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Compaq's numbers to reveal state of the turnaround

Compaq announces its third-quarter earnings today, putting chief executive Michael Capellas on the hot seat as he struggles to turn the computer maker around.

Compaq Computer announces its third-quarter earnings today, as many questions still loom for the beleaguered PC maker.

Chief executive Michael Capellas is on the hot seat as he struggles to turn the firm around. The ongoing integration of Digital Equipment, customer defections, layoffs, and the effect and extent of past and future cost-cutting measures are some of the major issues that likely will be addressed.

A consensus of analysts polled by First Call Compaq's stock woes predicted the Houston-based PC maker would post profits of 5 cents a share, or $85 million, for the third quarter, which ended September 30. The figure doesn't account for an expected $900 million charge related to restructuring, including up to 8,000 layoffs and numerous facility closings.

The bright spot: Analysts today expect to get the clearest picture of Compaq in nearly two years. The third quarter of 1999 was the first to include Digital revenue, giving some basis for comparison. Compaq for the first time is also expected to give a breakdown of profits by different segments, including consumer PCs, commercial systems, high-end servers, storage, and services.

Some financial and industry analysts questioned whether Compaq could even meet expectations.

"The nickel a share before the charge may be a tad optimistic," said Terry Shannon, publisher of the Shannon Knows Compaq newsletter.

Cutting expenses
One of Compaq's most troubling areas is operating expenses, which for PCs run as much as twice that of rival Dell Computer, said analysts. Compaq's manufacturing operations and distribution method, primarily relying on computer dealers, mean less profit on every box and higher returns, which are as much as 5 percent of expenses, said Ashok Kumar, an analyst with U.S. Bancorp Piper Jaffray.

Profit margins are also sagging as the company increasingly cuts prices to maintain market share, a practice analysts said is now catching up with Compaq. Lindy Lesperance, analyst with Technology Business Research, noted an unabated decline in gross margins--20.5 percent in the second quarter, down from 24.7 percent a quarter earlier and 26.4 percent the fourth quarter of 1998.

To his credit, Capellas is aggressively tackling Compaq's bloated cost structure by streamlining operations and completing the stalled integration with Digital. He also set a goal of 25 percent direct sales by year's end and 40 percent in 2000.

Compounding the expense problem is Compaq's relative growth rate. Figures from Dataquest and IDC yesterday showed that Dell passed Compaq as the No. 1 PC company in the U.S. Compaq remained No. 1 worldwide, but it's only growing as fast as the market as a whole. In past quarters, Compaq often grew at twice the rate of the market. Dell and Gateway, meanwhile, are selling more computers than the market average.

Job cuts accounted for much of the expected $900 million charge. Compaq announced about 2,000 layoffs during the quarter, 1,600 in Singapore, and numerous facility closings. As many as 6,000 people could still get the ax, saving Compaq an estimated $700 million a year. The company also expects to save an additional $930 million annually from facility closings and manufacturing and distribution changes.

Cutting core technologies
What bothers some industry watchers most is Compaq's cutting of core technologies that could undermine future growth, particularly the squandering or selling of the technology jewels picked up with Digital.

Analysts point to three recent decisions that hurt Compaq's technology strategy: selling AltaVista to CMGI, stopping future Window development on the Alpha processor, and abandoning Tru64 Unix support for Intel?s Merced processor.

"If Compaq was headed for Chapter 11, and you had to throw things over the side, you could defend decisions like that," said Bill Moran, an analyst with D.H. Brown Associates. "That's not the case with Compaq. They're far away from being in that bad a financial situation."

The sale of AltaVista, which is expected to save Compaq $400 million annually, surprised many analysts, who questioned the wisdom of giving up one of the hottest properties on the Internet and a potential engine for developing e-commerce products and services.

Analysts also faulted Compaq's decision with Microsoft to stop development of future versions of Windows NT and Windows 2000 for the Alpha processor, although sales have been less than exciting. The move also ended development of other Microsoft software used on commercial servers, such as BackOffice and Exchange.

The balance sheet
The three strongest areas will likely be consumer PCs and notebooks, servers, and storage. Likely trouble spots: commercial PCs and high-end Alpha and Himalaya servers.

Compaq's consumer division is expected to increase in unit shipments, spurred by back-to-school sales, but not show comparable revenue growth. This is because of the increasing number of low-cost PCs, which typically offer less profit-margin per box. Sub-$1,000 PCs, for example, accounted for about 72 percent of Compaq's retail sales in August, according to PC data.

Low-end Alpha servers are expected to do quite well, but higher-end systems may falter because of aging technology and slowing demand as larger customers "lock down" purchases as they prepare for the Year 2000 date change. Slower sales in Europe are likely also to take a toll.

Services revenue is expected to gain, but analysts report a number of defections to IBM Global Services. This is in part due to confusion as Compaq continues to merge together the formally separate enterprise and services divisions.