Merger anf takeover

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Chapter 1 Introduction

"There is no more dramatic or controversial activity in corporate finance than the acquisition of one firm by another or the merger of two firms. It is the stuff of which reporter's dreams are made, and it is also an embarrassing source of scandal."(Ross,S.1996)

A merger refers to the absorption of one firm by another. The acquiring firm retains its name and its identity, and it acquires all of the assets and liabilities of the acquired firm. After a merger, the acquired firm ceases to exist as a separate business entity. In resent years, more and more merger and acquisition happened for those big companies as a result of intense competition in the business world. To maintain the competitive position in their respective industry, merger and acquisition become suitable strategic alternative, which would bring synergy to both companies. Revenue enhancement, cost reduction, lower taxes, and lower cost of capital can be the basic categories of possible sources of synergy.

The merger of Compaq and HP companies is a resent case, which brings controversial discussion in the public media. When Hewlett-Packard CEO Carleton S. Fiorina and then-Compaq CEO Michael D. Cpellas met with investors last fall to sell their controversial merger, many comments present different opinions on this event. In this case study, it will focus on the pre-merger of HP and Compaq. By looking insight of the whole process of the merger, the motivation of the merger will be identified, as well as its expected synergy resulting from merger. Important analysis will be of whether the expected effects of the merger were a reasonable basis for going ahead with it at the time of the merger and the challenge facing the merger.

Chapter 2 Background of Compaq and HP companies

2.1 Compaq company profile before merger

Compaq Computer Corporation is a company which manufactures, designs and markets hardware, software, solutions and services for the NonStop TM Internet world. Compaq provides industry-leading enterprise computing solutions, networking and communication products, fault-tolerant business-critical solutions, portable products and consumer PCs, commercial desktop. Customers of the company include, home users, business interests, government and educational users. The products of the company include industry-standard servers, business-critical servers, storage products, portables, monitors, desktops, workstations, handhelds, Internet access devices, life-cycle management products, desktop PCs, printers and related products. The company operates mainly in Japan, North America, Asia-Pacific, Latin America, China, Europe, the Middle East and Africa. In fiscal year 2001, Compaq reported revenues of $33.6 billion. Enterprise computing accounted for 34% of 2000 revenues; consumer pc 18%; commercial personal computing 31%; Compaq global services, 16% & other, 1% (

Compaq Computer Corporation was founded in February 1982 by Rod Canion, Jim Harris and Bill Murto, three senior managers who left Texas Instruments and invested $1,000 each to form their own company. The first product was a portable personal computer, which is able to run all of the software being developed for the IBM PC. In January of 2000, Compaq was named "world leader" in Consumer PC Market according to IDC. Enterprise Storage earns No. 1 ranking from leading network storage users. In April, Compaq and Siebel extend relationship into Global Strategic Alliance and was ranked No. 1 vendor in Linux server market. At the same time, it was recognised by President Clinton as the leader in bringing the digital divide. In July, it reports best financial performance for the second quarter.

In 2001, Compaq and Yahoo! announced comprehensive global technology and marketing alliance. In April, Compaq awarded three supercomputer wins in Japan and Australia. It retained number one spot in worldwide server sales in Q1. In May, It was

named as one of the "Top 25 Most Innovative Wireless Companies" by Unstrung, an influential publication in the wireless industry. In September, Compaq demonstrates first global storage network using Internet and Fibre Channel technologies.


Its financial performance from 1999 to 2001 is as following.


Revenue$38.5B$42.2 B$33.6B

Gross Marginal23%24%21%


Operating Profit$0.7B$2.4B$0.5B



From the figure, we can see that the revenue, GM, Operating Profit and EPS have an obvious decrease since 2000 as a result of IT industry weakeness.

In 2001, Compaq took action to focus on the structural improvement to compete in PC business world. It made effort to reduce structural costs; streamline supply chain and distribution; build world-class e-commerce capabilities; strengthen balance sheet and extend product/services portfolio. By effort, what Compaq achieved in 2001 are as following annualized operating expenses down $1.7B

*Positive cash flow of $1.5B

*Inventory down $2.5B

---channel down $1.7B

---Compaq-owned down $800M

*Direct sales engine in place

---60% direct in North America commercial


Moreover, market is moving to Compaq's strengths, such as storage systems and storage area networks; industry standard servers--Fault-tolerant systems; clustering and parallet computing; windows&Linux; global service and support and broad access portfolio. Compaq's strategic objectives were

1. Extend enterprise capabilities

*# 1 in industry standard servers

*# 1 in fault tolerance

*# 1 in high performance technical computing

*# 1 in storage

2. Grow and achieve critical mass in services

*Benchmark profitability in customer services

*Grow Compaq financial services

*Expand managed services

*Sharper focus in systems integration

3. Improve PC economics and increase supply chain velocity

*Return to profitability

*3-5% return on sales

*strong ROA with positive cash flow

*Balance innovation and high velocity

*Leadership in mobility

In summary, Compaq is leading server and storage market transition. It extends service offerings and increase asset velocity and PC innovation. At the same time, Compaq is leveraging operational improvements for increased EPS and cash flow.

