HP Compaq merger—valuation

23
23.1 Industry overview
In the late 1990s, the computer hardware industry was characterized by extreme
competition between the top players, namely IBM, Dell, Compaq, and
Hewlett-Packard (HP). It witnessed frequent product introductions and improve-
ments in respect of product pricing and features arising due to changing customer
requirements and transforming economics of the IT industry. Thus, in light of the
radically changing industry, the participants had to equip quickly and profitably to
the dynamics to sustain the market pressures. IBM and Dell performed well by fol-
lowing different strategies. Dell’s ability to turnover inventory at a much faster rate
dramatically changed the cost structure necessary to survive in the PC-making
industry. While the former employed a full-service provider model, concentrating
on its high growth, high margin businesses, and the later relied on a focus strategy
principally aimed at the lower margin segments, namely personal computers and
servers. On the contrary, Compaq, which was once the industry leader in PCs, faced
challenges regaining its position in the industry. In such scenario, each of these
participants was faced with a threat of dissolution or acquisition by a strong competitor.
HP, one of the top in the industry, was evaluating its opportunities to expand into new
and adjacent markets; it faced decline in sales growth. A change in the management
was deemed as imperative by some critics, which was then followed by appointment
of a new CEO, Carly Fiorina in July 1999. Fiorina was entrusted with the responsibility
to a sustainable growth path for HP and take advantage of the Internet Age. Even after
strengthening the cost structures and streamlining product lines, Fiorina did not achieve
the desired objectives in terms of profitability. It was then in early 2001 that
she explored the possibility of a business combination with Compaq and engaged
investment banks to gain advice on the financial aspects of the same. The five main
players in the enterprise hardware market were IBM, Sun, Dell, HP, and Compaq.
On September 3, 2001, the merger agreement was permitted by the boards of
both the companies who then sought approval from their respective shareholders.

23.2 Company highlights

23.2.1 Acquirer company: HP
HP Company established in the year 1938 by two Stanford graduates—William Hewlett
and David Packard—is a leading provider of computing and imaging solutions and
services. It is focused on making technology. HP made total revenue from continuing
operations of $48.8 billion in the fiscal year 2000. HP introduced its first PC in 1980
and its most successful product LaserJet in the year 1985. Table 23.1 provides the
comparison of financial highlights of Dell , HP and Compaq in the period of merger.
Valuation.
© 2016 Elsevier Inc. All rights reserved.
456 Valuation

Table 23.1 Financial highlights in period surrounding merger

Values ($ billion) Dell HP Compaq
Sales (ttm) 31.2 44.2 33.6
EBITDA (ttm) 1.8 2.1 0.6
Net income (ttm) 1.3 0.7 20.6
Operating margin 5.70% 2.90% 22.30%
Profit margin 4.00% 1.60% 21.70%
ROCE (ttm) 9.30% 2.20% 22.40%
ROE (ttm) 24.40% 5.10% 24.80%

Table 23.2 Worldwide high-end Unix servers in the year 2000

Firm Factory revenues ($ million) Market share (%)
Hewlett-Packard 512 11.4
Compaq 134 3.0

23.2.2 Target company: Compaq

Compaq Computer Corporation founded in 1983 is a leading global provider of
enterprise technology and solutions. Compaq designs, develops, manufactures and
markets hardware, software, solutions and services, including industry-leading enter-
prise storage and computing solutions, fault-tolerant business-critical solutions, com-
munication products, and desktop and portable personal computers that are sold in
more than 200 countries. Compaq’s primary business divisions were Access, com-
mercial and consumer PCs, Enterprise computing: servers and storage products and
Global services. Compaq had successfully created a direct model in the PC Industry.

23.2.3 Performance statistics

Sun Microsystems with factory revenues of $2.1 billion had 47.1% market share in
high-end Unix servers.
In the category of mid-range Unix servers, HP had revenues of $3.673 billion
with market share of 30.3% in the year 2000. Compaq had revenues of $488 million
with market share of 4%. Sun Microsystems with $2.8 billion in factory revenues
had a market share of 23.5%. HP and Compaq’s revenues and market share in the
high end Unix servers segment is given in the Table 23.2.

