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Rush to Judgment

Many experts predicted Hewlett-Packard's merger with Compaq would become yet another M&A diaster. What did they miss?
Roy Harris, CFO Magazine
October 1, 2006

Was Carly Fiorina embracing a disastrous "bigger is better" strategy when she engineered the 2002 merger of Hewlett-Packard Co. with Compaq Computer Corp.? Many at the time, both on Wall Street and within HP, saw the deal as Fiorina's Folly. And some still do. HP's board seemed to validate such criticism when it sacked the CEO in early 2005, due to differences over executing strategy.

As long as the stock market was punishing the combined company's stock price, experts tagged it as a classic illustration of how mergers can destroy value. New criticism on the old theme comes from Where Value Hides (due in November from John Wiley & Sons, $29.95), in which author and LEK Consulting vice president Stuart E. Jackson describes the deal as "even more notorious than the Quaker/Snapple fiasco" — the universally jeered 1994 example of Quaker Oats throwing good money after a market segment that was totally wrong for it.

"There is an old military adage: Never reinforce failure," writes Jackson in the segue from Quaker to HP-Compaq. "Unfortunately, that is a perfect description of what happened with HP." It pursued more market share in PCs "while diverting resources and distracting attention from its strengths in printers and servers." Meanwhile, "rivals Dell and IBM were flourishing."

But increasingly, such analysis is looking like a rush to judgment. In mid-July, five years after the merger announcement, HP's total shareholder returns were up 46 percent. Over the same period, the Standard & Poor's IT index had sunk 9 percent, rival IBM was down 23 percent, and even Dell was up only 2 percent. The common argument now is that HP's indirect sales model is better suited for today's marketplace than Dell's ballyhooed direct-sales model.

Even Jackson — whose book persuasively analyzes other companies at which the pursuit of market share went awry — concedes that the merger looks much better today.

The Case for Scale
"The idea that somehow focusing on market share in low-margin PCs hurt our printing business is just not correct. And our PC business has steadily improved," says longtime HP CFO Bob Wayman. Wayman finds Jackson's analysis of HP "entertaining" but "flawed." "We are bringing competition to Dell that Dell has not seen for the past 5 or 10 years," he says.

In Wayman's version, a vital element lies outside Jackson's analysis: how the merger let the company dominate retail shelf space for items from PCs to printers to servers. "Scale has really helped, and we've been taking assets out as we got to scale," says Wayman. "There was a whole package of changes for which the merger was a key enabler." Meanwhile, free cash flow soared from $1.5 billion in fiscal year 2001 to $6.6 billion in 2005, which equates to a rise from 75 cents a share to $2.26 a share after accounting for a postmerger stock issuance.

Wayman has long acknowledged that it was hard to sell him on the merger at first, since he knew that successful deals were rare in HP's business (see "Doubly Blessed?" CFO, September 2003). "But market share can be and often is helpful in driving shareholder value," he says. The deal drove "cost improvements, supply-chain improvements, channel improvements, and leveraged R&D investments more effectively." HP's 50 percent position in retail stores looks particularly good against the buffeting Dell's direct-sales model has taken lately.

As for charges that HP chased market share at the expense of ROI, "there's good market share and bad market share," Wayman says (a statement, incidentally, that could have come right out of Where Value Hides). "In our printer business, good share consists of devices that deliver color, photos, lots of output, and that do multiple functions. Those characteristics lead to more pages printed, and more profitability." HP extended that business, leaving low-end, single-function printers to competitors. The company also refused to respond to Dell price-cutting intended to weaken HP's market share in printers.

Gaps in Understanding
"Anytime you use an example, you risk oversimplification," Jackson says in discussing how his first-year analysis has a much different look now that HP's retail business is thriving. At CFO's request, Jackson updated a bubble chart in his book that depicts HP's weighted average "strategic market position," or SMP (see "Bubbling Up" at the end of this article). The first year of the Compaq deal creates a downward shift in overall SMP, Jackson's term for his brand of market analysis. But today, the operating-margin component of average SMP has improved significantly from the premerger position.

The gap between analysis and reality reflects problems that some academic case studies encounter both in understanding peculiarities within specific industries and in selecting the right time frame for review. In its industry, HP argues, hunkering down in its profitable markets in 2001 would have robbed it of a unique strategic opportunity. "We weren't the only ones with rocky roads during that time," Wayman says of the year that Jackson examined. "I'm glad we had the Compaq merger to work on when the industry went through what it did. We had levers to pull that our competitors didn't."


The view at HP now is that Fiorina's replacement, Mark Hurd, has made a success of exactly the strategy that his predecessor designed. And yes, that could well entail passing IBM in revenue this year.

As for the 2001–2002 period chosen for the HP analysis, Jackson concedes that some strategies take longer to develop. Still, the first year "gives you a purer look," he maintains. "Long term, you get all sorts of other things that happen." For HP, "there was a boom time for tech that wasn't there before, and other cost-cutting came into play after the merger."

Now, says Jackson, "operationally, HP clearly has gotten its act together."

Reputationally, though, HP remains challenged. The company faced a firestorm of bad press over the methods its board used to detect leaks about board discussions about Fiorina and other subjects. While the board chair ultimately decided to step down, some have pointed fingers at CEO Hurd for not questioning how the leaks were investigated. Maybe Carly's way of doing business wasn't so bad after all.

Roy Harris is a senior editor of CFO.


Bubbling Up

At CFO's request, Stuart Jackson updated the strategic market position (SMP) chart his book displays for Hewlett-Packard, adding 2006 results to the one-year post-Compaq-merger results shown in Where Value Hides. The margin component of SMP now is up sharply, after the one-year decline, with PC returns significantly improved. HP's printer returns have slipped, reflecting the competitive effects of Dell's printer price-cutting of recent quarters. — R.H.




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