaction from big Compaq and HP shops ranged from stunned to cautious.

"This scares the hell out of me," said Michael Sherwood, director of IT for the city of Oceanside in California, which depends on 160 Compaq servers to handle key business applications. Sherwood said he feels left in the dark about what may happen to the companies products and support.

Facing mounting pressures to turn around their respective troubled companies, Fiorina and Capellas, both chairmen and CEOs, decided that combining their two problem-plagued businesses would make things right.

But many are questioning that logic. HPs costly gamble—initially estimated at $25 billion, but which quickly sank to $21 billion after the news of the announcement sent both companies stock prices plummeting—will create an unwieldy bureaucracy of more than 130,000 employees spread across more than 160 countries. There also will be logistical nightmares in sorting out a convoluted mix of overlapping products, software and services amid an industry downturn and increasing competition.

Fiorina and Capellas said their decision was fueled by a need to adapt to a changing competitive environment. But the executives may have felt compelled to make such a high-risk wager while they still could.

"They needed to do something like this, or they were facing having to look for new career options before the end of next year," said Rob Enderle, an analyst with Giga Information Group Inc., in San Jose, Calif. "However, the reality is that most of these large mergers have not been successful."

Among the failures Enderle cited were AT&T Corp.s $7.4 billion acquisition of NCR Corp. in 1991, which ended with AT&T divesting itself of the company six years later, and Compaqs $9 billion acquisition of Digital Equipment Corp. in 1998, "which Compaq only finally began fully addressing this year," he said.

As for IT managers, some, like HP customer Patrick Flynn, CIO of heavy-truck manufacturer Paccar Inc., in Bellevue, Wash., are concerned about price and competition. "It will be interesting to see what the effect is on pricing of [Windows] NT servers and the desktops," he said. "For us, thats the big issue."

Still, Gigas Enderle was positive about the merger. "There is a lot of potential with this merger, but it comes down to execution," he said. "The reconciliation of the product lines is going to be painful."

The merger could do for the two companies something they couldnt do on their own—become a major player in the services arena. Compaq has been pushing for that since acquiring Digital, with limited success. HPs efforts hit a roadblock this year with its failed bid to buy Pricewaterhouse- Coopers IT consulting business (see story, Page 20). The companies also will have to merge their formidable portable computer lines, Compaqs iPaq and HPs Jornada (see story, above), not to mention the companies vast stable of enterprise hardware and software.

Nevertheless, an HP-Compaq merger would certainly create a potent new competitor. "On paper, this could sound like a good move because it positions the combined company as No. 1 in printers, PCs, servers [and] storage, and as a major player in services," said analyst Andy Neff of Bear Stearns & Co. Inc., in New York. But given the companies recent poor performances, Neff has his doubts. "It is not clear how this merger addresses the issues faced by the companies separately," he said.

The plan to create a massive new company comes at a time other high-tech companies are retrenching and streamlining operations to weather an ongoing slump that has battered the industry since last fall.

While the HP-Compaq pairing would create a computer company second in size only to IBM, a bigger HP would face internal challenges second to none. Already, HP and Compaq are struggling to shore up falling sales and eroding market shares. By merging, theyll face even-more-daunting challenges. In addition to ironing out the massive product overlap, they will need to meld nearly 85,000 HP employees with 60,000 from Compaq, installing new management across the organization and addressing complex contractual and antitrust issues.

Make Way for Dell

Meanwhile, rivals such as Dell Computer Corp. will likely devote more resources to luring away HP and Compaq customers unwilling to wait the estimated two years for HP to absorb Compaq. There are already signs that the deal will spur customers to bolt. If the deal goes through, Oceansides Sherwood will likely abandon Compaq and switch to Dell. "Weve tried HP equipment before and were not satisfied with it," he said.

Seeking to head off potential widespread desertions, HP, of Palo Alto, Calif., and Houston-based Compaq are calling corporate customers to ensure them that their needs will be met.

"Both HP and Compaq representatives contacted me the day of the announcement," said Gregor Bailar, CIO for NASDAQ, in New York, which relies on about 50 high-end Compaq Himalaya servers to handle stock transactions. After receiving assurances that the Himalaya line will continue, Bailar fully endorsed the merger.

But that support only goes so far. "We are a Dell user for PCs, so that wont change in this respect," he said.

That perspective undermines what HP and Compaq claim is the key reason for the merger, their belief that corporate customers prefer to deal with one vendor that can provide all their IT needs. Fiorina said the "synergies" resulting from the merger will elevate HP to IBM-like status, enabling it to offer a range of products and services few could match.

But given the companies falling fortunes of late, the odds are clearly stacked against them. Last month, HP said quarterly earnings plummeted nearly 90 percent from a year ago. It also said it will reduce costs and cut 6,000 jobs this year. Compaq, in a pitched price war with Dell, hasnt fared well, either. In July, Compaq reported a loss of $279 million for the second quarter. It has also announced cost-cutting moves that include slashing 8,500 jobs. Both companies stock prices have taken a beating as well. The day before announcing the merger, both hit 52-week lows, with Compaqs stock down 76 percent from its high in 1999, and HPs down 66 percent from its peak last year.

In a telling example of how little confidence investors have in the deal, last weeks merger news sparked a massive sell-off that sent the stocks of both companies to multiyear lows.

On a larger scale, the deal could ignite a wave of consolidation that would dramatically reshape the landscape. In January, Bear Stearns Neff predicted HPs bid to acquire Compaq, and said more consolidation was needed. He also urged Dell, of Round Rock, Texas, to buy IBMs PC business and called on San Diego-based Gateway Inc. to sell its business. Now that HP has acted, he said, rivals will study the impact before making their own moves. Still, "I think there is some potential for consolidation outside the U.S., particularly in Japan, and Gateway is still a candidate for something," he said.