23.3 Merger highlights

Hewlett-Packard and Compaq merged to create $87 billion global technology
leader. The merger was aimed at creating world’s number one position in servers,
personal computers, hand held, imaging, and printing. The merger was aimed at
creating leading positions in IT services, storage, and management software. The
HP Compaq merger—valuation 457

Table 23.3 Projections for the combined firm in billions of dollars

Key facts (last four quarters) HP Compaq Pro forma combined
Total revenues 47 40.4 87.4
Assets 32.4 23.9 56.3
Operating earnings 2.1 1.9 4

Source: http://www.hp.com/hpinfo/newsroom/press/2001/index.html, press release issued on September 3, 2001.

companies expected annual cost synergies of approximately $2.5 billion. Compaq

shareholders received 0.6325 share of the new company for each share of Compaq.
HP shareholders would own approximately 64% and Compaq shareholders 36% of
the merged company. The premium paid to Compaq shareholders was approxi-
mately 18%. The deal financing involved issuance of 1.1 billion shares of HP com-
mon stock with a fair value of approximately $1.4 billion. The expected value of
the deal can be assumed to be $24 billion based on the market price of $20.92,
which was derived by averaging the closing price of three days surrounding the
date of announcement. The announcement date was September 3, 2001. The merger
agreement had a termination clause, which stated that HP or Compaq may terminate
the agreement, and as a result, either HP or Compaq may be required to pay $675
million termination fee to other party in certain circumstances. The medium of
exchange was stock. The ownership of Hewlett and Packard Families before merger
was 18.6% and after merger the ownership dropped to 8.4%. The new merged HP
was structured around four operating units—Imaging and Printing franchise, Access
Device business, IT infrastructure business, and Service business. The new HP had
operations in more than 160 countries and over 145,000 employees. The projections
for the combined firm is given in Table 23.3.

23.4 Expected synergies

The merger was aimed to increase synergies for HP in desktop market and for
Compaq in the servers market. The strategy was aimed to converge server families
into IA64 [64-bit] Intel platform. The combination of the IT conglomerates was
expected to provide the industry’s most complete set of IT products and services
for both businesses and consumers. As a result of the merger, the new HP was
expected to be the primary global player in servers, imaging and printing and access
devices (PCs and handhelds) as well as Top 3 player in IT services, storage, and
management software. The merger facilitated the new entity to unify systems, archi-
tectures and promote aggressive direct and channel distribution models. The trans-
action was expected to be substantially accretive to HP’s pro forma earnings per
share in the first full year of combined operations based on achieving planned cost
synergies. Cost synergies of approximately $2 billion were expected in fiscal 2003.
The fully realized synergies were expected to be $2.5 billion by the mid-fiscal year
2004. The cost savings were expected from leveraging HP’s new bulk to renegotiate
458 Valuation

Table 23.4 Breakdown of cost synergies

Category Anticipated cost savings ($ millions)
Administrative/IT costs 625
Cost of goods sold benefits 600
Sales management benefits 475
Research and development efficiencies 425
Indirect purchasing benefits 250
Marketing efficiencies 125
Total 2500
Source: HPQ S-4 Report filed January 14, 2002.

contracts for supplies such as memory chips and hard drives. The big chunk of sav-
ings amounting to $1.5 billion annually was expected from trimming the payroll. It
was expected that by eliminating redundant administration functions, HP cost sav-
ings would reach $3 billion a year by 2004 (Table 23.4).
These anticipated synergies result from product rationalization; efficiencies in
administration, procurement, manufacturing and marketing; and savings from
improved direct distribution of PCs and servers. The merger was expected to signif-
icantly improve the profitability and operating margins in Enterprise Access and
Services (Annual Reports of HP).

23.5 Impact of merger announcement on wealth

creation
The merger was announced on September 4, 2001. The merger announcement led
to an 18.1% fall in price of the HP shares from $23.21 as on August 31, 2001 to
$19 as on September 4, 2001. The merger was approved with a margin majority on
March 19, 2002 and the stock price closed at $18.80, which resulted in a fall of
2.34% from the previous day close. On announcement, the Compaq prices were
down 34 cents closing at $12.35 (Figure 23.1).
The stock price returns of HP were analyzed for the time window of 41 days sur-
rounding the merger announcement. HP had a cumulative return of 236% during
the time window of 220 to 120 days surrounding the merger announcement.
Table 23.5 gives the cumulative returns for HP in different time window periods
surrounding the merger announcement. Table 23.6 gives the returns for HP during
the merger time window period of 2 5 to 1 5 days.
The HP stock price fell by approximately 18% on the day of announcement. The
stock price recovered and improved on the third day after announcement day. On
the fifth day after announcement, the stock price fell by approximately 10%. The
cumulative abnormal return (CAR) was also estimated based on the difference
between stock returns and market index returns. The CAR for the period surround-
ing 240 to 140 days was approximately 30% (Figure 23.2).
HP Compaq merger—valuation 459

Figure 23.1 HP share price trend during merger event.

