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

Though I have to disagree with a couple of points made by Chris (a.k.a. "The Shill"), I think we largely agree on the facts. We simply differ over what investment stance those facts warrant.

For starters, Compaq's inventory isn't restricted to that $1.26 billion that shows up on its balance sheet. That doesn't include the stuff on the back shelves at CompUSA and other resellers. The company says this channel inventory will be down to four weeks by the end of the second quarter. We'll see.

Inventory issues can be a temporary problem, and there surely are other competitive concerns that any computer manufacturer has to address, including basic things like, how do you convince folks to buy your stuff rather than a competitor's? Compaq's answer seems to be: use DEC's service wing to turn customer relationships into future sales; play up DEC's 64-bit Alpha products while working on bridging the Unix/Windows NT transition; and diversify the sales channels so that whichever way a customer wants to do business, Compaq is there. So... service, technology, and convenience.

The missing ingredient here is competitive pricing, and that's where inventory turns become crucial. Dell is master of that game while Compaq appears sort of ready to play it and sort of not that interested. In my view, hardware prices (and real build-to-order flexibility in configurations) matter to all customers today. With the DEC deal, Compaq seems to be saying that manufacturing efficiency is no more important than these other things. I think that's wrong.

Of course, PCs will become a smaller part of Compaq's revenues. But to pick up DEC's service biz ($5.9 billion, or 45% of DEC's FY97 sales), Compaq had to buy its hardware business, too. Much of it, however, will be shut down. Alpha-based systems accounted for just 32% of DEC's FY97 product sales (total: $7.2 billion). Of the rest, the HiNote laptops appear to be the sole survivor.

While gross margins in DEC's service unit were higher than Compaq's gross margins in FY97 (31% versus 27.5%), they've been falling in recent years. Investors ought to wonder where they will end up in the future since IBM's service unit delivered 20.8% gross margins last year and EDS reported similar 20.2% gross margins. Also, as Chris himself points out, a bunch of DEC's service revenues came from Dell. That business is now gone. In other words, Compaq's margins may return to FY97 levels. Then again, maybe they won't.

Sure, Compaq seems pretty well-positioned for the next millennium, but you can believe that while being agnostic or atheistic on the stock. Chris thinks the current price represents an overreaction to uncertainty and suggests that the stock will head higher as the company delivers the goods. My fear is that the stock could leap ahead from time to time on hopes that Pfeiffer can sort everything out -- only to then fall back as Wall Street gradually comes to understand the challenges the company faces in changing its business model.

Chris admits that Compaq has a "tricky problem" in changing something as basic as its sales approach without alienating its partners. The analysts seem to agree. That FY97 estimate of $1.63 per share that Chris quoted is based on a range of $1.10 to $2.20. Now that's uncertainty! I wouldn't consider buying this stock until Compaq delivers real results that clarify the currently murky picture.

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