HP-Compaq: Excerpts from ISS report

The recommendation by ISS, an adviser to major money managers and pension funds, has long been considered crucial to the passage of the hotly contested $22 billion merger. The following are excerpts from the ISS report:

Merger as a building block
"...A company's integration efforts can impact the strategic/financial determination. Strong integration planning can minimize the risks associated with failure, and thereby shift the balance in favor of a deal.

"Mergers are rarely the best way to immediately maximize shareholder value (from the acquirer's perspective, anyway), but the prospect of becoming a stronger, more valuable competitor some years down the line may be more desirable than maximizing value with an expeditious but more short-sighted alternative today, according to our approach."

Financial, strategic merits
"ISS concludes that management offers a reasonable prediction about what the future may hold. Specifically, we believe that: (1) the cost synergies projected by management are achievable...and (2) management's revenue loss predictions are reasonable. On the latter point, HP's most recent quarterly results showed generally strong performance. HP's outperformance of analyst expectations justifies, in our view, a certain degree of confidence in the company's ability to deliver on revenue goals going forward."

Keeping an eye on integration
"From a procedural standpoint...it appears that management has done everything it can to maximize the chance that integration will be a success. Management told ISS that HP's board has spent half a day of every board meeting reviewing integration issues, and that the structure they have developed to oversee integration issues will remain in place for 12 to 18 months after the merger closes, to ensure that management keeps its eye on the integration ball."

Behind boardroom doors
"Whatever one's assessment of the merger, it is clear that many boardrooms across the country could benefit from the kind of sincere, courageous independence that (Walter) Hewlett has displayed in his willingness to contest management.

"In particular, Mr. Hewlett maintains that the board has never thoroughly considered alternatives such as a spinoff of the imaging and printing business or scaling back of the PC business. If true, such a claim would severely taint every communication made by the board to shareholders in support of the merger, and would eliminate any inclination shareholders might feel to defer to judgement (sic) of HP's board. The record available to ISS, however, provides no support for such a claim."

Money: No "smoking gun"
"Recently, Mr. Hewlett and management have extended their conflict over the merger to a new front: previously negotiated (but never executed) compensation packages for (HP CEO Carly) Fiorina and (Compaq CEO Michael) Capellas. Mr. Hewlett and his team argue, however, that the HP and Compaq CEOs were promised compensation packages that together had a value of $115 million (of which Ms. Fiorina's share was $63.2 million).

"...we conclude that there is certainly no "smoking gun" indicating that management is unduly conflicted in its assessment of the merger. However, HP's decision not to disclose what clearly were very advanced discussions falls far short of the good governance ideal."

Future plans
"In recent weeks, Mr. Hewlett has defined a three-pronged strategic plan that he is now advancing as his chief alternative to the merger. The three prongs of his plan relate to HP's three business units. On the I&P (imaging and printing) front, Mr. Hewlett calls for the reallocation of investment to I&P to focus on opportunities in the digital arena, and the serious consideration of a spinoff of the unit. At the enterprise level, he proposes filling in HP's gaps in the mid- and high-end with targeted, smaller acquisitions and through organic growth. And with respect to access, he proposes the de-emphasizing of PCs, and the restructuring of PC operations to focus on profitability rather than market share.

"Ultimately, however, we are unable to confidently embrace the focus and execute strategy as superior to the Compaq merger. The linchpin of Mr. Hewlett's plan, in our opinion, and clearly the primary reason that some investors have embraced it, is his proposal that the imaging and printing business be spun off at some time in the reasonably near future. We do not dispute that a spinoff of the I&P unit is likely the best option from a shorter-term perspective. However, over the longer-term, an I&P spinoff leaves unanswered a fundamental question: What will become of HP's residual businesses, which would likely prove shaky on their own?"

What's next for Hewlett
"Mr. Hewlett is unlikely to be renominated for election to the board should he lose this contest. Notwithstanding management's insistence that Mr. Hewlett's candidacy will be considered at an appropriate time by the nominating committee, recent rhetoric makes his renomination a close to zero percent proposition. We believe that the board would benefit materially from the continued presence of a significant shareholder on the board, however--a presence that would be lost if Mr. Hewlett leaves and is not replaced by another member of the Hewlett or Packard families."

Conclusions
"Based on our assessment of the strategic and financial prospects of the combined company and our analysis of the integration plan and other procedural aspects of the merger, we recommend that shareholders vote for the HP-Compaq combination. While Mr. Hewlett makes a credible case that the risks associated with the transaction are real and material, we believe that management's upside scenario is achievable. Indeed, we believe that Mr. Hewlett himself has helped press management to take steps, particularly on the integration front, that mitigate the risks of the transaction and thereby tip the balance in favor of supporting the transaction.

"Finally, while Mr. Hewlett's focus and execute alternative strategy is attractive, and justifiably so, in the short term, we believe that the Compaq merger provides a better means of maximizing long-term value by exploiting the potential of all of HP's assets rather than just a single 'crown jewel.'

"We recommend that our clients vote FOR the merger agreement."