Out of the valley: IT's new champion stalls at the start line

The hype attached to Hewlett-Packard's £17bn takeover of Compaq last week lasted only hours. Then the market had its say and reality kicked in
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Had she been the manager of a Premiership football team rather than the chief executive and chairman of an IT company, Carly Fiorina would already be history. Last month, having seen Hewlett- Packard's share price drop on the back of a series of poor results, members of the board publicly spoke out to give Ms Fiorina their unqualified backing. In the footballing world, a boardroom endorsement is usually the prelude to a sacking. At HP, however, the directors saw it differently, not least because they knew Ms Fiorina was about to pull off a spectacular coup – the $25bn (£17bn) all-share acquisition of rival supplier Compaq Computer.

In the days following Monday night's shock takeover announcement, however, the pressure on Ms Fiorina has intensified. The financial market's reaction to the agreement has been withering, with HP's shares falling 18 per cent on Tuesday, and a further 3.5 per cent on Wednesday, wiping out the premium originally offered to Compaq stockholders and raising questions as to whether the deal will be approved. Industry analysts have expressed a range of reactions from nervous concern to outright hostility. The only parties that really appear to be happy with the agreement are the competitors that the merged company is supposed to be squaring up to.

Clearly, the upbeat message being hammered out by Ms Fiorina and Michael Capellas, the aggressive chairman and chief executive of Compaq, isn't getting through. Announcing the "merger" – which in fact gives HP shareholders 64 per cent control of the combined company – they heralded the creation of an IT giant with $87.4bn annual revenues, earnings of $3.9bn, and operations in 160 countries. The deal would give the new company the number one position in servers, PCs and hand-held devices, while retaining HP's dominance in imaging and printers. Likewise, the combined operation would gain ground in the much-coveted IT services field and take a leading position in areas such as storage. And while they conceded that revenues are likely to dip slightly over the next two years, a huge rationalisation programme is slated to save around $2.5bn per year, making the deal accretive in year one.

So much for the good news. What's been occupying the minds of analysts since then is a host of questions relating both to the practical difficulties of carrying the merger through and to the strategic vision that underlies it. Once the implications were digested, they weren't slow to deliver a verdict. "I think it's very poor for all concerned," said Todd Kort, principal analyst at research firm Gartner. "It's not good for HP, it's not good for Compaq. I fail to understand the whole logic behind the deal – apart from getting Compaq fairly cheap."

At the heart of the controversy lie two primary issues – the dire conditions in the PC and server markets, and the combined company's prospects for cracking the lucrative higher-end services sector. While prices have plummeted in the PC arena, with the volume of shipments declining this summer for the first time in 15 years, the services sector offers high margins and the prospect for long-term profitability. HP, like others, long ago spotted that trend and has been seeking to ramp up its own offerings. But while the proportion of its services revenue has increased, much of it is in the lower-value repairs arena, rather than the more profitable consulting and outsourcing activities offered by industry leaders such as IBM, EDS and the "big five" consulting firms. HP effectively acknowledged as much when it attempted – and ultimately failed – to acquire the consulting operations of PricewaterhouseCoopers last year.

What's alarmed analysts is that the Compaq takeover appears to be a near-180 degree turnaround on that strategic vision. In its second-quarter results to 30 June, Compaq announced that its global services revenue now constituted 23 per cent of group turnover, a capability that will certainly extend HP's reach in that sector. Much of the rest of the company, however, is rooted in hardware – analysts suggest that around half of Compaq's revenue comes from its PC business. Instead of propelling itself into the ranks of the big services players, HP is landing itself with a chunk of business that for the moment at least is struggling.

The latest quarterly results from both companies reflect just how tough conditions are, both in the PC environment and the higher-end server arena. Second- quarter sales in Compaq's enterprise computing business, which comprised almost a third of total revenue, were down 21 per cent year-on-year, thanks to fierce price-cutting and inventory reductions. Likewise, sales in its "access" business, covering commercial and consumer PCs, fell 22 per cent, with the one highlight being strong growth of its iPaq pocket PC. For its part, HP reported a year-on-year revenue decline of 22 per cent in its computing systems operation in the third quarter to July 31, and a loss of $178m. Broken down, the figures made for bleak reading, with Unix server revenue slipping 22 per cent and home PCs falling 36 per cent.

As far as the PC market goes, that puts a different gloss on HP's boast that it will take the number one slot. The unpalatable truth for both HP and Compaq is that Dell, the market leader, is calling the shots with a highly efficient direct sales model that leaves rivals trailing in its wake. HP and Compaq, by contrast, have historically relied on a third-party sales force of resellers, and for years have struggled with the political problem of increasing direct sales without alienating their channel partners.

Speaking when the merger was announced, Mr Capellas conceded that both companies need to collaborate with their resellers to become more effective, working to a game plan to slash inventory and increase speed. However, analysts fear the process of merging will focus attention on other issues, such as business alignment and product overlap, and that it could take the two companies longer to solve this issue together than if they tackled it separately.

Getting their model close to Dell's operational efficiency, warns Gartner's Kort, will take far more job cuts than the 15,000 planned so far. "The [better] idea is to get out of Dell's way and find some high-margin business that's complemented by hardware," he adds.

Concerns have been raised about the group's prospects in the server market, where their combined product sets see them competing against Dell at the lower end, as well as the likes of Sun Microsystems and IBM. While both companies are committed to the Intel architecture, uncertainty among users and prospects about future rationalisation in the two product lines could play into rivals' hands.

Meanwhile, the sheer scale of the task ahead of HP is daunting. Assuming it can stave off regulatory concerns, particularly in Europe, the company will have a job on its hands to consolidate in a fiercely competitive and rapidly changing market. All of which will keep the spotlight on Ms Fiorina, who retains her current responsibilities in the merged operation, and for different reasons on Mr Capellas, president-elect and some might say, heir-apparent.

Lance Travis, director at industry analyst AMR Research, remarks: "Until this happened I was only giving her one more quarter. If she survives [the immediate future], they'll have to give her six to nine months." If she pulls it off, it will be an astonishing achievement.