Table 23.5 Cumulative returns of HP

Period Cumulative returns (%)
220 to 120 days 236
210 to 110 days 236.60
25 to 15 days 242
21 to 11 days 223
Zero is the announcement day.

Table 23.6 Returns of HP

Day Returns (%)
25 20.44
24 21.64
23 22.68
22 22.30
21 20.81
0 218.14
1 24.16
2 22.80
3 2.15
4 21.05
5 210.45
460 Valuation

Figure 23.2 CAR of HP. CAR, cumulative abnormal return.

Table 23.7 Operating performance

Year 1998 1999 2000 2001 2002 2003 2004 2005

Sales 70,588 80,895 91,253 78,780 56,588 73,061 79,905 86,696

EBITDA 83,838 92,376 104,369 88,104 55,576 75,957 84,132 0
EBIT 13,250 11,481 13,116 9324 21012 2896 4227 3473
Net Profit 202 4060 4266 2377 2903 2539 3497 2398

The values are given in millions of dollars. The average growth rate of these operating parameters in the premerger period (1998 2001)
is compared the average growth rate of these variables in the postmerger period (2002 2005). The sales, EBITDA, EBIT, and net profit
of HP and Compaq are combined in the premerger period 1998 2001. The merged firm data is used for postmerger comparison. The
average growth rate of sales in the premerger period (1999 2001) was 3.7%. The average growth rate of sales in the postmerger period
(2003 2005) was approximately 15%.

Table 23.8 Profitability and liquidity position

Year 1998 1999 2000 2001 2002 2003 2004 2005
ROA 0.09 0.10 0.11 0.01 20.01 0.03 0.05 0.03
ROE 0.17 0.19 0.26 0.03 20.02 0.07 0.09 0.06
Current ratio 1.56 1.51 1.53 1.53 1.54 1.61 1.50 1.38
The average return on asset of HP during the premerger period (1999 2001) was 7.8%. The average return on asset
of HP during the postmerger period (2002 2005) was 2.45%. The average return on equity for HP during the
premerger period and for postmerger period was 16.35% and 4.9%, respectively. The average current ratio in the
premerger period declined from 1.53 to 1.51 in the postmerger period.

23.5.1 Operating performance analysis

The operating performance of HP is analyzed on the basis or premerger and post-
merger period. Three years prior to merger is the premerger period and 3 years after
merger is the postmerger period. The premerger data of both acquirer HP and target
Compaq are added for the premerger years and compared with the postmerger data
(Tables 23.7 23.10).
HP Compaq merger—valuation 461

Comparison of HP and Compaq in the

Table 23.9
year before merger completion
Firm HP Compaq
Total assets 32,584 23,689
Sales 45,226 33,554
EBITDA 2808 9262
EBIT 1439 7885
Net income 408 2785
ROA 10.87% 23.31%
ROE 26.02% 27.06%
The values of total assets, sales, and operating performance variables are in millions of
dollars. The profitability position of HP was much better compared to Compaq in the year
of merger announcement.

Table 23.10 Market capitalization in millions of dollars

Year 1998 1999 2000 2001 2002 2003 2004

Market 20,204.36 30,138.83 50,761.35 34,983.52 40,733.7 56,399.97 52,284.96

capitalization

Table 23.11 Performance models

Year 1998 1999 2000 2001 2002 2003 2004
EBITDA/Mar Cap 0.24 0.17 0.10 0.08 0.03 0.10 0.13
EBITDA/Total assets 0.15 0.14 0.15 0.09 0.01 0.07 0.09
Sales/Mar Cap 1.95 1.41 0.96 1.29 1.39 1.30 1.53
Sales/Total assets 1.24 1.20 1.44 1.39 0.76 0.98 1.05

Table 23.11 highlights different ratios of performance measures in the pre- and
postmerger years.
See the resource file HP Compaq .xlsx for details of analysis.

Reference
Annual Reports of HP.