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Failed HP-Compaq merger would be painful

Hewlett-Packard's acquisition of Compaq may be complicated and poorly timed, but some experts say undoing the deal could be disastrous for both companies.

Shareholders opposed to the proposed marriage of Hewlett-Packard and Compaq Computer should be careful what they wish for: Undoing the $20 billion deal would unleash problems for both companies that could be far more debilitating than those related to the complex combination.

Last week, descendents of Hewlett-Packard co-founder William Hewlett announced they would vote against the deal. Walter Hewlett, a member of HP's board as well as chairman of the William and Flora Hewlett Foundation, said the foundation would vote against the merger.

Hewlett offered a laundry list of ills that would result from a merger: Acquiring Compaq would boost HP's exposure to the PC market, which he said is "neither growing nor profitable." He emphasized that the two companies would undertake an unprecedented merger at exactly the time their core markets were deteriorating and the general economy was slipping into a recession. The merger would distract HP's management and prompt customers to shift business to other computer makers, he warned.

Hewlett was merely echoing some of the concerns critics have been expressing since HP CEO Carly Fiorina announced the merger in September. But now that naysayers are gaining momentum, an increasingly vocal group of other observers--including HP insiders and a number of financial and legal experts in the Silicon Valley--insist that killing the merger at this point could be equally disastrous.

HP and Compaq have likely been privy to key details of each other's business. The independent companies also would face extreme skepticism from Wall Street, which had already been dubious about the companies before the merger.

By far the most serious problem, some industry experts say, would be the likely departures of Fiorina, Compaq CEO Michael Capellas, several key board members and dozens of senior executives who have become staunch supporters of the deal.

"I don't think Walter (Hewlett) has thought this through," said a source familiar with the HP board. "None of the directors, except Walter, would stay, and I guarantee a lot of the senior management would leave too."

"Dark cloud" approaching?
It's hard to say exactly what would happen if the HP-Compaq deal were to fall apart; few mergers of this magnitude have ever failed so late in the process.

Between January 1999 and April 2001, roughly three out of 25 buyout offers for public companies worth $500 million or more didn't close, according to BusinessWeek. Most deals failed because of early regulatory concerns or because one company backed out shortly after the proposal.

see special coverage: Big iron: HP to buy Compaq In one of the few last-minute bailouts, France's Alcatel and Murray Hill, N.J.-based Lucent Technologies broke off a $34 billion merger that would have resulted in the world's largest telecom-equipment maker. But even in that 11th-hour rejection, the merger never made it to a shareholder vote: Lucent balked in June because it wouldn't have equal representation on the board.

Still, the fallout of the failed merger was immediate. Alcatel lost Krish Prabhu, its American chief operating officer and widely considered a successor to 63-year-old CEO Serge Tchuruk. Lucent lost a number of middle and senior executives. Both companies also announced massive layoffs shortly after the deal collapsed.

"When it gets scuttled, there's sort of a dark cloud that follows the executives who advocated the deal," said Lindsay Hoover, a vice president in the technology group of investment bank Houlihan Lowkey Howard & Zukin. "There's a lot of second-guessing after a failed deal."

The 47-year-old Fiorina, who came to HP from Lucent, faces especially intense scrutiny because she was so widely heralded upon becoming HP's chief executive. Most recently, she was named No. 1 in Fortune magazine's 2001 "Power 50" ranking of powerful women in business--the same placing she's received every year since the list debuted in 1998. She heads the biggest company run by a woman, and she's one of the few outsiders to have become a staple of the Silicon Valley.

Many people on Wall Street and in the tech industry believe that Fiorina has staked her career on the merger. If it falls through, she'll leave--as will all ambitious executives who publicly support her. Some speculate that several key board members may also resign.

"She came into her current position as CEO as the media's darling," said Robert Eldridge, vice president with Broadview International, a mergers and aquisitions adviser for the technology, communications and media industries. "Now, rightly or wrongly, that position has changed...You'd have to believe the consequences (of a failure to acquire Compaq) would put her under additional pressure to be an above-average manager."

If the Compaq deal is killed, it would mark the second significant failure for Fiorina. In an attempt to expand its capability in the consulting arena, HP sought to acquire PricewaterhouseCoopers' consulting business for about $18 billion. Wall Street was unimpressed and the deal was called off last November due to market conditions.

Inside intelligence
Another major complication of a last-minute bailout: HP and Compaq would each possess key information about the rival's marketing plans--the equivalent of inside intelligence on an archrival.

According to sources familiar with the companies' integration team, members are sharing information about pricing and business strategy for product lines that aren't due to hit markets for several years. HP integration team leaders include Webb McKinney, president of HP's corporate sales, and John Brennan, vice president of strategy and corporate development. Compaq's members include CFO Jeff Clarke and strategy czar Claude Pumilia.

