the merger of hewlett packard and compaq: STRATEGY and valuation

THE MERGER OF HEWLETT PACKARD AND COMPAQ: STRATEGY AND VALUATIONCase Highlights: HPs acquisition of Compaq valued at $25 Billion in an all stock purchase was the biggest deal ever in the corporate IT sector. We shall analyse the pros and cons of the deal and the decision of HP With the rapid changes in the technology industry HPs executives were recognizing the need to adapt and thus in the year 2000 HP started pursuing a strategy of organic growth and acquisitions to expand its businesses. Carly Fiorina was the President and CEO of the company and hired McKinsey and Company to help with its new strategy. McKinsey helped HP to open negotiations with Compaq On September 3rd HP and Compaq jointly announced a merger agreement, as per the agreement each Compaq shareholder would receive 0.6325 shares of HP common stock. Ownership in the merged entity would be HP 64% and Compaq 36%. The merger was termed a merger of equals, HP and Compaq had different strengths in their lines of business and the combination would provide a complementary set of products and services so as to serve the customers better. The merger was expected to bring both financial and strategic benefits On the strategic front the new company would be able to exploit the resources of two companies to become effective, innovative organization offering an array of products to customers On the financial front management projected a recurring, annual, pre-tax cost savings of $2.5 billion by mid-2004Reactions to the announcement of merger:Post the merger announcement HPs stock fell by 18.7%. Markets did not see any rationality in the merger and found the deal to be extremely difficult to make the promised synergy.Walter Hewett, member of HPs board of directors and Packard foundation, which controlled 10% of HP shares opposed the merger and actively lobbied with institutional investors to oppose the mergerIn response to Hewletts opposition, Fiorina also launched an active campaign to prove the worth of the merger before the investorsMcAlesters firm held around 1% share in HPs common stock and needed to figure out whether the deal should be supported or not. The main opposition from Hewlett came in contending that management has underestimated the revenue losses of Compaq and the proposed synergy will not materialize owing to integration debacles and highly different cultures of the two firm.Fiorina opposed Hewletts claim on account of presenting a narrow and static view of HP, selectively ignoring synergies in key areas, displaying anti-merger bias and providing no alternativeIndustry AnalysisPlayers in computer hardware industry have to quickly adapt in order to match the constantly changing market demand. This requires constant change of strategies and product lines to focus on areas where demand is most concentrated. The market was fiercely competitive. Dell was achieving significant profit owning to lower costs and this was putting huge cost pressure on HP. IBM had refocused its priorities to lucrative corporate customers and Fujitsu and NEC focused primarily on portable notebook market. Both HP and Compaq faced the risk of standing still and hoped merger will enhance business segments through complimentary operations

Key Priorities for HPNeed to adapt more quickly to direct sales model and alter the cost structure that has put the company into competitive disadvantage.Need to attack the enterprise market more aggressively which was seen as the primary engine for value creation. It was $800 Billion market and was growing at 12% CAGRNeed to continue to invest in printing and imaging business which was a highly profitable for HP and was facing intense competition from players like Lexmark and Japanese companies like CanonIntent of the dealHP was strong in the high end server segment and Compaq was a leader in the low end segment and storage segment, together they aimed to become the strongest player in the industryThe combined entity could become and integrator who can help enterprise customers envision, design and build end-to-end solutions and can have tremendous influence on the full range of technology decision of clients by becoming a one stop shop for technology and computing servicesThey operated many complimentary businesses and the cost savings realized through synergy would lead to improvement in operating margins for all three categories of HPs BusinessFinancial Cost BenefitsAdministrative /IT Costs$625 Million

COGS Benefits$600 Million

Sales management benefits$475 Million

R&D efficiency benefits$425 Million

Indirect purchase Benefits$250 Million

Marketing efficiencies$125 Million Total : $2.5 Billion

SWOT Analysis of HPSTRENGTHS The HP way symbolized innovation, integrity, flexibility and teamwork and the brand sold well Long term dominance in imaging and printing Strong in high end servers Strong in UNIX Market

WEAKNESS Only 15% of HP Pcs shipped directly to customers. Whereas Dell and Compaq shipped all PCs through direct sales model Ranked poorly in PCs storage and services

OPPOURTUNITY End-to-end solutions strategy for server, storage and services businesses could be achieved through acquisitions of significant industry participants Strong complementary business lines Merger to make HP market leader

THREAT Slimming industry margins Strong competition from Dell altering the cost strategy of the industry Threat from low cost players like Cannon and Lexmark in printing business

SWOT Analysis of CompaqSTRENGTHS Strong Presence in the PC segment Leading supplier of storage systems

WEAKNESS Poor financial results poster quarter after quarter Poor presence in server market Poor inventory management Declining margin in PC business

OPPOURTUNITY Great demand for portable PCs Great demand from small and medium businesses Merger with a big partner could lead to economies of scale in PC manufacturing

THREAT Rapidly changing demand in the PC business segment Pressure to deliver newer products due innovation from competitors High cost pressure due to alteration in value chain of the industry

SWOT Analysis of the merged entitySTRENGTHS New company can exploit the SAN market by using HPs competency in sever and Compaqs expertise in storage Strong brand recognition Merger would create an end to end full service firm preferred by clients Huge cost synergy and elimination of redundant products

