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Commentary: Merger requires patience

The merger of HP and Compaq reflects a broad trend toward increased technological stability and a somewhat slower pace of innovation.

The merger of Hewlett-Packard and Compaq Computer, a major milestone in the corporate history of the two companies, will have little impact on either company's corporate customers for 12 to 18 months, and a moderate impact in the next two to three years.

Organizations should pay careful attention to see how HP and Compaq products they use will be supported and evolved by the combined company.

For the computer industry in general, this consolidation of existing major players reflects a broad trend toward increased technological stability and a somewhat slower pace of innovation. Additional combinations of large global computer companies are possible, as competitors left out of the oligopoly of IBM, HP/Compaq, and Dell Computer attempt to buy their way into the leadership bracket.

Of course, an analysis of the effects of the HP/Compaq combination assumes that this deal will be approved by the U.S. Department of Justice and European regulatory bodies. We believe approval is likely but by no means certain, due in part to the dominant retail-store market share of the new company as well as worries about job cuts. European regulators, in particular, have recently posed obstacles to major mergers (such as GE/Honeywell). Gaining European regulatory approval will probably require some form of job guarantees to France, where HP's commercial PC division is currently headquartered, and possibly to other countries in Europe.

The basic motivation for the HP/Compaq deal seems clear--to transform two companies that have been turning in lackluster results in the PC and server markets into a larger competitor that can leverage massive resources and a substantial customer base. We believe that Compaq's board of directors accepted a relatively low acquisition price (a 19 percent premium over the current Compaq market valuation; about 65 percent of estimated 2002 revenues) because it expects a continuation of disappointing results in upcoming quarters.

This acquisition was driven by three factors: first, the slowing IT marketplace; second, the growing competition from IBM and Dell; and third, the gradual trend toward commodity servers, which is increasingly relegating high-end (and high-margin) Unix and proprietary back-end servers to legacy platform status.

After the acquisition of Compaq, the new Hewlett-Packard would be No. 1 in PCs, No. 1 in servers (in terms of unit sales) and No. 1 in printers, with a large services division. It would be the second-largest computer firm overall, barely trailing IBM--assuming that it can hold on to the current customers of both HP and Compaq. However, severe disruptions in service and product delivery tend to accompany any large merger. It would be reasonable to expect 10 percent to 15 percent of customers to slip away, as both Dell and IBM move aggressively to capitalize on any market confusion or uncertainty.

Savings for the future
The financial rationale behind the deal is that the expected savings generated by the HP/Compaq combination would pay for the consolidation of the companies' product lines and operations, followed by the launch of strong new product offerings and marketing initiatives. In addition to previously announced cuts of about 10 percent of the work force at both HP and Compaq, the combined company would eliminate about 15,000 more jobs, with the exact number depending on how soon the PC and server markets regain their sales momentum.

In its announcement, HP said it expects annual cost savings of $2.5 billion. However, only minimal savings are projected in the near term, and there may even be some revenue loss due to the consolidation. Furthermore, some revenue may be lost in the longer term as disappointed loyalists refuse to migrate from discontinued legacy products.

We believe that integrating these two competitors will require two to three years of painful restructuring, given the two-plus years that Compaq required to integrate its acquisition of Digital Equipment. HP and Compaq have been fierce competitors in many market segments, with contrasting approaches to product design and marketing, different user bases, and dissimilar organizational cultures. Although this deal will enable significant consolidation of competing offerings, there is little synergy of complementary products.

The great strength of HP is its engineering culture--and its inability to think outside that culture has been a weakness. It remains to be seen how HP's unified culture will mix with Compaq's multiple cultures. Technology issues will not determine the success or failure of this deal. Preserving and enhancing HP's organizational ability to execute will be vital.

Although we expect HP management to move relatively quickly, the sheer number of product lines and channels to be integrated and difficult issues to be resolved is considerably larger than during the Compaq/Digital integration. To HP's credit, it is acknowledging upfront that a long integration phase will be required.

Integrating the sales forces will be particularly difficult, because the sales cultures, incentive programs, and methodologies of the two firms are different. And competition for lower- and middle-management jobs will create distrust that may lead to poor sales and customer support. Additionally, the sheer task of managing such a massive integration will consume significant resources for the next few years.

While HP and Compaq are preoccupied with their marriage, major competitors such as IBM, Dell and Sun Microsystems will have an opportunity to consolidate momentum in the marketplace. In particular, HP/Compaq must protect its current advantage in international sales (vs. U.S.-only sales) compared to Dell. In the near term, this acquisition makes rivals like Sun and Dell look like more focused companies. However, this advantage will be fleeting. In the longer term, the new HP will marginalize Sun as too small and lacking in credible Intel-based offerings.

PCs and servers
In the PC market, we would expect the combined HP/Compaq entity to consolidate its offerings in new product lines within 12 months (one to two product cycles). We believe the HP (and Pavilion) brand name will persist as the marketing focus in the retail PC channel, while Compaq offerings will still be sold to corporate accounts. In the handheld arena, we believe the iPaq product line will be the key offering.

Because the near-term outlook for the PC market remains cloudy--dwindling profits from HP and Compaq PCs were a key driver of this deal--we expect the new HP to focus on slashing costs from its consolidated operations, as it seeks to entrench itself for future PC wars against Dell, IBM and others. The new company's leadership position in the PC sector, now almost a pure commodity business, is negated by diminishing margins. Successful consolidation of the HP and Compaq retail and corporate distribution channels will be at least as important as the melding of their product lines.