All these are regarded by HP as a beneficial aspect in connection with the plan of merger.

2.2 HP company profile before merger

Hewlett-Packard (HP) is a big company which provides computers, imaging and printing peripherals, computer-related services, and software. In the HP years of the 21st century, HP focuses on three key areas of invention: connected access devices, intelligent, infrastructure solutions and applications that can be delivered over networks as Web services. Under Carly Fiorina's direction, HP continues its process of reinvention as a company. HP divides its businesses into two customer-facing organizations and three product-generation organizations. Compaq focuses on being a unifying force across the Internet, building out the business-critical Internet ,delivering

next-generation access devices, and ensuring customer success through global partnerships, solutions and services. By mid-2001, the focus put an even greater emphasis on total solutions for customers. The company's goal is to become the world's leading IT solutions provider. (

With the introduction in February of two software families -- HP Netaction Software Suite and HP OpenView Software Suite -- HP unites its software offerings into a comprehensive platform for developing, implementing and maintaining Internet-based services. In May of 2001, HP introduces systems and services based on the new Itanium processor, developed by HP and Intel. Developed as an extremely parallel high-performance architecture, Itanium is the platform for next-generation 64-bit computing. In September, HP acquires StorageApps, whose storage virtualization technology enables customers to easily implement and manage storage networks. On September 4, HP and Compaq announce a definitive merger agreement to create an $87 billion global technology leader. And in September, HP announces that they will acquire Indigo, a leading commercial and industrial printing systems company. It accelerate HP's plans to transform and lead the rapidly evolving digital publishing market.(

2.3 The two companies after merger

In September of 2001, Hewlett-Packard Corporation and Compaq announced plans to merge, creating $87 billion global technology leader and resumed stock repurchase program. In November, Compaq announces grid computing program and broke into Top 10 on Interactive Week's Interactive 500. In March of 2002, Federal Trade Commission clears proposed HP-Compaq merger. Compaq shareholders approve HP-Compaq merger. Compaq Computer Corporation becomes part of Hewlett-Packard Company on May 3, 2002, as merger is legally closed. HPQ is unveiled as new stock ticker for combined company. New HP is officially launched on May 7, 2002. The acquisition of Compaq Computer in a stock transaction valued at approximately $19 billion. (

HP and Compaq officially merge, beginning operations as one company. The new HP serves more than one billion customers across 162 countries, with an employee of 150,000. The combined company boasts improved market share across a number of hardware lines, including UNIX and Windows-based servers, personal computers and enterprise storage. HP furthers its strategy to be the leading provider of access devices, applications delivered as Web services. It is running on infrastructure solutions as market leadership in enterprise storage, UNIX, Windows, and Linux servers, management software, PCs, imaging and printing devices and IT services. The new HP will offer the industry's most complete set of IT products and services for both businesses and consumers, and commit to serve customers with open systems and architectures. For consumers, the new HP is the leading consumer technology company in the world which offer a range of technology tools designed to help them live, learn, work and play--from digital cameras to PCs to handheld devices.

The merger creates a richer portfolio of products and solutions and a deeper service team. The expectation from the merger is that New HP will be the leadership across all the essential component of business infrastructure: storage, servers, management software imaging and printing, and the leadership in the delivery of mission-critical infrastructure solutions and multi-vendor support and outsourcing. In addition, HP will provide choice, stability, flexibility and security at the lowest cost of ownership. It is expected that New HP will have #1 worldwide revenue positions in servers, access devices (PCs and hand-held) and imaging and printing, as well as leading revenue positions in IT services, storage and management software.


From the press release, it was reported that, "The merger is expected to generate cost synergies reaching approximately $2.5 billion annually and drive a significantly improved cost structure. Based on both companies' last four reported fiscal quarters, the new HP would have approximate pro forma assets of $56.4 billion, annual revenues of $87.4 billion and annual operating earnings of $3.9 billion. It would also have operations in more than 160 countries and over 145,000 employees." (

Chapter 3 the consideration of merger

3.1. Consideration of the merger by HP Company

At a meeting held on September 3, 2001, the HP board of directors determined that the merger is advisable, and in the best interests of HP and its shareowners and approved the merger agreement. Before making the decision to approve the merger agreement, the HP board of directors consulted with HP's management, and HP's legal counsel about the legal terms of the merger, HP's business consultants about the strategic aspects of the merger and alternatives to the merger, and HP's financial advisors regarding the financial aspects of the merger.

Before making the decision of merger, HP board of directors considered the historical information concerning HP's and Compaq's respective business, prospects, operation, technology, financial performance and condition, management and competitive position, including public reports about results of operations during the most recent fiscal year; management's view of the financial condition, results of operations and businesses of HP and Compaq before and after the merger; current financial market conditions and historical market prices, and another strategic alternatives for HP, including organic growth as an independent company..


