Will Compaq's Downturn Nix HP Deal?

News of a drastic third-quarter revenue shortfall from Compaq Computer Corp. (NYSE: CPQ) (see Compaq Lowers Expectations) has prompted financial analysts to slash earnings estimates for this year and next. And it looks like the warning, issued after Monday's market close, could derail the enterprise computer and storage giants pending merger with Hewlett-Packard Co. (NYSE: HWP).

Although both companies insist the merger is on track, Compaq’s stock price is now trading at a 15 percent discount relative to the merger valuation. The proposed merger, announced a month ago (see Compaq/HP Hairball), calls for HP to swap 0.6325 of a share for each share of Compaq.

Typically, when investors expect a merger to be consummated, the stocks will trade very close to the merger valuation, usually within 5 percent. The current trend, coupled with a situation in which more than half of HP's stock is owned by institutional invenstors, indicates investor sentiment could apply pressure to call off the deal.

Compaq CEO Michael Capellas blamed various factors for the revenue shortfall, including the September 11 terrorist attacks and tropical storms in Asia. (And how'bout that Mad Cow thing? Couldn't have helped.) Although Compaq will not officially announce third quarter results until around the middle of this month, Capellas said he expects revenues to be $7.4 billion to $7.5 billion, or a sequential drop of 12 percent. He predicts an operational loss of 5 to 7 cents a share. And the company plans to take a $500 million non-cash charge for the quarter, due to losses on its investment in Internet company CMGI Inc.

Analyst Ashok Kumar, of U.S. Bancorp Piper Jaffray, in a research note titled “Dr. Kevorkian, Where Art Thou?” slashed his estimates for Compaq for the second half of this year. His previous projections of 40 cents earnings per share on $21 billion revenues are now down to a 7 cent per share loss on $15 billion revenues. Likewise, he cut 2002 estimates from 60 cents per share earnings on $43 billion revenues to 10 cents per share on $32.5 billion revenues.Kumar doubts that business lost to the disruptions will be recaptured in ensuing quarters. He notes the huge revenue shortfall “will completely mask the purported cost savings” of the merged companies, and he believes there is “a high probability” the merger will not be consummated.

From the storage perspective of both companies, there are too many variables to determine whether the merger would add or subtract value. The combined company would certainly have a broader range of offerings.

“Compaq is the leader of the bottom half of the storage business and is trying to come up,” says Jim Porter, president of Disk/Trend Inc., a market research firm. He notes HP’s reseller relationship with Hitachi Ltd., a company with very high customer satisfaction ratings, would put the merged entity on solid ground at the high end.

But he also points out myriad issues on the downside. For instance, some enterprise customers, who may not like either one of the merger partners, may switch to other vendors with comprehensive offerings, such as IBM Corp. (NYSE: IBM) or Sun Microsystems Inc. (Nasdaq: SUNW).

Other sources say the CEOs of both Compaq and HP are relatively new on the job and neither is experienced at a large merger. Some say HP, which used to be slow moving and bureaucratic, is changing rapidly under CEO Carly Fiorina. But it may be too soon to say how she'll handle this type of deal.“Carly is transitioning HP from the old HP way," says Porter. “But it’s kind of hard to figure out what her way is yet.”

— Tom Davey, special to Byte and Switch, http://www.byteandswitch.com