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Compaq must tap business sales, services for profits

The giant PC maker's best chance of weathering the high-tech equivalent of "The Perfect Storm" may be its high-end computer and services business, analysts say.

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Compaq hit by sales slowdown
Matt Sargent, analyst, ARS

Compaq Computer's best chance of weathering the high-tech equivalent of "The Perfect Storm" may be its high-end computer and services business, analysts said.

In the wake of Tuesday's fourth-quarter profit warning, analysts said Compaq faces more rough seas ahead. With consumer PC sales tanking this holiday season and sales sluggishness spilling into other parts of its business, the company must rely on its business-computer sales and services units to pick up the revenue slack.

On Tuesday, Compaq revised fourth-quarter growth expectations downward at 8 percent to 10 percent and reset its revenue target to between $11.2 billion and $11.4 billion. The company now forecasts earnings per share between 28 cents and 30 cents compared with 36 cents from a consensus of analysts polled by First Call/Thomson Financial.

Shares in Compaq lost $2.72, or 13 percent, to close regular trading at $18.05. Several analysts downgraded the stock. ING Barings cut Compaq to "buy" from "strong buy." SG Cowen downgraded the PC maker to "neutral" from "buy." Prudential Securities maintained a "strong buy" on Compaq but cut fourth-quarter 2000 and calendar year 2000 estimates to 30 cents and 97 cents from 37 cents and $1.04, respectively. Prudential also cut the price target to $30 from $49 per share.

The rash of recent profit warnings--from Apple Computer, Gateway, Intel and others--prepared Wall Street for bad news from consumer PC leader Compaq.

Bad news spilling over
But in a conference call with financial analysts Tuesday, Compaq chief executive Michael Capellas delivered unexpected news: Soft consumer PC sales and resulting competing pricing had spilled over from consumer systems into commercial, small- and medium-business PC sales and even to low-end servers sales. Essentially, Capellas said Compaq's core areas would slow through the first half of next year.

"It's a $1 billion revenue miss for the quarter potential," said Robertson Stephens analyst Eric Rothdeutsch. "They did essentially write off the first half of next year. Compaq seemed concerned about the North American environment, and things are going to get dramatically worse for everyone."

Offsetting potential consumer losses will be Compaq's biggest task for the coming quarter. On Tuesday, Capellas told financial analysts sales for the highest-end, very high-margin Himalaya servers are good and that AlphaServer sales are on track. This could help, but analysts say it is not enough.

With a potentially stormy first half ahead of it, Compaq must harness the full potential of a profitable services business acquired through its June 1998 acquisition of Digital Equipment.

Capellas understands this. "I believe Compaq global services is one of our key engines for growth in 2001," he told financial analysts Tuesday.

"Services has benefited Compaq's ability to sell more hardware," Gartner analyst Kevin Knox said. "The next step for Compaq is to break services out so that people go to Compaq for services, not go to Compaq for hardware and also get their services."

Until now, the company has taken a more play-it-safe approach, tightly tying specialized services to high-margin products, such as Microsoft's Exchange server, or connecting wireless devices to corporate networks.

But in the face of collapsing consumer PC sales and the potential effects on its commercial computer and low-end server operations, Compaq must further articulate what Technology Business Research analyst Lindy Lesperance called a "services story."

Less reliant on PC sales
Compaq is much less reliant on PC sales than it was nearly three years ago, when the overstocking of dealers' shelves dragged down profits for nearly a year. Its product line is now broader, and the company relies less on PC profits.

With the Digital buy, Compaq increased focus on high-margin servers, storage devices and services, meaning that it will weather the PC slowdown storm better than rivals, particularly Dell Computer, analysts said.

"Compaq is much better positioned to weather a downturn than, say, a Dell," Rothdeutsch said. "They have transitioned the company over the last couple of years for the enterprise and higher-end system sales. Compaq will be one of the first companies to emerge once PC demand does get better."

Compaq started the shift from PC maker to enterprise computer company with the Digital acquisition. But rather than the quick integration envisioned by former Compaq CEO Eckhard Pfeiffer, ongoing problems syncing operations, along with management conflicts, slowed the transition.

For example, about a month after announcing the merger, Compaq dropped a bombshell on Wall Street: The company had about 12 weeks of inventory sitting on dealer shelves, and correcting the problem would mean flat revenue growth for all of 1998.

While Compaq struggled to digest a company 60 percent larger, its core commercial PC business lost momentum, sinking into the red while the company ceded market share to Dell. At the same time, conflict between Compaq and Digital managers hurt sales in key geographic areas, particularly Europe.

"I think it wasn't until after Michael Capellas took over (as CEO)--maybe six months ago--that Compaq was in a position to benefit from the Digital acquisition," Knox said.

After one major and another minor reorganization of its business units, Compaq has largely shifted away from the era when the company relied almost solely on the PC for profits. During the third quarter, the Houston-based PC maker reaped most of its revenue--just more than 50 percent--from high-end servers, storage and services.

"The story's getting better"
"In retrospect, it's probably a damn good thing Compaq bought Digital," said Terry Shannon, editor of the Shannon Knows Compaq newsletter. "At least they have a high-end story they can tell, and the story's getting better." The best Dell can do are eight Intel-processor servers, "while Compaq can offer much more," he said.

Capellas has effectively harnessed some of Digital's best assets, helping to grow Compaq beyond its core PC business. But "Capellas has been, until now, in fix-it mode," said Lesperance, who added the real challenge facing Capellas "is growing Compaq."

Now more than ever, growing Compaq could depend on the Digital assets, particularly with the company's low-end server business taking a hit, analysts say. Slowness in consumer systems and some sluggishness in commercial PCs was expected. But the server slowdown caught many analysts by surprise.

"This is the first hint servers are going from just red-hot sales to just strong sales," Rothdeutsch said. "Compaq said the hit was in the low end of the server product line. But low today could move upstream tomorrow."

Compaq led the worldwide server market in the third quarter, according to market researcher Dataquest. The company had 27.3 percent market share compared with 14.9 percent for second-ranked Dell.

The company reaps the most profits from Intel processor-based ProLiant servers, which are expected to see a steep sales decline in the fourth quarter. After two quarters of 40 percent or more year-over-year growth, Compaq projects only about 25 percent growth going forward.

The ProLiant slowdown gives Compaq less income to combat the potentially devastating impact of slow consumer PC sales. While the company has successfully shifted away from dependence on PC profits, its consumer operation still accounts for 19 percent of revenue. Any problem in that division could cut deeply into the bottom line, analysts warn.

Lesperance predicted that unless Compaq can clear out inventory before the holidays--estimated to be between seven weeks and 10 weeks--"profits will be slim to none for the consumer business. The big risk is you don't want that business to slip into the red, because it can sap the (server) profits."

Knox remained cautiously optimistic. "Compaq has some enterprise stuff, they have some commercial stuff, and then there is the services business. If they can pull back, they can weather the storm."