Shareholder to HP, Compaq: Scrap merger

Dear Board Member:

We respect your bold initiative to rework the competitive landscape of the technology field through the Hewlett Packard combination with Compaq Computer. However based on the factors outlined below, we urge each company's Board to take another, equally bold step, and to abandon the proposed merger.

It has now been well over a month since the Board and senior management of each company announced its intent to combine. During this period, we have engaged in dialogues with both Hewlett and Compaq executives, had numerous discussions with analysts, portfolio managers and industry specialists, and reviewed scores of analytical pieces; we have also solicited comment and feed back from customers and competitors.

All of this has been done in an effort to understand better the proposed deal and hopefully to share the vision expressed by your respective management teams.

Unfortunately, we have not been able to reach this conclusion nor can we share that vision. Instead, two immutable facts lead us to the conclusion we have reached.

The first fact is that investors clearly have voted against the merger with their feet. Both stocks have been in virtual freefall since the September 3rd announcement. On days where technology or the market has dropped CPQ and HWP have led the charge. However, on days of recovery your stocks consistently have not participated.

Simultaneously your competitors exhibit unbridled enthusiasm for the merger. They see themselves gaining great competitive advantage and none has expressed concern for the competitive challenges posed by the combined entity. Instead, there is a sense of relief at having one less player to contend with, where the remaining player will be beset with the non-productive distractions of a massive combination.

It is apparent to us that there is a connection here. The analyst community is as negative about this merger as we have ever seen. They have indicated that it substantially increases the risk profile of an investment in HWP/CPQ while doing very little in terms of adding upside potential.

We estimate that about 70-75% of the analysts are neutral to negative, 20% are neutral with a positive bias and maybe 5% are very upbeat about the combined entity's prospects. These statistics become even more startling since both companies are selling at their lowest five and 10 year trough valuations, and already sell at enormous discounts to all your primary competitors such as Lexmark, Dell, IBM and Sun Microsystems on a normalized price/earnings, price/sales, price to book value and price to cash flow metrics.

We do not believe that the anxiety of analysts nor the delight of your competitors is misplaced. A recent study by Sanford C. Bernstein & Co. demonstrates that in those cases where stocks meaningfully declined in the aftermath of an announcement, the deals were rarely successful. In other words, when there is a strong investment community reaction, investors most often get it right.

Indeed, a thorough review of mega-mergers in the past 20 years reveal that few are truly successful in enhancing or accelerating the business prospects of the combined company, or in enhancing shareholder value.

Frankly, we cannot identify one successful combination among the limited universe of large cap technology mergers.

From a competitive standpoint, while perfect execution could transform HWP/CPQ into a powerhouse three to five years from now, we think the substantial near and intermediate term risks associated with integrating multiple products and business lines, diverse sales forces and sales channels, and management far outweigh this potential upside.

We believe that this too is the rationale behind the reaction of your competitors. We also believe that your competitors have concluded, as do we, that synergies based on cost reductions from layoffs are not synergies at all, but are in fact morale-destroying distractions. Our own due diligence indicates that internal morale is poor at your companies, and that the reaction internally to the merger is also quite negative.

If we are correct as to each company's prospects as independent entities--based on current prices, as well as the prices prior to the announcement--both stocks have far greater near and intermediate term potential, with far lower levels of risk, as individual going concerns.

Once again, the facts argue strongly against moving forward with the proposed merger. The boards of Compaq and Hewlett Packard have historically been proactive and shareholder oriented. Now you must each ask yourselves, what is being perceived by others that we need to perceive ourselves?

We urge you to live up to your fiduciary duty and to your shareholder orientation. The owners of each company have sent each Board a strong negative message through analysis, communications with the media and management and, most importantly, by the aggressive sale of their stock.

We urge each Board to re-evaluate its decision and to abandon the misplaced effort to combine.

Sincerely,

David A. Katz, CFA Chief Investment Officer