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THE MERGER OF

HEWLETT PACKARD AND


COMPAQ: STRATEGY
AND VALUATION
Submission for Financial Markets and
Corporate Strategy Assignment

DWAIPAYAN CHAKRABORTY

2013PGP079

GAURAV BHARADWAJ

2013PGP081

JYOTI RANJAN BEHRA

2013PGP086

MOHIT GUPTA

2013PGP093

PARSITA KUNDU

2013PGP099

THE MERGER OF HEWLETT PACKARD AND COMPAQ:


STRATEGY AND VALUATION
Case 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-2004

Reactions 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 merger
In response to Hewletts opposition, Fiorina also launched an active campaign to prove the worth of
the merger before the investors
McAlesters 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 alternative
Industry Analysis
Players 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 HP


Need 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% CAGR
Need 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 Canon
Intent of the deal
HP 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 industry
The 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 services
They operated many complimentary businesses and the cost savings realized through synergy would
lead to improvement in operating margins for all three categories of HPs Business
Financial Cost Benefits
Administrative /IT Costs
COGS Benefits
Sales management benefits
R&D efficiency benefits
Indirect purchase Benefits
Marketing efficiencies

$625 Million
$600 Million
$475 Million
$425 Million
$250 Million
$125 Million Total : $2.5 Billion

SWOT Analysis of HP

STRENGTHS

WEAKNESS
symbolized innovation, integrity, flexibility and teamwork and the brand sold well
Only
15%
of
HP
Pcs
shipped
directly
to
customers.
Whereas
Dell and Compaq shipped all PCs
Long term dominance in imaging and printing
Ranked
poorly
in
PCs
storage and services
Strong in high end servers
Strong in UNIX Market

OPPOURTUNITY

THREAT

Slimming industry margins


er, storage and services businesses could be achieved through acquisitions of significant industry participants
Strong competition from Dell altering the cost strategy of the indust
Strong complementary business lines
Threat from low cost players like Cannon and Lexmark in printing busi
Merger to make HP market leader

SWOT Analysis of Compaq

STRENGTHS
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

THREAT

Rapidly changing demand in the PC business segment


Great demand for portable PCs
Pressure to deliver newer products due innovation from competit
Great demand from small and medium businesses
High cost pressure due to alteration in value chain of the industr
rger with a big partner could lead to economies of scale in PC manufacturing

SWOT Analysis of the

STRENGTHS

WEAKNESS

Both were
poor atindirect
distribution model
xploit the SAN market by using HPs competency in sever and Compaqs
expertise
storage
The
merger
would
not
help
HP
to
gain
a
toehold
in
services
especially
high margin busine
Strong brand recognition
The
PCs
businesses
were
growing
less
and
less profitable
Merger would create an end to end full service firm preferred by clients
THREAT
Huge cost synergy and elimination of redundant products
High competition in the low end server market
Threat of not meeting the desired economies of scale due to integration c
Shifting of focus from HPs high margin business in imaging

OPPOURTUNITY

Strong opportunity in storage services


onomies of scale would leave opportunities for greater innovation expenses

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 postmerger.

Positive aspect
1. 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 synergies
We have calculated the value of each firm as follows:
Compaq's share price
Compaq's share
Equity Value

12.35
1689
20859.15

HP Share Price
HP Shares outstanding
Equity Value

23.21
1974
45816.54

Value of the merged


entity

66675.69

Compaq's ownership

24003.25

million

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 Rate
Terminal Growth Rate
Discount Rate
Synergy Gain from Revenue

11%
3%
15%
3.5% 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 revenue
It works with similar assumptions as that of optimistic scenario without any gains from synergy
The 2002 synergy values from both the scenarios have been illustrated in the attached
spreadsheet
What 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 share
On 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 share
2) 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 drain
3) 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 war
4) HP Management does not considers the cultural issues of the merging two firms which are
vastly different in their way of functioning
5) The Management also has not seen the difficulty of integrating operations on a global scale
on such a short span of time
6) The execution of the distribution model post-acquisition is unclear
7) 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 firms
9) The combined entity would get stuck in the middle behind Dell in PC segment and behind Sun
and IBM
10) 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.