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HP-Compaq deal a long time in the making

Details of talks between the two computer giants--which ran into troubles at least once--is disclosed in a 120-page proxy statement filed with the Securities and Exchange Commission.

Hewlett-Packard's board had identified Compaq Computer as an acquisition candidate as early as 1999, the same year Carly Fiorina joined the company as the first chief executive officer from outside HP's ranks.

See special coverage: A Fight to the Finish The lengthy courtship between the two computer giants--which hit an impasse at least once--was disclosed Thursday in a 120-page proxy statement filed with the Securities and Exchange Commission. It provides details and insights into one of the largest mergers in high-tech history, a deal that is being challenged by family members of HP co-founders William Hewlett and David Packard.

"In 1999, due to an increasingly competitive market, the HP board and members of HP management became particularly focused on developing strategies to secure HP's future," the filing said. "As part of this process, HP evaluated a range of strategic alternatives and potential acquisition candidates, including (with support in particular from HP directors Richard Hackborn and George Keyworth) Compaq."

Hackborn is a retired executive vice president of HP--credited with building its LaserJet printer business--and Keyworth is chairman of the Progress & Freedom Foundation, a public policy research institute.

In June 2001, Fiorina contacted Compaq Chief Executive Michael Capellas to discuss Compaq's interest in licensing HP's version of the Unix operating system.

"After several days of deliberation, Mr. Capellas contacted Ms. Fiorina to suggest that the synergies between the two companies were broader and that HP consider whether a broader strategic relationship might be a viable option," according to the statement.

Fiorina first apprised the HP board of her discussions with Capellas on June 24, and the board authorized her to explore the business combination further. The two executives met repeatedly throughout the summer, often joined by other executives, investment bankers and lawyers. Consulting firm McKinsey & Company played a large role in advising HP.

Hitting an impasse
The talks were at times tenuous. Both sides had difficulty reaching agreement on numerous issues, including valuation, the management structure of the combined companies, job protection and board appointments.

On Aug. 5, the talks hit an impasse, and "the Compaq board determined not to proceed with further discussions with HP based on the proposed terms that then were being discussed," according to the filing.

But the boards reconsidered, and throughout the rest of the month, Fiorina and Capellas had "a number of meetings" to work out their differences. Both boards unanimously approved the deal Sept. 3.

The companies agreed to so-called retention payments for some top executives to help close the deal. The payments will total more than $55 million if executives who are eligible from both companies remain employed through the first anniversary of the completion of the merger.

Both Fiorina and Capellas were eligible for retention payments, but they declined to receive them to show their support for the deal. Capellas' payment would have totaled $14.4 million, while Fiorina's would have been $8 million, the proxy said.

Compaq CEO Michael Capellas However, top executives including Fiorina could receive substantial pay raises if the deal is completed.

"HP is negotiating new employment agreements" with Fiorina; Chief Financial Officer Robert Wayman; Duane Zitzner, president of HP's computing systems group; Vyomesh Joshi, president of the Imaging and Printing Systems Group; Ann M. Livermore, president of the Services Group; and Webb McKinney, president of Business and Customer Organization, the proxy said.

"HP currently expects the employment agreements to include increases to the executives' current salaries to reflect their expanded responsibilities within the combined company, as well as the potential for a bonus that may be equal to or greater than the executives' base salaries. HP also expects the employment agreements to provide for the grant of stock options."

In addition, to prevent executive flight, the boards approved accelerated vesting of restricted stock previously granted to Compaq executives upon closing of the deal, the proxy said.

Risks to consider
Some of the risks the companies cited include a greater reliance on foreign sales. The combined company would receive more than half its revenue from outside the United States, which could translate into longer accounts-receivable periods.

see special coverage: Big iron: HP to buy Compaq HP faces risks even without the deal.

If HP does not improve its position with business customers, the company will be "marginalized" in a consolidating industry, according to a letter Fiorina sent to employees this week.

The company also reported its fourth-quarter results Wednesday, with revenue declining 18 percent, to $10.9 billion, from a year ago. It expects first-quarter revenue to drop slightly sequentially due to normal seasonal effects and no economic recovery next year.

HP reported a fourth-quarter net profit of $97 million. Excluding charges, the company posted a profit of 19 cents a share. That beat analysts' expectations for a profit of 8 cents a share, as well as revenue estimates of nearly $9.9 billion, according to First Call.

The Federal Trade Commission asked both companies for additional information on the merger under the Hart-Scott-Rodino Act, effectively extending the waiting period for the merger.

HP must pay a breakup fee of $675 million to Compaq if HP shareholders reject the merger.

Although the two companies agreed to merge, discussions regarding a Unix licensing agreement--which sparked the deal in the first place--are ongoing.

HP once was the leading Unix server seller, but the company lost share when it turned much of its attention to Windows servers running on Intel chips.

Compaq, despite its highly regarded Tru64 version of Unix and Alpha chips, had little success outside telecommunications and technical computing customers. The company discontinued its Alpha chip in June, deciding to move its operating systems to the still-young Itanium chip co-developed by HP and Intel.

News.com's Stephen Shankland and Dawn Kawamoto contributed to this report.