WEAKNESS Both were poor at direct distribution model The merger would not help HP to gain a toehold in services especially high margin business of Consulting services The PCs businesses were growing less and less profitable

OPPOURTUNITY Strong opportunity in storage services Economies of scale would leave opportunities for greater innovation expenses

THREAT High competition in the low end server market Threat of not meeting the desired economies of scale due to integration challenges Shifting of focus from HPs high margin business in imaging

Was the merger strategy sound? Proper due diligence was not exercised considering various factors The shareholders and employees response was not taken into consideration which led to fall in the market price and also lot of resistance from the stakeholders Various issues like Capellas role in the combined company was not fixed which resulted in Compaq calling off the talks. A proper due diligence for cultural integration was also not done pre-merger which could result in increased integration cost for the merged company. Both companies were having different pricing strategy which could create a problem post-merger.

Positive aspect1. Such a merger be an opportunity to take a competitive advantage over its rivals like IBM 2. Development of markets 3. Propagated efficiencies 4. Allowances to use more resources 5. Better opportunities

Negative aspects 1. Legal contemplations 2. Compatibility problems 3. Fiscal catastrophes 4. Human resource differences 5. Lack of determination

Valuing the synergiesWe have calculated the value of each firm as follows: Compaq's share price12.35

Compaq's share 1689million

Equity Value20859.15

HP Share Price23.21

HP Shares outstanding1974

Equity Value45816.54

Value of the merged entity66675.69

Compaq's ownership24003.25

Thus, HP pays the equivalent of $24003.25mn to get Compaq, which is $20859.15 m. The new firm must have a value of $71588.3mn (=45816.54/0.64) in order for HP to be indifferent before and after the merger. Thus, for HP to be better off after the merger, the merger must produce 71588.3mn - 66675.69 = $4912.65mn in synergy.

So as per synergy valuation using this model the merger is expected to generate a Synergy Value of $4912.65mn of which the HP would be giving (14.68 12.35)* 1689 = 3935.37 mm Synergy value to Compaq and the rest ( 4912.65 3935.37 ) = $977.28 mm it will keep for itself. Where 14.68 is the share price of Compaq on the last trading day before announcement of the merger.For synergy valuation we can do a DCF of the firm with an optimistic and pessimistic scenario:Optimistic: Gain from revenue along with cost savings in synergy Assumptions: Revenue Growth Rate11%

Terminal Growth Rate3%

Discount Rate15%

Synergy Gain from Revenue3.5% of revenues

Traditionally HPs margin has been 4% but post-merger it is projected to be 8%. Therefore the excess increase of 3.5% is the synergy gain from revenue.Pessimistic: Only cost benefits happens from merger with no significant increase in revenueIt works with similar assumptions as that of optimistic scenario without any gains from synergyThe 2002 synergy values from both the scenarios have been illustrated in the attached spreadsheetWhat was the appropriate valuation range for the merger?Based on the synergy calculations the maximum amount an acquiring company can offer to the shareholders of the target company is given by the relation:Max. Share Price = Pre-Announcement Price of the target company + Synergy per shareOn the basis of the above relationship HP can offer share price in the range of $ 14.00- 27.38.Also based on these estimates the valuation range of the deal comes to 23.64 billion 46.24 billion.The calculations for the above have been illustrated in the attached spreadsheet.Our Take:1) This is a consolidation merger and not a portfolio diversification and the intent was right to gain a larger market share2) The Merger does not add any value to the printing and imaging business of HP which is its most profitable line of Business. The larger PC business will lead to cash drain3) PC Business did not yield a requisite margin as compared to services for many of the big players, HP was trying to buy a low end PC maker at a time when IBM was trying to sell its PC business. Compaq was a low end PC maker a market that was bleeding due to price war4) HP Management does not considers the cultural issues of the merging two firms which are vastly different in their way of functioning5) The Management also has not seen the difficulty of integrating operations on a global scale on such a short span of time6) The execution of the distribution model post-acquisition is unclear7) Weak economy and industry consider might inhibit the merger at anytime 8) Integration of risk is substantial as there are no precedent of successful merger of big technology firms9) The combined entity would get stuck in the middle behind Dell in PC segment and behind Sun and IBM10) The services business of Compaq was also of traditional support services and not of consulting services nature that usually yielded good revenues

Theoretically, we have seen that the deal is generating synergy in both optimistic and pessimistic cases. However, these synergies is contingent upon successful strategic and operational integration of the combined entity. HP assumes a time period of 2-3 years to reap the benefits of synergy. Nonetheless, given the pace of change in technology industry, competitors can outrun the company through innovation in this timeframe.In summary we can say, from a business point of view Compaq was not the right company to acquire for HP. It should have rather focussed on a player that can add value to its printing and imaging services and focus on more high ended products. Fiorina had accused Hewlett of taking a narrow view of the industry however, she herself failed to foresee the rapid technology changes in the PC market that HP would fail to capitalize on if it focused all its resources in merging with a low end PC maker.In this case McAlester has asked for the SWOT analysis, synergy value and valuation range of the company. These factors are computed from the data provided by the management. From our analysis it is reasonable to conclude that McAlester will approve the merger if he takes his decision based upon the above factors. However he should put due diligence in considering other factors also that we have cited above that may act as a deterrent to the successful merger.