Battle of Hewlett-Packard comes down to the wire

Whether or not shareholders back a merger with Compaq, internal strife at the computer giant is set to intensify

As shareholders prepare for this Tuesday's vote on Hewlett-Packard's controversial takeover bid for Compaq, the leading protagonists continue to exchange blows as they try to sway uncertain investors.

With approval for the massive $22bn (£15.5bn) deal hanging in the balance and the mud flying, the vote has all the dramatic makings of the Florida count in the US presidential election. For what is technically a friendly takeover, the action has become distinctly hostile.

But despite the months of heated debate about the proposed deal, the vote will only be the start of the real battle for the future of HP. If the acquisition is approved, the company will begin the huge task of integrating Compaq's operations with its own. This, both critics and proponents of the deal agree, will be a phenomenal challenge, particularly in an industry that's had more than its fair share of failed mega-mergers. Should the deal be blocked, the fall-out could be spectacular, with multiple resignations anticipated at senior management level and no clear Plan B. Either way, the next few months won't be pretty.

For Carly Fiorina, HP's chief executive, this is make or break time. Charged with bringing the spark back to a company that was in danger of losing its way, she has already seen one proposed mega-deal, a merger with PricewaterhouseCoopers, collapse. Now she finds herself pitted against dissident HP director Walter Hewlett, son of the company's co-founder and the driving force in the anti-merger camp. The gloves came off early on. In January, HP wrote Mr Hewlett off as a "musician and academic". Last week, he hit back at Ms Fiorina, suggesting that a new chief would be appointed if the merger failed, and that this time they wouldn't look for someone "learning on the job".

So far, some 20 per cent of the company's shares are lined up in the anti-merger camp, the bulk of them belonging to Hewlett and Packard family foundations, the rest to big investors such as Bank of America, US banking group Wells Fargo, and the influential Californian pension fund Calpers. For its part, HP has secured a range of both public and private backers, including Institutional Shareholder Services, an advisory group whose clients speak for around 23 per cent of the shares. Each day has brought a new twist – a fillip for Ms Fiorina – with regulatory approval for the deal from the Federal Trade Commission, followed by a downgrade from Standard & Poor's, the credit-rating agency, based partly on concerns about the operational risks of the takeover. Not surprisingly, few observers are prepared to call the vote.

What makes the battle so intriguing is that the protests against the deal are based partly on differences of opinion about long-term strategy, and partly on the practical difficulties that lie ahead for a merged company. What's not in dispute is that HP needs to shift direction. Although its printing and imaging business remains dominant and it is strong in the Unix server market, it lags in third position in the PC market, fourth in Windows servers and eighth in IT services. HP says a merged company would have leadership in a range of markets: number one in printers, PCs, enterprise storage and Unix and Windows servers, and number three in IT services. With increased efficiencies – HP expects cost savings of at least $2.5bn (£1.76bn) from the merger – and the combined purchasing power of the two organisations, its PC business would swing into the black from last year's negative 4 per cent operating margin. Critics of the merger say it would trade away HP's "crown jewel", the printing and imaging arm, in exchange for a greater stake in the fiercely competitive PC industry. They also argue that while the deal would bring in additional services capability, much of that revenue is lower-margin rather than high-value consulting.

In addition, as Mr Hewlett argues, it would "impose a substantial and unacceptable integration risk by attempting to combine and rationalise sales forces, support services, product lines and production facilities".

Mr Hewlett's camp highlights a series of failed mergers in the IT industry, and says Compaq itself struggled with its acquisitions of Digital Equipment and Tandem in the 1990s. Even proponents of the deal concede the risks are high. How will employee morale hold up as the Texas and Silicon Valley cultures come face-to-face, and how will staff react to the aftermath of a deal in which 15,000 jobs are shed from the combined entity? As the propaganda war heated up, David Packard, also the son of an HP co-founder, released surveys showing that HP employees at specific sites were two-to-one against the merger.

Just as important, both camps have concerns about customer reaction. The merger will bring consolidation in product lines, changes in account management and a long period of uncertainty. Last week, food giant Nestlé announced it had awarded a $500m IT contract to HP rival IBM, citing continuity in the business as one of many factors influencing its decision.

While these post-merger challen- ges are huge, the alternative is just as daunting. Should the merger be voted down, it's inevitable Ms Fiorina will quit; what isn't yet known is how many other directors would follow. As one analyst says: "Management is committed to the mer-ger. From their point of view, in some senses it's a vote of confidence."

What's more, Mr Hewlett has put forward his own broad proposal that would see HP defending its leading position in printing and imaging, perhaps through a spin-off, while filling the gaps in its mid-range and high-end enterprise operations, and focusing on prof- itability rather than scale in PCs. His suggestions have been roundly attacked by HP.

In some respects, fear of the unknown and concerns about the two companies' market positions fuel the case for the merger. "If they stay separate, they're doomed to be number three or four in an awful lot of markets," says the analyst. "There's no question this is a high-risk move. The issue is, is it higher risk than the alternative? To me it is not."

Once the votes are counted, perhaps recounted, it will be clear which gamble is favoured by inves- tors. Let's hope it's more reliable than Florida.