by Scott Tilley

It seems like just last week I was talking about Compaq dropping support for its Alpha chip, in favor of Intel's Itanium. Wait a minute, it was just last week! On Monday, Compaq announced that it dropped support for, well, Compaq. The Houston, Texas-based PC company announced it was being bought by Palo Alto, Calif.-based Hewlett-Packard for $25B. By Friday, the value of the deal had dropped to about $19B, with the stock of both H-P and Compaq dropping about 24% and 16%, respectively. Seems like Wall St. dropped its support too.

This week began with a block-buster announcement: H-P is acquiring Compaq for approximately $25B.  Even at the height of the dot.com boom this would represent some serious money. Given the current economic climate, the merger seems more like the "wedding of the wallflowers", a joining of two not-quite top-tier players in the PC arena. Whether or not the couple will enjoy marital bliss or strife is anyone's guess.

Wedding of the Wallflowers

Picture a two-panel cartoon image of a wedding. In Panel 1, a man and a woman, both smiling, dressed in business attire, and holding attaché cases, stand in front of a preacher. The preacher asks "If anyone knows why you, Compaq Computer Corp., and you, Hewlett-Packard Co., should not be joined together in matrimony, let then speak now..." In Panel 2, everyone's hand in the congregation is raised. The congregation represents shareholders in the two companies, who clearly seemed to have voiced their disapproval of the proposed merger. The man and the woman both frown. The preacher stops the ceremony.

That is how this Saturday's National Post portrayed the merger of H-P and Compaq. Not as a great business idea destined to create a computing powerhouse, but as a bad decision derided by industry analysts and the market alike. If no one seems to think the merger is a good idea, why are H-P and Compaq going forward with the forced marriage? Maybe they felt they had no other choice. But if history is any guide, most takeovers and mergers in the computer industry have failed miserably.

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Terrible Takeovers

The computer industry is full of failed takeovers. Consider AT&T's disastrous purchase and subsequent spin-off of NCR, which resulted in several billion dollars in loses for the telecom giant. Why should H-P or Compaq be any different? Both have had mixed results from previous mergers. In 1989, H-P swallowed Apollo, which was then a maker of popular engineering workstations. Soon after Carly Fiorina's arrival as CEO at H-P, she spun out the testing division as Agilent Technologies -- something that many analysts still say was a mistake.

In 1997, Compaq took control of Tandem Computers. A year later, Compaq bought Digital Equipment Corp., a takeover that Compaq never fully completed to this day. The architect of Digital's takeover was then-CEO Eckhard Pfeiffer; in retrospect, the Digital fiasco was a poor career choice for him and for all the employees involved.

This is also one of the worst times to be making takeover history, given the recent economic downturn. Large corporate customers want continuity above all else; they want their investments to still mean something in five years. If the customers feel that the merger will create too much uncertainty in the market over the longevity of certain products, they may opt for solutions from H-P/Compaq's competitors to reduce the risk. While H-P and Compaq are practicing for their first after-dinner wedding dance together, their "meat and potatoes" business may get eaten by the competition watching from the sidelines.

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The Big Squeeze

The main driver for the merger is a desire to move H-P into the lucrative services business, something that IBM has been able to do under the leadership of Lou Gerstner. However, the new H-P may find itself squeezed from both above and below. From above, H-P's main competitors are IBM and Sun on the hardware side, and IBM (and to a lesser extent, EDS) on the services side. If the goal is to become a services company, raising revenue from consulting and systems integration, H-P will have a very tough time going head to head with IBM. Over 60% of H-P/Compaq's 65,000 service people do basic computer repairs, not high-end consulting. Last year, H-P tried to buy PricewaterhouseCoopers, the IT consulting firm, in a bid to boost H-P's services arm. The deal was scuttled after press leaks caused the stock price of H-P to fall so much that the takeover became too expensive.

From below, H-P's main competitor is the ultra-aggressive Dell Computer. Dell is rightfully known as a category killer, operating direct to business and consumers and avoiding retail outlets. This lets them squeeze out their competitors through lower prices in an already low-margin business. With nearly no inventory, Dell's expenses have been reported to be about half of those of either Compaq or H-P. It would seem that the new H-P will find it tough going in the low-end commodity business of personal computers. However, 70% of retail PCs will be made by the new company.

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The New H-P

The new H-P will have revenue of $87B a year, just shy of industry giant IBM's $90B. It will employ over 130,000 people in 160 countries. Combined, H-P/Compaq currently employs over 145,000 people, but 15,000 people will be made redundant in the merger. In fact, this is one of the cost savings offered by the management for the merger, which is scheduled for completion in the first half of 2002. The resultant company will be called H-P and will be headed by H-P's current CEO, Carly Fiorina; the current CEO of Compaq, Michael Capellas, will become President. The new H-P will be based in Palo Alto, Calif., with a strong presence in Compaq's current headquarters of Houston, Texas. How long the Texas branch has to be of some concern to staff in the Lone Star state.

The merged company will have four separate business units:

1. Access Devices
2. IT Infrastructure
3. IT Services
4. Imaging and Printing

The last business unit, Imaging and Printing, is where H-P makes most of its money now. Their lucrative inkjet printer and replacement cartridge business is a cash cow, but how long that can be sustained is an open question. This past summer I received an inkjet printer for just $1 as part of a total system purchase; that's a hard price to compete against.

Just managing the smorgasbord of legacy operating systems, hardware platforms, and software systems will be extremely complicated. After the merger, the new H-P will have to manage old Apollo workstations, H-P PCs, Tandem computers, HP-UX and Windows NT servers, OpenVMS systems, Windows CE devices, and so on. This is a result of previous takeovers each company had made in the past, not always with much success.

There are a few bright spots in the merger, notably storage devices and PDAs. The Compaq iPAQ is doing very well, and combining it with the strengths of H-P's Jornada will make it a considerable competitor to the Palm Pilot line. Coupled with Microsoft's inevitable improvements in the PocketPC operating systems, this seems like an area to watch in the future.

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What's Next for H-P/Compaq

It's still not a certainty that the deal will go through. If the stock prices of both companies continues to fall, H-P shareholders may balk. Already the premium placed on Compaq stock has been erased. There's also the issue of antitrust regulators in the U.S. and the European Union. The U.S. authorities will probably let the deal go through, possible subject to getting rid of certain business units, but the European commission is another question.

Considering that there were serious rumors circulating that Ms. Fiorina was in danger of losing her job as head of H-P just weeks before the merger was announced, this change of fate is nothing short of miraculous. For someone with an undergraduate degree in philosophy and medieval history, Ms. Fiorina would seem to have some significant challenges ahead of her in guiding the new H-P to profitability.

The Wall Street Journal stated "Their [Fiorina, Capellas] No. 1 priority right now is to communicate the long-term benefits to shareholders that this merger represents." So far, I personally haven't seen these benefits clearly enunciated. In an industry that moves as fast as the PC world, long-term benefits that may only be realized in 3+ years can seem like forever. And H-P/Compaq doesn't have forever if it wants to stay competitive in personal computing.

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