Compaq Bear's Den
by Louis Corrigan ([email protected])

Investors need to know what they're buying. However, Compaq is no longer a known quantity.

Looking at FY97 results, I see a computer giant that delivered $24.6 billion in sales (up 23%) and $1.35 in earnings per share (up 52%), excluding non-recurring charges. Its PC sales grew at around 63%, or four times faster than the industry overall. Meanwhile, gross margins rose from 25.8% to 27.5%. Operating margins before taxes and charges jumped to 12.3% from 9.7%. Meanwhile, its acquisition of Tandem boosted the enterprise business to 37% of sales in the fourth quarter, helping to counteract margin pressure in the desktop business.

Such terrific numbers sent Compaq shares soaring from under $15 at the end of '96 to nearly $40 by September. But since then, the stock has been crushed due to dismal results in the increasingly competitive PC market and a whole lot of uncertainty about what the purchase of Digital Equipment Corp. (DEC) will mean for Compaq.

First quarter revenues increased just 8% as the company finally had to admit that much of the inventory it had pushed into the reseller channel in the latter half of '97 was still there. The result was some very bad news: EPS fell to $0.01 versus $0.28 in the year-ago period, as gross margins fell to 18% from 26.9%. Second quarter results are expected to be merely break-even because the company has been forced to slash prices and even halt some production. While inventory held by resellers at the end of the second quarter should be around 4 weeks versus 10 weeks earlier in the year, that's still a lot in a marketplace that is keying off of Dell's build-to-order model.

Compaq had promised a rapid implementation of its own build-to-order manufacturing last summer, but it so botched that initiative that its inventories actually soared. Yet, while Compaq is fighting Dell, it's also using the DEC deal to refocus its business around services, system integration, and all the other stuff that transforms hardware into "enterprise computing" and "information technology." That sounds fine, but let's check out the pro forma combined financial statement for FY97. DEC would have pumped up Compaq's revenues to $37.6 billion, but EPS of the combined firms would have actually dropped to $1.10.

That doesn't take into account the pending $5.4 billion restructuring that will claim 17,000 jobs and no doubt enhance future results. Still, Compaq's core business has suffered from slowing sales, shrinking margins, and rotten execution. The company is now looking to refocus its operations by acquiring a business that won't add to profits unless Compaq executes like crazy.

Investors should all but ignore current analyst estimates; they're little more than guesses. Compaq may have found the future of computing, but until it shows it can deliver, why rush in? Here are the main reasons this one-time star has dropped from the A list to the D list.

Disclosure: On January 21, CEO Eckhard Pfeiffer said he expected a "strong 1998" with "improve[d] profitability." Right! Everybody and his brother was already worried about Compaq's excess inventories, and the firm was six weeks away from pre-announcing the first quarter disaster. Management refused to be straight with investors. On other occasions, Compaq has told money managers material information without bothering to tell the public. Companies with poor execution and poor disclosure are the kind you want to avoid.

Demand: Worldwide growth in PC sales has slowed from 15% last year to just over 10% in the first quarter to maybe 9% in the second quarter. With everyone looking to capture market share, price competition is intense, underscoring the necessity of low-cost manufacturing.

Dell: Given the above, build-to-order rules because the value of inventory drops 1% per week. Dell has about a week's inventory while Compaq has four weeks of channel inventory plus several weeks of in-house inventory. So, until Compaq executes to precision, Dell has a significant price/profit advantage.

DEC: This deal poses more than an integration challenge; Compaq is going to use DEC to remake its own business model. Compaq now has 25,000 technicians plus 10,000 direct marketing/sales personnel who are supposed to help it build relationships with customers, thus pumping up service revenues and helping the firm win jobs it otherwise might have lost. However, Compaq will now be competing against many of its current partners, from information technology consultants to its channel resellers. That usually spells trouble.

Distractions: Compaq just launched a $300 million branding campaign with a beautiful but idiotic 12-page spread in the Wall Street Journal. These ads (like those run by Seagate and Oracle) are a waste of money because they don't focus on actually selling products. Besides, those pull-out ad sections just get tossed anyway. Pfeiffer also thinks Compaq should blow money investing in cable and on various Web start-ups to help accelerate demand for faster, higher margin PCs. But Compaq simply doesn't have the margins of Microsoft or Intel, so it just can't afford such extraneous ventures. Add this kind of stuff to the task of taming DEC, and Compaq seems a long way from what should be its major concern -- improving manufacturing efficiency.

The question is, what business model will thrive in today's computer marketplace? Compaq is moving from being primarily a manufacturer to being all things to all customers. This strategy should lead to continued revenue growth, but its effect on margins is unclear. Meanwhile, Dell is focusing on one goal: being the most profitable computer manufacturer on the planet, partly by managing its assets exceptionally well and partly by migrating its business into the server market rather than down into the under $1,000 box market. Dell is happy to rely on partners for all the other stuff.

While there's nothing wrong with developing new competencies, it's tougher than focusing on improving your core competencies. I see Compaq fooling around on the former while Dell keeps working hard at what it does best, which includes preparing to kick Compaq's butt while Pfeiffer et al. have their backs turned.

Next: The Bull Responds