A Long Haul

Compaq has a tough journey ahead with Digital.
Ian SpringsteelMarch 1, 1998

When Compaq Computer Corp. first approached Digital Equipment Corp. in 1995 with an acquisition in mind, talks went nowhere. This time, however, the two sides quickly reached agreement on a $9.6 billion deal. But Compaq will need even more persistence to make the merger a success.

Granted, the combination would create the second-largest computer company in the world, with $37.5 billion in 1997 revenues, and position Compaq to make a viable run at reaching president and CEO Eckhard Pfeiffer’s stated goal of $50 billion in sales by the year 2000. It would also shift Compaq away from the increasingly low-margin PC business and toward the higher-margin corporate systems and service market.

Battered though it is, Digital comes with some choice divisions. Foremost is its 22,000-strong service division, seen as an essential component to support large corporate sales. On the hardware side, there’s DEC’s powerful line of servers and its capable storage division, backed by its legion of talented engineers.

Compaq CFO Earl Mason asserts that the $60-a-share deal will add slightly to earnings per share for the full 12 months, despite an expected acquisitions-related charge.

Even at $9.6 billion, it will be hard for Compaq not to gain some earnings from the deal. For starters, Compaq will have to issue only 150 million shares for the $4.8 billion of the purchase price that Digital shareholders will get in stock. In addition, DEC holds tax loss carry-forwards worth about $1.6 billion in future earnings that Compaq will be able to put to use over the next few years. The remainder of the $9.6 billion is to be paid in cash.

As a result, “Compaq needs to generate only about $225 million in additional earnings from the combined companies in 1998 for the deal to be accretive to earnings,” says Wasserstein Perrella Securities Inc. analyst Stephen Dube. Given DEC’s high SG&A costs of $3.2 billion, about 22 percent of sales, Dube says it shouldn’t be hard to find those kinds of savings.

But short-term earnings potential isn’t the main concern. Rather, it is whether Compaq will be able to incorporate its 1997 purchase of Tandem Computers and the prime pieces of Digital to become a powerful “enterprise solutions” company–without slipping from the top of the PC and server market heap.

Integration, for one thing, could be difficult. “Compaq is a honed and aggressive competitor,” says Gopi Bala, director of management strategies research at The Yankee Group, in Boston. Digital is not.

“The cultures of the two companies are like night and day,” says Hambrecht & Quist analyst Todd Bakar, in San Francisco.

There’s also a question about the quality of Digital’s service revenues. Of the $5.9 billion that business represents, a large and declining piece–about $1.5 billion currently–is from maintenance of DEC’s aging installed base, and another $2.3 billion (estimated) is from technical support for other computer companies, such as Dell Computer Corp., not all of which is likely to continue.

But Digital’s enterprise networking consulting service looks like a gem. It generated about $1.8 billion in 1997 revenues, with a gross margin estimated near 20 percent, and is expected to grow about 20 percent a year or better.

But smooth sailing even here isn’t a given. Much depends on whether Compaq can gain access to CIOs and CFOs at larger companies. “Digital never had the kind of senior management access that IBM has, and more recently HP [Hewlett-Packard] and Sun have developed,” says Wasserstein’s Dube.

Yet analysts say that could change. Says Daniel Niles, an analyst at BancAmerica Robertson Stephens, in San Francisco: “Compaq’s management is very innovative.”

The final word on this deal won’t be heard for some time. Meanwhile, however, Pfeiffer has vaulted Compaq into position for its next growth stage. And he’s done it at a price few can fault him for.

Ian Springsteel is an associate editor at CFO.

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