HP-Compaq: Biggest challenges ahead

But it's not like life is going to get much easier.

Relentless price pressures, slowing PC sales, a sour economy, and the difficulty of merging two overlapping corporate bureaucracies that have been trying to shed employees during the past few months are just some of the problems facing Carly Fiorina and Michael Capellas, the respective CEOs of HP and Compaq.

"There are so many overlapping units, and there is no complementary benefit," said Ashok Kumar, an analyst at U.S. Bancorp Piper Jaffray. "The problem with HP is that they have a lot to deal with, and it is going to be really tough."

On paper, the merger creates a computing colossus. Combined, the two companies pulled in revenues of $87.4 billion during the past four quarters--a figure that is second only to IBM's.

The acquisition also will help the two companies shed costs to better compete with Dell Computer, which surpassed Compaq as the largest PC maker in the first quarter this year. Measured by PC sales, the conglomerate will be slightly smaller than Dell in terms of market share in the U.S. but bigger worldwide. Dell, however, is growing at a faster rate on a worldwide basis.

HP also will get its hands on a consulting and services group. Last year, HP tried to buy PricewaterhouseCoopers, but the deal did not materialize.

Problems lurk within both Compaq and HP. Both companies have been losing market share and have suffered with lower PC revenues in recent quarters. In the second quarter, Compaq's market share was 12.1 percent; HP's was 6.9 percent, according to IDC.

Making matters worse, PCs will be the largest source of revenue for the new company at a time when prices are plummeting and unit sales are declining. Combined, the two companies sold $29 billion worth of PCs during the past four quarters--a sum that dwarfs revenue from any other division of the two companies combined.

IDC analyst Al Gillen said the acquisition "is a little bit surprising, because both companies are struggling so much to keep their businesses in line. For them to make this kind of disruption to their business operations is really very interesting. But it may have been perceived as necessary to remain successful over the longer term."

Face of the industry changed
If the merger is completed, the industry will be reduced to a "Big Three" among PC makers: Dell, IBM and HP. Many analysts have predicted that IBM will exit the business. And Gateway recently has made substantial cutbacks.

HP's buyout of Compaq is expected to intensify the pressure on Gateway, which is attempting to revamp itself into a U.S.-only PC company. Gateway last week announced it would slash its work force by 25 percent, close a U.S. manufacturing plant and several call centers, and shutter its Asian operations.

The merger between HP and Compaq could prove prickly. With so much overlap, layoffs are inevitable. HP already is trying to lay off 6,000, while Compaq is looking to shed 8,500.

Analysts, competitors and investors will watch carefully to see if the resulting organization behaves more like Compaq, which has been a fairly aggressive company driven by sales goals, or HP, which has been more consensus-driven.

Redundancies aside, Gillen said, the combined company will have a portfolio of products that could make for some interesting competitive posturing, to IBM in particular.

"On the other hand, we have a lot of product issues to be worked out," he said. "What's going to happen to (Compaq's) Tru64 or VMS? These products have to be killed off gracefully. Frankly, those products have loyal customer bases that are not going to be particularly interested in moving to a Hewlett-Packard product. This is going to be a real challenge for both companies as they combine operations."

The companies also will feel a "financial bite in a lot of the services areas," Gillen said.

HP recently has focused its energies on selling large Unix/RISC servers and becoming a software powerhouse. Sales of its Superdome server, however, got off to a slow start. In the first quarter, HP lost ground in the server market to competitors.

Its software strategy, meanwhile, has been long on code names and short on results. The company has come up with strategies including e-services, but few efforts have paid off.

HP's printers also could take a hit. Dell currently teams with HP on corporate accounts, selling the PCs itself but bringing HP along for its printing needs. Dell may reconsider that arrangement, just as it dropped its field-service alliance with Digital Equipment after Compaq bought the venerable company.

Since its founding in 1982, Compaq has been one of the most important players in the PC market. It was the first company to develop a clone of the IBM PC. Compaq also led the industry in notebooks. In the 1980s, Compaq co-founders Jim Harris and Rod Canion, while working on plans for what would become the portable computer, sketched out their vision on an upturned placemat at the House of Pies in Houston.

Compaq has been focused on cutting costs and was one of the early proponents of using Asian contract manufacturers. It overtook IBM to become the largest PC company in the world in 1994, and three years later it became the first major manufacturer to release a sub-$1,000 PC.

The company largely stumbled when it couldn't undercut Dell on its direct-to-customer sales model. For years, Compaq struggled to move to a direct-sales model.

By contrast, HP predates the PC revolution by about 50 years. Launched in a garage, it got its first contract by making equipment for Disney's film "Fantasia." Besides having a storied technical history, the company is also famous for "the HP way," a management philosophy that stresses cooperation and the rights of individual employees.

In the days ahead, the challenges loom large--those of the merger itself, and those that predate Monday's announcement.

Gartner/Dataquest analyst Martin Reynolds said that the two companies appear to be merging after being unable to solve their problems internally.

"What we have is management teams that are struggling to come to grips with the reality (of the PC market) making a really rather desperate move for survival," Reynolds said. "I don't see the benefit for customers, I don't see the benefit for stockholders, and I don't see the benefit for employees."

News.com's Joe Wilcox contributed to this report.