In the dry language of business, it does not sound like much -- "integration risk." But it represents the greatest single doubt that surrounds the merger plan of Hewlett-Packard and Compaq, and the biggest obstacle to winning shareholder approval for the deal.
The concern, in simple terms, is this: Big mergers in the computer industry never seem to work.
In declaring their opposition to the merger, the largest in computer history, the heirs of the Hewlett-Packard founders have repeatedly cited the daunting integration risks. And in his proxy filing last week, Walter B. Hewlett said that he believed that mergers involving computing companies have consistently destroyed shareholder value, and that Hewlett-Packard should not expose its shareholders to that risk.
PHOTO: NY TIMES
In fact, one of the object lessons demonstrating the inevitable failure of big computer mergers is the Compaq Computer Corp's own acquisition in 1998 of the Digital Equipment Corp for US$9 billion.
But in purely financial terms, the Hewlett-Packard and Compaq management teams can argue that the Digital Equipment deal was a success. A new study done by Salomon Smith Barney -- at the request of Michael D. Capellas, the chief executive of Compaq -- concludes that the internal rate of return on the Digital Equipment acquisition, calculated as after-tax cash flow as a percentage of the present value of the deal, is 29 percent. Rates of 16 percent to 18 percent on corporate investments are generally considered very good.
The new study will supply the Hewlett-Packard and Compaq teams a bit of ammunition as they meet in the next several weeks with institutional investors. Still, while the study may modify some views, it will not reverse the conventional wisdom that the Digital Equipment merger was a disappointment.
The integration of the two companies went slowly, the business bogged down, and 15 months after the deal was announced Eckhard Pfeiffer, Compaq's chief executive, was ousted.
"There was a lot of turmoil, and we did not do a good job until Capellas took over," said Benjamin M. Rosen, the cofounder and former chairman of Compaq.
Capellas, 47, is regarded in the industry as an outstanding operating executive, known for his energy, discipline and attention to detail. Capellas has displayed these traits since his days as a high school student in the Ohio steel town of Warren, where, though handicapped by being blind in his left eye, and not a natural athlete, he became an outstanding football player, winning an athletic scholarship to Kent State University.
In Rosen's view, the Hewlett-Compaq deal is sound strategically, but he also believes that with the lessons learned from the Digital Equipment merger and with Capellas as chief operating officer of the combined company, the integration risks should be substantially reduced.
Rosen plans to bet millions that he is right. He left the Compaq board in 2000, so he no longer reports his holdings. But he said he still holds most of 5.7 million Compaq shares disclosed in an earlier proxy statement.
Rosen intends to hold onto the Hewlett-Packard shares he receives in exchange, assuming the deal is completed, because he said a well-executed merger should be so positive for earnings within a year or so.
The Digital Equipment experience left Capellas with the belief that what computer mergers need most are speed and clarity. Capellas, who joined Compaq as chief information officer in 1998 from Oracle, had been promoted to chief operating officer by June 1999, when he was placed in change of bringing efficiency and coordination to the Compaq and Digital Equipment fiefdoms.
At the time, Capellas recalled, "The company was decelerating, frankly, and organized in a matrix structure where no one had accountability." He locked the 10-person senior management team in a conference room for three days, with few breaks, to hammer out changes. A disparate collection of engineering and product groups were sheared down to four, unified sales teams were assigned to big customers, and unallocated costs were cut from 30 percent to 2 percent.
Today, 25 percent of Compaq's revenues come from Digital businesses and 92 percent of its services revenue, or US$1.9 billion a quarter with operating profits of 13 percent. With Digital, Compaq also picked up valuable technologies in data storage and systems integration.
But while Digital Equipment added new offerings, the merger never really repositioned Compaq as a full-service computer company with a complete portfolio of products and services for corporate customers. Compaq has remained greatly dependent on its personal computer business, and its image is still irretrievably that of a PC company. That may help explain why the combined company will simply be Hewlett-Packard, jettisoning the PC-tainted Compaq name.
The goal behind the Compaq acquisition is to do for Hewlett-Packard what the Digital purchase failed to do for Compaq itself -- create a computing powerhouse more in the IBM mold. But these ambitious combinations have not lived up to their promise in the past, from Sperry and Rand in the 1950s to Burroughs and Univac in 1986, which made Unisys, which was briefly the worlds second-largest computer maker after IBM. And, once again, a big deal is being greeted with skepticism in the industry.
"The talk is always about putting together two big companies to take on IBM, and the results have always been a disaster," said Edward J. Zander, president of Sun Microsystems, a competitor to both Hewlett and Compaq.
The two leading proponents of the merger -- Capellas and Carleton S. Fiorina, the chief executive of Hewlett-Packard -- say that things are different this time around, and so are the two companies involved. The computer industry is maturing, they say, so consolidation is needed, as it has been in industry after industry over the years from oil and chemicals to automobiles and banking.
In addition, they add, Hewlett-Packard and Compaq are a very good fit of businesses, overlapping in PCs where rationalization is needed and yet with little overlap in the business earmarked for growth -- selling big computers, storage and services to corporate customers. "I certainly wouldn't be interested in any other merger," said Capellas.
Fiorina and Capellas already have joint teams in place, planning the integration. By the time the deal is completed, they say, the new company will have the top three levels of management in place, product road maps in hand and sales and service teams assigned for the top 100 corporate customers. Capellas, the operating executive in charge of making the new Hewlett-Packard work smoothly, sounds confident. "There is risk in a big merger like this, but also opportunity," he said. "That is why there is the promise of high returns."
Perhaps, but doubts about big mergers in computing remain, and Hewlett-Packard and Compaq have a considerable challenge in convincing shareholders that the risk is worth taking this time. Unlike slower-moving industries such as chemicals or cars, the major product cycles in the computer business are 18 months or less. So the merging companies must retain their most skilled people, trim the payroll by thousands (at least 15,000 employees, Hewlett-Packard has said), and keep racing ahead with product development.
"Ultimately, the trouble with big computer mergers is the execution problems that no one has been able to solve in the last 30 years," said David B. Yoffie, a professor at the Harvard business school. "This could be the exception, but no one has done it yet."
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