HP Financial Advisor, Goldman Sachs delivered its written opinion to the HP board of directors that subject to the assumptions, considerations and limitations in its opinion, the exchange ratio in the merger of 0.6325 of a share of HP common stock for each share of Compaq common stock is fair from a financial point of view to HP. ( Goldman Sachs provided the opinion from the information and assistance of the HP board of directors in connection with its consideration of the merger.

3.2. Consideration of the merger by Compaq company

The Compaq board of directors approved the merger agreement on the base of some material factors. First, the merger will present, based on the market price for HP

common stock, the opportunity for the holders of Compaq common stock to receive a premium over the trading value of Compaq common stock on August 31, 2001, the last day of trading before public announcement of the proposed merger. At the same time it allowed Compaq shareowners to participate in a combined company positioned to benefit from new growth opportunity. Second, according to the Compaq board of directors' knowledge of Compaq and the industries in which the Compaq business compete and its belief that the greater resources which Compaq will realize as a result of the merger are important to the long-term future of Compaq.

The Compaq Financial Advisor, Salomon Smith Barney reviewed the synergy estimates provided by the management of Compaq. The synergy estimates were prepared by Compaq management and its consultants to reflect the increased benefit anticipated to result form the merger, which includes cost savings and operating synergies. The synergies is assumed of $1.3 billion in the first full year of combined operations after the merger, $2.5 billion in he second full year of combined operations after the merger, $2.9 billion in the third full year of combined operations after he merger and £3.1 billion annually thereafter.( The analysis were prepared based on the assumptions that synergies would arise through the development of new retail programs in the consumer PC product area and through savings in sales and marketing, in manufacturing, logistics and procurement, in research and development, and in support functions.

"Salomon Smith Barney estimated the present value of the anticipated cash flow effect of the estimated synergies as of the transaction closing dated, by applying discount rates reflecting a weighted average cost of capital ranging from 12.5% to 13.5% per annum to cash flow effects for a five-year period after the date of completion of the transaction and by adding a terminal value determined by applying an EBIT multiple of 13.5x to 14.5x." ( His analysis resulted in a range of present value for Compaq common shareowners' proportionate share of the synergies of $28.3 billion

to $31.2 billion, representing a range of synergy value per share of Compaq common

stock from approximately $5.96 to $6.56. The estimates of achievable synergies and timing of the realization of such synergies are based on numerous estimates, assumptions and judgments and are subject to significant uncertainties.

Chapter 4 Motivation of Compaq and HP's merger

4.1 Transition in the IT industry

In the development of IT industry, there is a transition during the resent years. Global economic becomes weak, and IT demand has been reduced. Overcapacity in IT industry has yields "brutal" pricing environment. Structural reductions in margins and leading to consolidation in all segments are also the characters of IT industry.

As technology becomes more broadly accessible, the products and solutions that solve real problems and make life and work easier to manage become more important. Specialized, custom-built hardware and software solutions to meet business computing needs are not be supported by Business cycles anymore. So, companies have to adapt their infrastructures more rapidly and deploy systems and applications as fast as possible.

On the other hand, customers also want easy-to-use tools and compelling digital content to help them stay connected, informed and entertained informed and entertained during they are on the move. In IT industry, a new generation of hardware and software technologies based on open, industry-standard architectures is changing the economics and the value proposition for technology used by business and consumers.

4.2 The background of the merger

In the highly developing IT industry, HP and Compaq evaluate strategic opportunity and business scenarios as a part of its ongoing evaluation of changes in the marketplace and opportunities to strengthen their business. In 1999, HP became focused on developing strategy to secure HP's future by strengthening HP's product and service offerings. In order to improve HP's enterprise computing and services business and its relationships with independent software vendors, strengthen its sales force, the HP board of directors sought strategic alternatives. As written in Joint Proxy Statement, the alternatives include:

*A "go-it-alone" strategy that consisted of continuing its then-current business plan and making targeted acquisitions and divestitures designed to incrementally refine HP's product and service offerings.

*A "go-it-alone" strategy that consisted of continuing its then-current business plan coupled with shutting down, spinning-out, selling or otherwise divesting HP's PC business.

*A service-focused strategy that consisted of moving aggressively into information technology outsourcing and systems integration by developing alliance with, or acquiring, significant participants and assets in the IT services industry.

*An imaging and printing-focused strategy that consisted of strengthening its core printing and imaging business by intensifying its investment in higher-growth technologies and markets such as digital imaging, and by developing alliances with, or acquiring, other participants and assets in the imaging and printing industry.

*A spin-out of the imaging and printing business

*An end-to-end solutions strategy that consisted of developing its server, storage and services business by acquiring significant participants and asset in these industries, including Compaq.


From 1999 to 2000,HP board of directors and HP management continued to evaluate these strategic alternatives on the base of market trends, industry dynamics and HP's relative position in the marketplace. By mid-2000, HP determined to develop HP's IT services business in ways of organic growth fuelled by increased internal investment in the IT services business and possible acquisitions.

