Compaq Bull's Pen
by Chris Rugaber ([email protected])

If I were just a company shill for Compaq, I could talk about its four years of global PC market domination, despite that market's cutthroat price competition. Or, I could note that its server computers are so widely used that, according to its 1997 annual report, "nearly 50 percent of e-mail transmissions, 60 percent of all credit card transactions, 80 percent of all Automated Teller Machine [ATM] transactions and 90 percent of all securities transactions� run through Compaq servers." Even allowing for some annual report hyperbole, that's pretty impressive. (Full disclosure: We use some Compaq servers here at the Motley Fool.)

While impressive, such corporate PR is really only half the story. Compaq, thanks to its recent acquisitions of Digital Equipment Corp. and Tandem Computers, is now the second largest computer company in the world. PCs will be a smaller part of its business going forward, and considering the challenges that the personal computing industry will face in the coming years, that's a good thing.

So, if you need PCs, servers, notebooks, networking equipment, web-hosting capability, modems, printers, hand-held personal digital assistants, 64-bit high-end workstations, and the support services and consulting needed to hold it all together, Compaq can provide it -- and more. The company's acquisition of Digital included Internet search engine Alta Vista, which presumably explains the nice big link to Compaq's website in the bottom right of Alta Vista's home page. Most companies would have to pay a pretty penny for that.

Compaq aims to have $15 billion in services revenue and $60 billion in total revenue by 2002, more than double 1997 sales. If the company returns to pre-1998 margins, profits should also grow accordingly. Zacks' consensus estimates are for EPS of $0.58 in 1998 and $1.63 in 1999. At recent share prices ($28 15/16 on June 26th), that's only 17.75 times '99 earnings.

Of course, the big knock against Compaq is its recent inventory problems, which reduced net income from a high of $667 million in the fourth quarter of '97 to an anemic, one-cent EPS, or $16 million, in the first quarter of '98. Clearly, the company miscalculated demand in the middle of an ongoing PC price war, and it suffered accordingly. But Compaq has moved aggressively to solve the problem. It has reduced inventories from over $2 billion in the third quarter of '97 to $1.26 billion in the first quarter of this year.

In addition, Compaq is developing its "Optimized Distribution Model," which will include direct sales over the Web and "build to order" kiosks that will be placed in most major computer stores. The kiosks are presumably an attempt to placate resellers, who will object to being undercut by direct web sales if Compaq goes too far down that road. It's a tricky problem, and it's unclear at this point how it will work out. Can Compaq move to a "just in time" direct sales model without alienating its resellers? Should it try to? Is there a happy medium? After all, it's perfectly easy to buy Compaqs both over the Web and at CompUSA now.

The happy medium may already have been found, however: Compaq CEO Eckhard Pfeiffer recently noted that when reseller websites are included, Compaq sells more over the Internet than Dell -- $6 million a day versus Dell's $5 million. Yes, yes, Dell turns its inventory over much more quickly than Compaq, but so what? Compaq is moving beyond simply trying to be the fastest PC distributor in the world.

Others question whether Compaq can swallow its $9.6 billion purchase of Digital Equipment Corp., the largest merger in the computer world's history. Clearly, DEC adds a lot to Compaq: 25,000 service technicians, including 2,000 certified Windows NT engineers; access to thousands of business customers, which will put Compaq ahead of IBM as the top PC supplier to large businesses; and the rights to Alpha, Digital's 64-bit high-end microprocessor that's two years ahead of Intel's Merced [Ed. Note: Intel recently bought the rights to Alpha technology.] This will be the acid test for Compaq over the next couple of quarters, but as one analyst noted, "Management is not underestimating the task." By looking at margins and revenue streams, it should be possible for investors to track the company's success (or failure) in this endeavor.

More importantly, these unresolved issues of sales models and acquisition digestion are at least partly priced into the stock, which declined significantly when Compaq's channel inventory problems became apparent. In fact, one could argue that Compaq is a classic example of Wall Street overreaction to what will likely be a temporary condition. In the long run, inventory management is simply not the biggest issue that PC companies will face.

Instead, there are bigger challenges to be faced. Will other "Internet appliances," such as Web-TV devices, cut into PC sales? Probably -- so it's a good thing Compaq is likely to beat Dell and other PC makers in bringing a PC-TV hybrid to market. Are price wars going to continue? Undoubtedly, but that's why Compaq's broadening of its business is a good thing. Dell, meanwhile, will also face challenges. Until recently, its main supplier of customer services was� Digital Equipment Corporation. Whoops!

Compaq is likely to significantly grow revenue and profits, it has a couple of clear, easily monitored risks, and all at a fairly decent price. What more does anyone need in a high-priced market like this?

Next: The Bear Argument