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Compaq reports slight gain

The PC giant posts a second-quarter profit of $32 million, or 2 cents a share, slightly better than Wall Street expectations.

Compaq Computer today reported a second-quarter profit of $32 million, or 2 cents a share, slightly better than Wall Street expectations.

The world's largest PC maker was expected to break even, according to First Call.

Revenue, including sales from Digital Equipment, which Compaq acquired last month, was $5.83 billion, up 5.7 percent from revenues of $5.52 billion reported one year ago.

Mostly as a result of the Digital acquisition, the company reported a net loss of $3.6 billion, or $2.33 per share. Excluding charges related to the acquisition and the closing of some Compaq facilities, net income was $32 million, or 2 cents per share.

In early morning trading, Compaq stock galloped ahead $1, following an upbeat conference call with analysts by Compaq executives.

"Overall, the Street is going to read the call pretty positively," SoundView Financial analyst Mark Specker said shortly after the call ended. The press was not invited to listen in.

Lou Mazzuchelli, PC analyst at Gerard Klauer Mattison, said that Compaq executives had an optimistic tone during the conference call, though he expressed concern about the lack of visibility on the computer maker's third-quarter results.

"It's pretty much business as usual," Mazzuchelli said.

Compaq reiterated in its second-quarter earnings statement that it expects third-quarter results to "largely be transitional" and that it will take until the fourth quarter before its $8.4 billion acquisition of Digital Equipment begins to add to the combined company's earnings.

CFO Earl Mason said he was happy with the pace of the initial integration of Digital, and noted that the company's cost-cutting efforts are helping to make the merger pay off quickly.

"We've seen some pretty good expense reduction already and we expect more of that to come," Mason said. He declined to offer specific figures, however.

In spite of the huge cost of the Digital deal--which closed June 11 and required Compaq to pay $4.5 billion in cash and to repurchase nearly $800 million in Digital debt--Compaq exited June with $4.6 billion in cash and little debt, Mason said.

Analysts said that the company made better-than-expected progress in bringing down inventory backlogs in its commercial PC business, which had hurt Compaq's competitiveness and dampened earnings during the first half of 1998.

Executives said inventory levels, or the amount of computers stuck in retail and and distribution channels, at the end of quarter stood at a three-and-a-half-week backlog worldwide, down from a seven- to eight-week backlog at the start of the quarter and below the company's stated goal of four weeks.

North American inventory backlog was around four weeks, and Europe was lower than that, Compaq executives told analysts.

"We will claim victory on that," Mason said of the reduced inventory levels, which protect the company from getting stuck with outdated technology in the fast-changing PC industry.

Mazzuchelli, who maintained his "hold" rating on the stock, was more circumspect. "Now the question is, what happens next quarter?" he asked. " 'Transitional' is the word they use. Transitional means anything could happen."

Mason said Compaq would focus during the third quarter on reducing inventory levels internally as it integrates the Digital Equipment PC business with Compaq's own. Specker said that executives guided analysts to expect third-quarter results within the range of current Wall Street forecasts. The recent consensus estimate for the third quarter was a profit of 6 cents a share, according to First Call.

Commenting on Compaq's consumer PC business, Mason said he told analysts participating in the conference call that, "The consumer business had a great quarter and continues to grow substantially."

He said consumer PC unit volumes grew 86 percent over the second quarter of 1997, thanks in part to the success of its lower-cost product lines.

In the enterprise computer business, which includes the Tandem Computer business Compaq acquired last year, Mason said that second-quarter sales out of the company's distribution channels to customers grew by 58 percent. "That grew way more than the marketplace," he said, estimating that growth for the market as a whole was only in the "mid-teens" as a percentage.

Mason noted also that second-quarter gross profit margins as a percentage of sales, excluding the effect of one-time charges, improved "a little bit," to 21.9 percent. "As we continue to integrate Digital, that number should go up," he said. Historically, Compaq's gross margins were 25 to 28 percent, he added. Digital's profit margins, which traditionally were in the mid-30 percent range reflecting the higher margins of its services business, should boost the combined company's levels.

In Wall Street's eyes, Compaq seemingly can do no wrong.

In recent months, the Houston-based PC maker has done everything imaginable to dent its profits. For example, the company slashed the prices of its product, plopped down $8.4 billion for Digital Equipment--a move that resulted in a $3.6 billion loss for the company during the current quarter--and, even without the charge, posted a meager 2 cents per share profit, or $32 million. The results mark the second quarter in a row that Compaq has posted less-than-stellar profits.

Yet financial analysts continue to rate Compaq's stock a "buy," and reaction on the trading floor resulted in only a slight drop in the stock's price--about 1 percent.

The reason: The short-term sacrifices add up to a long-term strategy that analysts predict will put Compaq in a solid position as the market leader.

"Compaq will continue to gain market share at the expense of weaker companies and, with the Digital acquisition, will solidify its position as a major computer company," Rich Schutte, PC industry analyst at Goldman Sachs in New York, said in a recent report on Compaq. "Long term, the Digital acquisition should help better position Compaq to deliver a complete portfolio of products and services as they push up through the enterprise."

Schutte also cited Compaq's attempts to become a one-stop PC shop as another way the company is positioning itself well for future market dominance. Compaq's product line now ranges from low-end PCs to high-end enterprise servers, and even contains some equipment, like Ethernet hubs and switches, needed to connect PCs to servers.

"As the PC industry continues to consolidate, Compaq's ability to offer complete solutions will ensure it a place in the top three PC vendors," Schutte said.

While the strategy looks good on paper, analysts continue to keep a wary eye on Compaq's ability to execute the plan, a traditionally weak area for the company. The purchase is prompting Compaq to revamp its entire business in a massive restructuring makeover.

"Large acquisitions tend to be disruptive in the near term, heightening execution challenges as the two distinct cultures are merged," Schutte said. "The pace of technological innovation further increases these challenges, as does the competitive environment. Competitors likely will attempt to exploit any integration concerns customers may have."

Reuters contributed to this report.