In early 2001, in order to maximize opportunities for its UNIX business, HP began approaching other companies to determine whether they would be interested in licensing HP's UNIX operating system, HP-UX. Ms. Fiorina, Hewlett-Packard CEO, contacted Mr. Capellas, Compaq CEO in June 2001 to discuss Compaq's interest in licensing HP-UX. After several days of deliberation, Mr.Capellas contacted MS. Fioria to suggest that the synergies between the two companies were

broader than HP-UX and that HP consider whether a broader strategic relationship might be viable option.

After the June 22,2001 meeting, HP initiated a general analysis of a possible business combination with Compaq using publicly available information to build up the strategic evaluation. On July 7, 2001, two companies further discuss various strategic, operational, financial legal and regulatory aspects of the business combination. They also reviewed the results of their respective preliminary analysis of the business combination, which include the potential strategic synergies of the business combination and business integration of the combined company. On September 3, 2001, the HP board of directors discussed the reasons for the merger, including the financial analysis and the risks associated with the merger. After discussing on the issure, the HP board of directors determined that the merger is advisable and in the best interests of HP and its shareowners. They approved the merger agreement, directed that the issuance of shares of HP common stock in connection with the merger be submitted for consideration by HP shareowners at a special meeting of HP shareowners, and resolved to recommend that HP shareowners vote "for" the proposal to approve the issurance of shares of HP common stock in connection with the merger. Following the meetings of the board of directors of each of HP and Compaq, HP and Compaq executed the merger agreement on September 4, 2001 and issued a joint press release announcing the execution of the merger agreement and the merger.

4.3 Reason for the merger

For the decision making of merger, both companies need to take a careful consideration of their business environment. As the world become more and more about the interconnections between people, content, devices, and infrastructures. In the modern world, each component of the technology landscape must be capable of working together--from servers to storage to handhelds to Web services. In resent years, high technology--personal computer industry is developing at a dramatic speed. The customers' need has greatly increased, the competition among big computer companies became more and more intense. For improving the technology and service, computer companies make effort to innovate their product and service. On the other hand, from

the aspect of market share, they try to enlarge it through different approaches. While merger, as a possible means to enlarge market share and economic scale, has been employed by the companies. The financial performance in 2001 in Compaq and HP are shown in appendix.

It can be shown from the financial performance of the two companies in 2001 that the revenue and profit is decreasing. Compared with 2000, the revenue of Compaq decreased by 20.8%; the profit decreased by 238%; Earning per share decreased by 242.4%. In 2001, the total return to investors dropped by 5.7%. From 1991-2001 annual growth rate is -5.7%. While HP' revenue decreased by 7.3%; profit is -89%; earning per share drop by 88.3% and total return to investors is -34.1%. From 1991-2001 annual growth rate is -5.7%. As Compaq's financial performance is not so optimistic in 2002, the decision of merger became a possible approach to increase the value to the respective shareowners of both companies.

The boards of directors and management teams of both HP and Compaq believe that the proposed merger represents the best strategic alternative for delivering increased value to their respective shareowners addressing a number of challenges and opportunities facing both companies. To maintain the competitive position in information technology industry, in the area of enterprise computing and its services-areas Compaq and HP were considered to be the primary engines for new value creation--customers increasingly are looking to purchase integrated solutions, not individual products and technologies, from a smaller number of global end-to end solutions providers. Meanwhile, these customers also are seeking to take advantage of the economics and flexibility of standards-based platforms and architectures. Accordingly, HP and Compaq must expand the scope of the leadership across the enterprise. The following part will present the motivation of merger because of the requirement of development in different segment of the industry.

*In the personal computer segment of the industry, which is maturing and consolidating, customers are looking for low cost products with greater feature and functionality, and purchasing flexibility. Because of these customer demands and intense competition among PC vendors, success in the PC industry requires increasingly lower cost structures, flexible distribution capabilities and continuous product innovation. Under this situation, HP has already undertaken independent actions, such as the recently announced outsourcing of its PC manufacturing operations in France, to improve the cost structure of this business, however HP recognizes that additional cost saving measures will be required.

*In the services segment, HP and Compaq companies both operate profitable, growing services business, but neither company alone has a services business of the size that places it among the top few global IT services businesses on a revenue basis. In order to reach the aim, both of them believe that the expansion of their services businesses is an important source of growth and profitability for their companies.

*In addition, HP has identified the expansion of its imaging and printing business into new areas of growth as essential to maintaining leadership in that segment. HP believes that the strengthening of its professional services capabilities and its PC business, the expansion of its reach into enterprise accounts and improvements in the profitability of those businesses will benefit the long-term success of its imaging and printing business in new and emerging markets.

At the same time, the boards of directors and management teams of both HP and Compaq rigorously analyzed numerous alternative strategies in order to position their companies to take advantage of the opportunities and address the challenges presented by these trends. As mentioned before, they have several strategic alternatives to choose, after reviewing and debating these strategic alternatives and the opportunities presented by the merger, the boards of directors and management teams of both HP and Compaq determined to pursue the merger instead of the other alternatives that were being considered independently. Because they believe that the merger provides a unique

opportunity to position themselves broadly to address the strategic challenges of their industries. Furthermore, combining their companies provides the most comprehensive opportunity among their alternatives for improving the cost structures and improving the long-term profitability of the enterprise systems and PC businesses in a timely and efficient manner.

