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Compaq beats lowered earnings estimates

Compaq nudges past lowered expectations for its third-quarter earnings, earning $117 million or 7 cents a share, but the company isn't out of the woods by a long shot.

Compaq nudged past lowered expectations for its third-quarter earnings, but the company isn't out of the woods by a long shot.

The troubled PC maker reported net income of $117 million, or seven cents a share, excluding one-time charges and gains. The figure topped Wall Street's consensus estimate of five cents a share, but is essentially the same as 1998's third quarter. Revenue rose slightly to $9.2 billion.

On one hand, Compaq's profit exceeded expectations and year-over-year revenue continued to climb. On the other hand, revenue from commercial PC sales dropped 12 percent from a year ago, and overall revenue declined 2 percent from the traditionally slow second quarter.

Compaq blamed its ongoing difficulties on continuing distribution and inventory struggles, the lingering integration of Digital Equipment, September's earthquake in Taiwan, and pricing pressures. Sources from rival manufacturers, however, have said that the company has lost strength in certain large accounts. In the third quarter, Dell past Compaq for the first time to become the number one U.S. PC maker.

Moreover, analysts and even Compaq executives pointed out that the company still needs to iron out several strategic issues. In a conference call, CEO Michael Capellas discussed the future challenges but gave little in the way of specific guidance.

"I want to underscore the objectives we are trying to achieve," Capellas told financial analysts.

"First, to get control of our business, including reduced cost and immediate return to profitability. Second, a clear focus on our product and solutions strategy and how we plan to drive the next-generation Internet. And third, re-ignite profitable growth."

Division performance
In June Compaq split into three broad business groups: consumer, personal computing (which incorporates commercial PC sales), and enterprise solutions and services. Today's earnings were the first to show the performance of Compaq's reorganized units.

Revenue for the personal computing group was down 12 percent on revenues of $2.7 billion, compared with year-ago figures from equivalent categories. Meanwhile the consumer group grew 15 percent to $1.5 billion and the enterprise solutions and services group recorded revenues of $4.9 billion, up 12 percent from the year-ago quarter.

As expected, Compaq's commercial PC unit, which accounted for 30 percent of ompaq's third-quarter revenue, lost some $169 million. The figure was down from a comparable second-quarter loss of $225 million.

Compaq cited a number of reasons for the shortfall, including declines in dealer inventory and the impact of the Taiwan earthquake. Inventory changes accounted for $200 million and the Taiwan quake $40 million. Worldwide dealer inventory declined 23 percent from the second quarter, as the company streamlined its distribution model to make it more efficient.

To recover its commercial PC business, Compaq will embark on a strategy of emphasizing profitability over market share. Capellas promised financial analysts a more consistent pricing policy and pledged not to "chase profitability at all costs."

"Let there be no doubt that we understand this segment of our business has changed dramatically, and there is even more change on the horizon," Capellas said on the conference call.

Compaq's consumer group, which represented 16 percent of third-quarter revenue, saw PC unit growth increase by 53 percent and notebooks by 44 percent from a year earlier. Operating income was $65 million, up 51 percent from a year earlier and an increase of 38 percent from the second quarter.

The enterprise solutions and services group increased operating income by 87 percent to $599 million, compared to the third quarter of 1998. Product revenue grew 14 percent over the third quarter of 1998 but was flat sequentially at $3.3 million.

Within that division, the PC server group grew 27 percent over the year-ago quarter; the high-end server unit increased by 12 percent; and the storage division grew by 12 percent.

Going forward, Compaq said it will launch a three-prong approach to future growth: delivering high-end systems and services that provide non-stop performance; expanding partnerships with companies like Intel and Microsoft; and redefining Internet access. The latter strategy involves increased emphasis on wireless and non-PC devices, and what Capellas called "e-tronics, the convergence of computing, consumer and entertainment devices."

Geographical breakdown
Compaq's sales breakdown by geography too showed a disturbing trend, particularly in North America and Europe, which accounted for 80 percent of revenue. The two prominent markets grew by 2 percent year-over-year, while Latin America grew 27 percent, Asia-Pacific by 18 percent, Japan by 14 percent, and China by 7 percent.

In stark contrast, Compaq's North American and European business sales grew by 37 percent and 54 percent, respectively, for the third quarter of 1998 over the year-earlier period.

On the bright side, gross margins gained 2.8 percent to 23.2 percent, improving on the second quarter's 20.5 percent and stopping a yearlong decline from 26.4 percent in the fourth quarter of 1998.

Operating expenses for the quarter declined by $224 million, or 10 percent, to $1.97 billion from $2.2 billion the second quarter.

Other items
During the third quarter, Compaq took a charge of $868 million, mostly due to layoffs and plant closings, as well as a one-time gain of $1.2 billion resulting from the sale of its stake in the Internet search engine AltaVista.

Compaq plans to eliminate more than 7,000 positions as part of restructuring, saving with facility closings nearly $1 billion annually. During the third quarter, Compaq let 700 permanent employees go and 2,100 contract and temporary workers.

The $868 million restructuring broke down to $490 million in severance costs, $100 million for facility reductions, and $280 million in other costs.

Capellas painted an uncertain outlook for the fourth quarter.

"This is likely to be a quarter that defies precise forecasting, particularly for a company as diversified as ours," Capellas told financial analysts. "Factors such as Y2K and industry supply constraints will have varying degrees of impacts on our different businesses."

While Compaq sees strong high-end server demand early in the quarter, it expects a slowdown in November and December because of the Y2K technology glitch. The company, like competitors, also faces shortages of LCD displays and processors, said Capellas.