Team members work full time on integration issues. A central team collects core knowledge from smaller business and function teams. Teams are made up of roughly half HP workers and half Compaq employees, though each team has only one leader--an attempt by both companies to avoid what they call "two-in-a-box governance."

The integration team leaders meet every Wednesday and have progress reports with Fiorina and Capellas on Thursday mornings, according to a filing with the Securities and Exchange Commission. They are responsible for "in-depth planning, coordination and creation of deliverables."

U.S. antitrust laws forbid companies engaged in merger talks from implementing merger-related business plans before shareholders and antitrust regulators bless the deal. HP and Compaq executives have emphasized that the workers should focus on business plans that preceded the merger announcement until final approval.

"As important as the merger is, we have an equally important objective in the short term. That is to deliver a solid performance in Q4," Capellas stated Friday in a letter to employees. "There's nothing we can do today that will say more about our strength and our passion for winning than to exceed our Q4 performance targets."

But Compaq spokesman Arch Currid confirmed that not all members of the integration team have signed nondisclosure agreements. If the deal falls through, only those who signed the documents would be legally prohibited from sharing or using the information if they go back to their former posts at HP or Compaq. No team members signed documents requiring them to resign should the merger fall through.

That means that both companies could have critical information about the other's pricing and strategy--in some cases for several years out.

"In theory, the due diligence won't be disclosed and won't be used for any purpose other than the due diligence or preparations for the merger," said Jeffrey Stewart, a lawyer specializing in technology industry mergers and acquisitions at Atlanta-based Arnall Golden Gregory. "In the practical world, it's very difficult, if not impossible, to set up a Chinese wall that prevents information from being used. There's always slippage."

A failed merger would also mean that Compaq would be bereft of a Unix server strategy, a key part of the company's relationships with sales partners and major software companies such as Oracle.

In June, less than three months before the merger announcement, Compaq canceled its Alpha chip, the widely respected but not widely used foundation of its Unix server line, in favor the Intel Itanium line codeveloped by HP. Merging would let Compaq lean on HP's Unix server line, which is still under active development and has a less abrupt plan for moving to Itanium.

With the acquisition, analysts expect Compaq to fold advanced features of its Tru64 version of Unix into the corresponding HP-UX. With no merger, Compaq would face the daunting prospect of resurrecting a plan to rework it for Itanium that the company canceled two years ago.

No backup plans
If the merger falls through, the companies would inflict upon themselves a potentially large financial penalty. That, combined with the fact that executives have insisted they have no "Plan B" if the merger falls through, would result in tremendous skepticism from Wall Street.

The most obvious pain from a merger collapse would be a direct earnings hit in the form of a fee paid by the party that abandons the deal. Regulatory filings indicate the HP-Compaq merger includes a breakup fee of $675 million--almost 35 cents per share for HP or 40 cents per share for Compaq, based on outstanding share totals of 1.94 billion and 1.69 billion, respectively.

On paper, it would seem that HP would be responsible for paying the fee because most of the shareholder opposition is coming from HP's side, but breakup negotiations are never simple.

Breakup fees can be especially tricky in deals involving equal or nearly equal partners, as with HP and Compaq. For instance, HP could try to avoid paying a fee by blaming factors in Compaq for creating uncertainty among HP shareholders, Eldridge said.

"You're always going to have a dispute over this," Eldridge said. "Is that dispute an afternoon on the phone...or is it a long, drawn-out process? Each situation is different, but I don't think there are very many amicable breakups."

Others say Compaq would have an especially tough time on Wall Street if the merger were to fall through.

"They did the deal at a low premium, in effect selling their company," said a banker close to the deal. "If the deal doesn't go through, there will be a lot of pressure on those guys. People will say, 'OK, guys, that didn't work. What's next?'"

It's still unclear whether Hewlett and other merger opponents will thwart the proposed combination. On Thursday, Hewlett hired prominent proxy solicitation firm MacKenzie Partners, possibly to persuade investors to block the deal--a move that escalates the public relations battle facing Fiorina and other merger advocates as they take their pitch on a Wall Street road show.

Also potentially standing in the way of the merger is the European Commission, which earlier this year blocked General Electric's $43 billion acquisition of Honeywell--even though it had been approved in the United States. The commission's chief complaint about the HP-Compaq deal so far is that the merger would allow HP to dominate PC distribution and therefore fix prices for the entire industry.

Although few overtly questioned whether the deal would go through when the merger was announced in September, it now appears to be unraveling. Arbitrageurs have flocked to HP and Compaq stocks, eager to make money quickly because of the likelihood of severe, short-term volatility in both stocks until the shareholder vote. Even insiders are starting to question whether it will happen.

"When they first announced it, I said the odds of it going through were very high," said an attorney who represents Compaq's financial advisers. "I would think now that it's got less than a 50-50 percent chance of going forward. It's going to be ugly."'s Dawn Kawamoto and Stephen Shankland contributed to this report.