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Commentary: How to make HP-Compaq work

Wall Street's thumbs-down on Hewlett-Packard's proposed acquisition of Compaq is no surprise. But if the transaction goes through, there still may be ways to strengthen the new company's competitive position.

Hewlett-Packard's proposed acquisition of Compaq Computer has been about as well received as a brass-knuckles exhibit at a convention of pacifists. Investors do not like the idea at all, and the stocks of the two personal-computer makers have plummeted since the deal was announced Sept. 3.

Faculty members at Wharton who have studied mergers and acquisitions and industry consolidations say Wall Street's thumbs-down comes as no surprise because this proposed marriage appears about as star-crossed as any relationship could be. Still, if HP and Compaq proceed with the transaction and receive shareholder and regulatory approval, there still may be additional ways to try to strengthen the new company's competitive position, say several professors.

The PC-manufacturing part of the industry is really in bad shape. That's why I think the Street is so down on this merger. It would put together two weak players in a crummy industry. --George Day, marketing professor, Wharton School However, the consensus is that, as things stand, the companies will have a difficult time making a merger work. "I think it looks desperate," says Robert E. Mittelstaedt Jr., vice dean and director of Wharton's Aresty Institute of Executive Education. "I don't see a bright side to it. I think they're both struggling, and they're throwing something up against the wall to see if anything sticks."

"Computer services--everything from repair services to technical assistance to running computer networks--is still a good business," says marketing professor George Day. "But the PC-manufacturing part of the industry is really in bad shape. That's why I think the Street is so down on this merger. It would put together two weak players in a crummy industry."

Day says Compaq and HP are not prepared to compete effectively against IBM in providing information-technology services. Nor, he says, could a combined company hope to make a serious run at Dell Computer, which is the leader in selling made-to-order PCs at low prices. Day also says Compaq and HP have "two very different cultures, so their integration problems are huge."

Daniel Levinthal, professor of management and economics, points out that Compaq has yet to fully digest its acquisition of 1998 Digital Equipment, a deal that many consider to be a failure.

For their part, HP, of Palo Alto, Calif., and Houston-based Compaq say they remain excited about joining forces. They say the merger would make the combined company, with $87 billion in annual sales, the world's No. 1 organization in servers, PCs, handheld computers, and imaging and printing. What is more, they say, the new company would have leading positions in IT services, storage and management software. The companies expect to eliminate 15,000 jobs and save $2.5 billion after merging.

HP CEO Carly Fiorina and Compaq Chief Executive Michael Capellas have been vocal in touting the benefits of a deal. But given Wall Street's harsh reaction, management professor Harbir Singh says Fiorina and Capellas may wish they could find a face-saving way to call off the transaction and, as separate entities, look for other ways to adapt in an industry that is ripe for a big-time shakeout.

Last one standing
One option would be to adopt a "last-survivor strategy" and try to be one of the few PC companies to remain standing after others disappear in a shakeout, faculty members say. Another option would be to form alliances with consulting companies that provide high-margin computer services to corporate clients.

All of the professors agree that HP's move to buy Compaq represents a textbook case of what happens when companies feel the enormous pressures that arise when a once-vibrant industry matures, sales growth sputters and profit margins get squeezed. In such an environment, consolidation looks to be the best way to weather the storm.

HP's move to buy Compaq represents a textbook case of what happens when companies feel the enormous pressures that arise when a once-vibrant industry matures, sales growth sputters and profit margins get squeezed. Eric Clemons, professor of operations and information management, points out that companies typically merge for any number of reasons. They may wish to obtain complementary resources, as when a company like Ford acquires Volvo and Jaguar, or to add to their geographic coverage, as when a European company buys an Asian company. Or, companies may want to provide an integrated portfolio of products or services; a merger of a bank and an investment company can achieve this goal.

In HP's case, Fiorina wants to acquire Compaq for another classic reason: to obtain critical scale in a core business and thus reduce costs. But Clemons finds this rationale unconvincing in HP's case.

"Even the most profitable PC makers do not seem to have (size and) scale comparable to IBM's, and those PC makers are doing much better" than HP or Compaq, he says. "Carly may wish to take HP into services, but I do not see how acquiring Compaq could be anything but a distraction if she wants to move HP in that direction."

Singh, who has extensively studied mergers and acquisitions, says it is not surprising that HP and Compaq wish to join forces. But he agrees with Day that even a combined HP-Compaq lacks the kind of high-margin computer-service business to take on an IBM. "In a consolidating industry it makes a lot of sense to acquire capacity, which has good future income-generating potential," Singh says. But in this case it's not clear "that the future income-generating potential combination is, in fact, high. Compaq and HP have not given a coherent plan for the market to look at. The question is, can these assets be used to create value."

To survive in a consolidating market, Compaq is more dependent on the deal than HP, Singh adds. "Compaq has been sliding for a long time. Compaq bought Digital Equipment and that did not work out." Nor, Singh says, did HP's earlier attempt to buy PricewaterhouseCoopers pan out; HP initiated that deal but walked away from it. HP, which in 1999 moved some of its business services to a spinoff company, Agilent Technologies, today is heavily dependent on profits from sales of printers and print cartridges.

While a merger would make the company the world's biggest PC maker, that may be a slim reed on which to hang hopes for success, given the state of the PC business. In a 1997 article in the Harvard Business Review, titled "Strategies for Surviving a Shakeout," Day described how, in a first wave of consolidations, the PC industry shrank from 832 to 435 companies in the late 1980s. He dubbed this a "boom and bust syndrome" where "an unsustainable glut of competitors is attracted to the market at a rate that overshoots the industry's long-term carrying capacity."

Day uses the term "seismic-shift syndrome" to characterize today's PC climate. Nowadays, stable, mature companies are compelled to look for measures to stay competitive in an industry where consumers are not as interested in buying PCs as they were just a few years ago. Day stands by a prediction he made in the article, which forecast that the number of major players in the computer industry, currently about 20 or so, will eventually dwindle to five.

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