In fact, the merger is a unique opportunity to create a combined company with a stronger, more efficient operating model than either company could achieve on its own. For example, the merger will enables them to improve the combined earnings by generating significant cost synergies for the combined company. "They expect to generate annual cost savings of at least $2.5 billion by the middle of the combined company's 2004 fiscal year, which translates into a present value of cost savings of approximately $5-$9 per share of the combined company. Moreover, even in an environment in which prices will remain under pressure, both companies believe that the combined company will be able to generate operating margins of 8%-10% by the combined company's2003 fiscal year after realizing anticipated cost savings."


4.4Strategic benefit of the merger

Firstly, the merger presents a unique opportunity to enhance the combined competitive position in key industries, at the same time strengthen the sales force of both companies. On the other hand, the merger will greatly expand and strengthen the product and service offerings, and provide a more robust platform for innovation. All of these will combine to accelerate the combined leadership position as an end-to-end solutions provider. From the following aspects, it can show that the merger will bring strategic benefit to the combined company.


HP and Compaq have complementary leadership in key markets. Both of them provide complementary solutions, which will give the combined company industry-leading product offerings spanning the server category. For example, Compaq's Himalaya offering is the segment leader in fault-tolerant servers with enhanced failure protection for critical business operations where system outages are very disruptive. While, HP

does not offer fault-tolerant systems. Moreover, Compaq is also the segment leader in industry standard servers--the fastest growing area in the server industry, that operate on third-part operating systems like Microsoft Windows NT and Linux. The combination of these offerings with HP's strength in mid-to high-end UNIX servers, which will be further enhanced by Compaq's technology, fills out the combined company's server leadership. Combining the companies' respective investments in Linux will also improve the combined company's innovation in this area.

*IT Services:

Strengthened business resulting from the merger will provide critical mass in key growth market. According to the estimation, the combined company will have available 65,000 IT architects operating in more than 160 countries around the world, and the merger will significantly improve the combined ability to offer IT services around the world. The directors of both companies believe that the combined support business will deliver a larger amount of predictable, regular revenues with double-digit net profits.


Complementary fit creates leadership across categories, which include highest growth areas. Compaq is the leading provider of storage systems in the world, measured on a revenue basis. The combining of this leadership position with HP's strength in high-end storage will create an even stronger industry leader in the enterprise storage area and especially in the fastest growing portion of storage--storage area networks--where Compaq's StorageWorks products will enable the customers to manage complex storage environments more efficiently.

*Personal systems:

The merger can improve economics and drives innovation. As both companies recognize the need to improve the overall economics of the respective PC business to create a sustainable and viable competitor. The combined company will have greater economies of scale that will lower the cost structure of the combined PC business and have a positive impact on margins. It is estimated that the merger will enable the new company to achieve positive operating margins of 3% in the personal systems business

(compared to an operating margin for HP's personal systems business of (4.2%) in

fiscal year 2001)by the middle of the combined company's 2003 fiscal year. Further, the merger will combine HP's strength in the consumer PC business and Compaq's strength in the commercial PC business to create a more balanced industry leader.

*Software Challenge:

When it comes to operating systems, "they've got Himalaya, VMS, Tru64, HPUX, and others," notes Laurie McCabe, an analyst with Summit Strategies. "It makes my head swim trying to keep track of each one." That could create a huge opportunity for Linux, the so-called open-source OS that's becoming an increasingly prominent player in the field.( If the new HP adopts Linux as its primary platform outside the Windows arena, it would break down the obstacles that have been standing in the way of Linux' growth and further market penetration. As for HP, by winnowing the OS plethora and unifying software-development efforts around two systems, Windows and Linux, the new company could create desperately needed economies of scale -- and perhaps save hundreds of millions of dollars in wasted development costs. More important, it could ease the integration of the two companies by giving them a common goal.

Not surprisingly, executives haven't had a chance yet to talk publicly about future software development at the combined company. HP's main Linux evangelist, Bruce Perens, expects see its Linux development efforts continue as before. "In the long run," says Perens, "I expect this merger to be good for Linux."


In conclusion, it is reasonable for HP and Compaq to make merger and the strategic benefit arising from the merger will enhance HP and Compaq's competitive position. Especially, in the IT area facing significant changing, the combination accelerates their further development in the market share.

4.5Financial benefit of the merger

In addition to the strategic benefits of the merger discussed above, the merger will enable the combined company to generate substantial cost savings and improve the profitability of the combined enterprise, personal systems and services business.

Furthermore, except generation shareowner value through improved earnings, these cost savings offer strategic benefits by reducing the cost structure in competitive businesses such as PCs. The merger can bring synergies and operational margin to the new company.