In the server market, the combination of HP and Compaq will further complicate an already complex lineup of product lines that has resulted from Compaq's prior acquisitions of Digital and Tandem. The danger is that the new HP will remain preoccupied with resolving differences among legacy product lines while competitors such as IBM and Dell move forward with more coherent offerings for Windows on Intel platforms (Wintel) and eventually Linux on Intel (Lintel).

We believe HP cannot be content with Compaq's profit strategy of milking diverse installed customer bases such as Tandem and Digital. It will need to develop a strategy to drive sales to new server and storage offerings via an orderly migration of current users--as opposed to simply being a "holding company" of diverse legacy product lines.

We expect the HP/Compaq combination to hasten the move to Intel platforms. HP has some near-term technology capabilities (Superdome and N-Class servers are already upgradable to Intel, for instance), but Compaq is developing its own high-end Intel alternative. Both organizations have strong in-house development traditions. We expect Compaq to remain dominant in the Intel midrange, and the combined HP/Compaq will face significant high-end competition only from IBM (with its soon-to-be-announced Summit technology).

We also expect broad Unix (HP-UX and Tru64) integration claims, and both vendors have already committed to Intel ports. However, we believe the result will be about 80 percent HP (trying to leverage HP-UX's stronger support among independent software vendors) and about 20 percent Compaq (including Tru64's best-in-class clustering capabilities). It is difficult to see much near-term impact on OpenVMS, MPE/iX and other legacy platforms. Tandem is well on its way to Intel (having started moving from MIPS to Intel initially, before temporarily trying Alpha).

Both HP and Compaq are investing aggressively and emphasizing the Intel Itanium processor family for their long-term high-end server direction. Even if there are few near-term synergies, in two to three years--when McKinley and higher-end Itanium products emerge--the combined entity should be well positioned to capture a good piece of that market.

The combined HP/Compaq will have a massive list of server customers to which it will be able to upgrade or sell new server and storage products. Users of Compaq legacy server products should expect a quickening pace of efforts to migrate them from these products to new product lines as HP/Compaq strives to move from its past of disparate Unix legacy platforms toward a cohesive lineup focused more on Wintel (and Lintel) offerings.

For corporate customers buying Wintel servers, there will now be three strong players--HP, IBM and Dell. That will still be enough to keep pricing reasonable.

Storage and service
The strongest intersection of the two companies appears to be in storage. Compaq is a leader in the low-end to midrange market, and the HP/HDS offerings at the high end are competitive with those of EMC. The sheer size of the combined user base could make EMC's life more difficult in the long term. Because storage is increasingly driving the entire systems picture, the HP/Compaq's enhanced ability to get a foot in the door with storage offerings will help the companies sell some of their weaker offerings.

See news story:
HP's incredible shrinking deal
The services dimension, which currently accounts for about 20 percent of both HP and Compaq, is another potential growth area for a combined HP/Compaq, even though at first glance this deal takes HP in a radically different direction compared to its previous (abortive) effort to acquire PricewaterhouseCoopers. Although IBM leads in the services market, a much higher percentage of its services business is integration services, while the majority of the HP service business is break/fix support.

During the past year, both HP and Compaq have reiterated their desires to grow and differentiate their respective businesses around integrated solutions and services, as their core hardware business is increasingly marginalized. Compaq is currently the largest integrator of Microsoft products, while HP is particularly strong in installing and upgrading management systems for Windows 2000 environments. Selling more HP/Compaq services will also facilitate hardware sales.

Although parts of the Compaq services story remain strong (such as systems integration services), we have seen it increasingly fall off in the outsourcing market (usually low-end services such as break/fix). Compaq had ambitions of growing toward the IBM services model, but it never made the hoped-for headway after the acquisition of the Digital services arm. It has been too "Compaq-centric" in its approach to sourcing services and often unwilling to fit into a more heterogeneous scene.

Both companies have had similar visions of "IT as a utility" and "IT delivered as a service" that mesh well. However, we expect HP to streamline the services functions from Compaq to raise revenue per employee, and we should see some internal reorganization focus in an attempt to dispel the interdepartmental rivalry that marked problems in the Digital services absorption into Compaq. Moving to a 30 percent to 40 percent growth model for services (vs. the current 7 percent to 9 percent) will be an impossible goal unless the potentially large and unwieldy services arm is aligned appropriately across company technology sectors and market verticals.

Also on the services side, we expect HP to look for synergies in Compaq Telecom to augment its opportunities in business, operations and enhanced network services. Compaq Telecom offers close to 10,000 telecom architects and consultants and, on the software side, Compaq's TeMIP is a direct competitor to HP's OVC (OpenView Communications) for telecom network management.

If this merger is finalized, we recommend that corporate customers of server and software products from HP and Compaq actively monitor plans for how these products will be supported and evolved. Although the impact on users will be minimal for 12 to 18 months, subsequently there will be more drastic product support changes and disruption. In two to three years, users should expect significant changes in HP/Compaq products and services as the combined entity moves to consolidate operations and merge overlapping offerings.

Meta Group analysts Jack Gold, Mike Gotta, William Zachmann, Dale Kutnick, David Cearley, Steve Kleynhans, David Folger, David Yockelson, Herb VanHook, Nick Gall, Brian Richardson, Rakesh Kumar, Rob Schafer and Louis Boyle contributed to this article.

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