The two companies believe that the merger will enable the combined company to generate annual cost savings of $2.5 billion by the middle of the combined company's 2004 fiscal year. They anticipate that these cost savings will be realized by the combined company in the following categories: (according to the proxy statement)

Category Anticipated

Cost savings

Administrative/IT costs .......................................... $625 million

Cost of goods sold benefits....................................... $600 million

Sales management benefits....................................... $475 million

Research and development efficiencies........................ $425 million

Indirect purchasing benefits....................................... $250 million

Marketing efficiencies............................................. $125 million

(1)The first item is the administrative and IT costs. Following the completion of the merger, the cost saving is realized by eliminating redundant IT investment and by eliminating redundant positions across corporate administration, finance, human resources and IT personnel;

(2)The second item is the costs of goods sold, which is saved by reducing materials costs, consolidating manufacturing operations and discontinuing duplicative infrastructure investments;

(3)In sales management, it can be saved by eliminating redundant positions;

(4)The cost of research and development will be saved by eliminating duplicative research and development efforts, principally in the combined company's PC and server businesses;

(5)Indirect purchasing spending can be saved by reducing the combined company's indirect purchasing base;

(6)In marketing, the cost can be saved by eliminating redundant product marketing personnel and by eliminating redundant marketing and communications programs.

The cost savings have a net present value of approximately $4-$5 per share of the combined company calculated by applying a range of price/earnings multiples to the estimated earnings per share impact of these cost savings in calendar 2004 and discounting those amounts to the present. According to HP management, the above synergy analysis is based on the following assumptions:


(1)$2.5 billion of pretax cost savings in calendar year 2004;

(2)a range of price/earnings multiples of 15x-25x, which is supported by the average one-year forward price/earnings multiple for HP in the last year(20.8x) and the last three years(22.2x);

(3)a discount rate of 15%, which is based upon the weighted average cost of equity of the combined company on a pro forma basis;

(4)an assumed effective tax rate of 26% for the combined company, which is based upon the weighted average of the effective tax rates of each of HP and Compaq;

(5)marginal pre-tax profit of approximately $500 million in calendar year 2004 resulting from estimated overall revenue loss for the combined company resulting from the merger in calendar year 2004 of approximately $4.1 billion(representing 4.5% of overall estimated revenue for calendar year 2004 of $92.8 billion or 4.9% of estimated revenue for fiscal year 2003), which is based upon potential revenue loss in businesses of the combined company as follows: 18% in home PC; 11% in UNIX servers; 8% in business PCs; 7% in appliances; 6% in NT servers; and 5% in storage. HP assumed that the combined imaging and printing business will not experience material revenue losses as a result of the merger because Compaq does not have an imaging and printing business. In addition, it is assumed that the combined services business will not experience material net revenue losses as a result of the merger.

(6)A weighted average contribution margin of 12%, which represents the marginal pretax profit decline resulting from revenue loss. It is assumed a weighted average

contribution margin of 12%, reflecting an assumed contribution margin of 11% for the combined company's Personal Systems business(which is expected to account for 66% of 2004 revenue loss) and 14% for the combined company's Enterprise business(which is expected to account for 34% of 2004 revenue loss).

(7)The estimated of the net present value of the cost savings resulting from the merger excluded both the cost savings expected to result from the merger in calendar years 2002 and 2003 and the expected nonrecurring cash costs of achieving those cost savings during those calendar years, as well as the pre-tax profit decline resulting from estimated revenue loss in calendar years 2002 and 2003. The estimate of the net present value of the cost savings resulting from the merger does not account for possible revenue increase resulting from the merger.

*Operating Margins

The two companies believe that the combined company will be able to generate an overall operating margin of 8%-10% in the combined company's 2003 fiscal year, after realizing anticipated cost savings (compared to an HP operating margin of approximately 3% in fiscal year 2001).There are segment operating margins in the combined company's 2003 fiscal year. Enterprise system business operating margins is estimated as 9.2%( compared to an operating margin for HP's comparable businesses of -3.2% in fiscal year 2001); Personal systems business operating margins of 3.0%( compared to an operating margin for HP's comparable businesses of -4.2% in fiscal year 2001); Service business operating margin of 13.7%( compared to an operating margin for HP's comparable businesses of 4.5% in fiscal year 2001).


In addition, the new HP still depends on printers and services for all of its profits. As Cliff Edwards reported that, "the printing division has $767 million in profits and a $358 million gain from the services."(Business week, June 17, 2002)

Chapter 5 Challenges facing to the new Company

HP and Compaq will operate as a combined company in a market environment that cannot be predicted and that involves significant risks, many of which will be beyond the combined company's control. Even though the proposed merger provides significant benefits, the failure to take quick and decisive action to address comprehensively the business opportunities and challenges facing their respective businesses will weaken their respective long-term competitive position, and result in the deterioration of their respective businesses. What's more, maintaining the status or moving too slowly to address these items will erode the value of both companies to their respective shareowners.

In addition, there are other hurdles existing during the completion of the merger. As Peter Burrows said, " HP's merger with Compaq is off to a good start, but plenty of big hurdles lie ahead" and " Many of the new HP's 145,000 employees don't know if they'll be laid off, and there's still lots of opposition to the deal among the ranks...HP is betting its new breath will help it vanquish rivals such as Dell and Sun, but those companies may have more focus with narrower product lines...With tech sales in the dumps, rivals will fight for every deal just as HP needs to concentrate on integrating Compaq's products and employees." (Burrows,P.2002)

1. The combined company may not realize the anticipated benefit because of integration and other challenges.

Realizing the benefits of the merger will depend on the integration of technology, operations, and personal. Because the integration of the two companies is a complex, time-consuming and expensive process that could disrupt the business of HP and Compaq if there is no proper planning and implementation. These challenges could include: consolidating and rationalizing corporate IT and administrative infrastructures; consolidating manufacturing operations; combining product operations; combining product offerings; coordinating sales and marketing efforts to effectively communicate the capabilities of the combined company; preserving distribution, marketing or other

important relationships of both HP and Compaq; Maintaining employee morale and retaining key employees.

The expected benefits and synergies could be doubted, as the anticipated benefits and synergies may not be realized to the extent, which relate to cost savings associated with anticipated restructurings and other operational efficiencies, revenue enhancement opportunities and greater economies of scale. What's more, these anticipated benefits and synergies are based on projections and assumptions, not actual experience, and assume a successful integration. In addition, the combined company's ability to realize these benefits and synergies could be adversely impacted by practical or legal constraints on its ability of combine operations or implement workforce reductions. As the "American News" reported, "Almost 75% of the 34 million shares in one HP retirement plan were voted against the merger... Part of the problem is layoffs. The merger alone will require 15,000 job cuts--a number that even drew angry employees from Compaq's French operations to the shareholder meeting." ( Burrow,P., 2002)

2. The stock prices and business of HP and Compaq may be adversely affected if the merger is not completed.

If the merger is not completed, the price of HP common stock and Compaq common stock may decline to the extent that the current market prices of HP common stock and Compaq common stock reflect a market assumption that the merger will be completed. In addition, HP's business and Compaq's operations may be harmed to the extent that customers, suppliers and others believe that the companies cannot effectively compete in the marketplace without the merger, or there is customer and employee uncertainty surrounding the future direction of the product and service offerings and strategy of HP or Compaq on a standalone basis. All of these will adversely affected the anticipated synergy. Completion of the merger is subject to several closing conditions, including obtaining requisite regulatory and shareowner approvals, and HP and Compaq may be unable to obtain such approvals on a timely basis. HP and Compaq will also be required to pay significant costs incurred in connection with the merger, including legal, accounting and a portion of the financial advisory fees, whether or not the merger is completed.

3. Cusomer uncertainties related to the merger could adversely affect the business, revenues and gross margins of HP, Compaq and the combined company.

In response to the announcement of the merger or due to ongoing uncertainty about the

merger, customers of HP or Compaq may delay purchasing decisions or elect to switch to other suppliers. In particular, prospective customers could be reluctant to purchase the combined company's products due to uncertainty about the direction of the combined company's product offerings and willingness to support and service existing product. Neither HP nor Compaq is aware of any loss of customers, as a result of the merger process that would have material impact on their respective results of operations. Customer assurances may be made by HP and Compaq to address their customers' uncertainty about the direction of the combined company's product and related support offerings which may result in additional obligations of HP, Compaq or the combined company. Accordingly, quarterly revenues and net earnings of HP, Compaq or the combined company could be substantially below expectations of market analysts and a decline in the companies' respective stock prices could result.

4. Changes in the credit ratings could adversely affect the costs and expenses of the combined company.

Any downgrade in the credit ratings of HP, Compaq or the combined company related with the merger could adversely affect the ability of the combined company to borrow, and result in more restrictive borrowing terms, including increased borrowing costs, more restrictive covenants and the extension of less open credit. This in turn could affect the combined company's internal cost of capital estimates and therefore operational decisions.

5. The economic downturn could adversely affect the revenues, gross margins and expenses of the combined company.

The revenues and gross margins of the combined company will depend significantly on the overall demand for computing and imaging products and services, particularly in the product and service segments in which it will compete. Softening demand for the product and services of HP and Compaq caused by the ongoing economic downturn may result in decreased revenues, earnings levels or growth rates and problems with the saleability of inventory and reliability of customer receivables for the combined company. HP and Compaq have observed effects of the global economic downturn in many areas of their businesses. The downturn has contributed to reported net revenue declines during the 2001 fiscal year for both companies. Each of HP and Compaq has also experienced gross margin declines, reflecting the effect of competitive pressures. In

the case of HP, inventory write downs and charges associated with the cancellation of planned production line expansion. HP's selling, general and administrative expense also was impacted due to an increase in bad debt write-offs and additions to reserves in its receivables portfolio. Further, delays or reductions in information technology spending could have a material adverse effect on demand for the combined company's products and services, and consequently, its results of operations, prospects and stock price.

6. The competitive pressures the combined company will face could harm its revenues, gross margins and prospects.

The combined company will encounter aggressive competition from numerous and varied competitors in all area of its business, and will compete primarily on the basis of technology, performance, price, quality, reliability, brand, distribution, customer service and support. If the combined company fails to develop new products, services and support, it could harm its operations and prospects. Moreover, the combined company may have to continue to lower the prices of many of its products, services and support to stay competitive, meanwhile trying to maintain or improve gross margins. Both HP and Compaq believe that the merger will result in improvement to gross margin on a

combined company basis, principally through lower procurement costs and the eliminations of redundant headcount. It is very important for business such as PCs and low-end servers to have the ability to respond to competitive pricing pressures by effectively managing inventory costs. However, if the combined company cannot decrease its cost structure in response to competitive price pressure, its gross margins and the profitability of the combined company could be adversely affected.

7. Due to the international nature of the combined company's business, political or economic changes could harm its future revenues, costs and expenses and financial condition.

Sales outside the United States will make up more than half of the combined company's revenue after the completion of the merger. The future revenues, costs, expenses of the combined company could be adversely affected by a variety of international factors. It could include overlap of different corporate structures; import or export licensing requirements; problems caused by the conversion of various European currencies to the Euro and macroeconomic dislocations that may result.

The above challenge facing to HP and Compaq will affect the success of merger. At the time of completion of merger, both companies not only make expectation of benefit and synergies which could be incurred after the merger, but also need to consider about these risk resulting from the merger, which could adversely affect the expectation. On the basis of the analysis of risk factors and the situation of the two companies at that moment, it is possible that the forecast benefit and synergies by the two companies cannot be realized. Hence, before the merger, the expectation of the merger as well as the forecast benefits should be measured by taking into account of the risk factors.

Chapter 6 Conclusion

According to the above analysis concerning about the motivation and risk of the merger, it can be shown that the forecast benefit is not definite, which depends on the varieties of factors, such as integration of technology, operations, and personal, customer uncertainty, economic downturn, etc. However, as the transition of IT industry, considering the situation of Compaq and HP at that moment, HP and Compaq share the conviction that advances in technology, increased competition and changing customer requirements are rapidly transforming the structure and economics of the information technology industry in ways that demand quick and decisive action to remain competitive. Both companies need to innovate new product and service to meet increasing customers' needs, as well as enlarge market share. Merger, as a possible way to realize their aim, is a suitable strategy for them to maintain their competitive position in IT industry. It is reasonable for HP and Compaq to complement with each other in technology and innovate new product and enhance service. By the merger, both companies can not only enlarge the market share but also save cost. If the merger is completed properly according to the plan and succeed, synergy from the merger can be realized either in the strategy or in the finance.

Among numerous alternative strategies to position the two companies, the merger may be seen as a unique opportunity to create a combined company with a stronger, more efficient operating model than either company. It could bring strategic benefit and financial benefit to both companies. From the aspect of strategy, the merger could expand and strengthen their product and service offerings, accelerating the combined company's leadership position as an end-to-end solution provider. From the aspect of financial benefit, the merger will generate substantial cost savings and increase the profitability for the combined business. The forecast financial benefit from the merger expected by the two companies is based on the reasonable assumption. In addition, shareowners value of both companies could be increased through improved earning. Accordingly, the merger is advisable and in the best interest of Compaq and HP. It should go ahead at that moment. As for the future of merger, whether it will really bring the benefit to the combined company will depend on the successful operation of the new combined company and the consistently changing IT industry.


Financial performance of Compaq in 2001:


$ millions% change from 2000:

Revenues33,554.0 -20.8

Profits-785.0 -238.0

Assets23,689.0 --

Stockholders' Equity11,117.0 --

Market Value 3/14/200218,190.0 --

Profits as % of




Stockholders' Equity-7.1

Earnings Per Share

2001 $-0.47

% change from 2000: -242.4

1991 - 2001 annual growth rate %N/A

Total Return to Investors


2001 -34.7

1991 - 2001 annual rate18.9

Financial performance of HP in 2001:


$ millions% change from 2000:

Revenues45,226.0 -7.3

Profits408.0 -89.0

Assets32,584.0 --

Stockholders' Equity13,953.0 --

Market Value 3/14/200237,663.0 --

Profits as % of




Stockholders' Equity2.9

Earnings Per Share

2001 $0.21

% change from 2000: -88.3

1991 - 2001 annual growth rate %-5.7

Total Return to Investors


2001 -34.1

1991 - 2001 annual rate14.6


Ross, S. 1996, Corporate finance, Richard D. Irwin, Chicago.

Burrows, P. April 1, 2002, what price victory at Hewlett-Packard, Business Week,


Burrows, P. May 20, 2002, what's in store for this happy couple, Business Week, USA.

Edwards, C. June 17, 2002, HP and Compaq: IT's showtime, Business Week, Boston


Proxy statement