INBK

The Merger of Hewlett-Packard and Compaq (A&B): Strategy Valuation and Deal Design Case Analysis

Submitted By: Amit Kumar Nahata Anindya Pal Reshma Jain Anshul Aggarwal

With HPs announcement in September 2001 that they would acquire Compaq in an all stock purchase valued at $25 billion began the worlds largest corporate Information Technology merger. The case highlights the various aspects pertaining to the merger. The document tries to analyze the case in the light of these aspects.

The Merger of Hewlett-Packard and Compaq (A&B) Case Analysis Case Facts
Hewlett-Packard (HP) was founded in 1939 by Bill Hewlett and Dave Packard By 2000 HP had 85,000 employees and revenues of 48.8 billion, and was ranked the 13th among the fortune 500 companies In July 1999, Carly Fiorina became the president and CEO of the company 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 In 2001 HP hired the services the of Mckinsey to help with its new strategy Mckinsey helped HP to open a negotiation 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% A reverse triangular merger would be followed 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 Post the merger announcement HPs stock fell by 18.7% Walter Hewett, member of HPs board of directors and Packard foundation, which controlled 10% of HP shares opposed the merger

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Industry Analysis
The computer hardware industry has evolved in a dramatic fashion over the decades, as market players are forced to shift strategies and product lines in order to focus where the market demand is most concentrated. This can be easily seen from the transition of mainframe supercomputers in the 70s, to examples abounding today: increasingly fast personal computers, mp3 players with gigabytes of storage, and PDA cell phones. This is an industry whose players have had to adapt quickly in order to match the constantly changing market demand.

Worldwide Annual PC Market Share (1999-2003)

20 Pct. M arket Share 15 10 5 0 1999 2000 2001 2002 2003 Year HP Compaq Dell IBM

Trends over the last five years tell the story of Dells increasing market share, at the cost of its competitors. This degree of competition prompted a merger between HP and Compaq in 2002, which accounts for HPs apparent explosion in PC sales in the graph above. On a quarterly basis, HP and Dell routinely trade the #1 spot in PC shipments. IBM has refocused its priorities to lucrative corporate customers, and other vendors such as Fujitsu and NEC focus primarily on the portable notebook market. In 2003, the PC industry grew 11 % as a whole. HP's slight edge on Dell in the global market was largely driven by the company's success in the consumer market in Europe. Dell has no physical outlets and thus tends to sell fewer total units than its largest competitor during the holiday season. Despite differing focuses, all players saw an increased demand by consumers for new systems.
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PORTERS FIVE FORCE ANALYSIS Bargaining power of buyers: Customers have considerable pricing negotiation power in this industry because of multiple vendors. It is customary for customers purchasing in this category to receive substantial discounts when as few as 50 machines are being purchased. However, as major corporations and governments usually have much higher IT system requirements, their purchase volumes often number in the thousands. This scenario allows customers to demand steep cuts in the price of hardware. Bargaining power of suppliers: It is high because in most cases, PC vendors manufacture no actual parts to the PCs they ship. Instead vendors focus on component interoperability and branding each product uniquely for marketing to the end user. This dependence on component manufacturers and suppliers can potentially lead to artificial shortages created by component suppliers. Threat of new entrants: It is relatively low because of huge capital investments required to enter into the market and then compete with the existing and well established players. But because of high profit margins of existing players, it can attract more players to enter. Threat of substitutes: With the advancement in technology, it is becoming quite a common site to see new and more innovative products coming up which can act as a replacement to the personal computers. Starting from high tech mobile phones to PDAs, all kinds of products are launched day in and day out. Hence threat of substitutes is becoming high. Intense segment rivalry: The PC hardware industry represents one of the most competitive markets today. There is a fight to gain more and more market share by either cost reduction or through differentiation. It is this kind of intense segment rivalry which prompted a multimillion merger between HP and Compaq.

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PESTLE ANALYSIS Political: Many countries still have restrictive policies to protect domestic manufacturers and suppliers. Government regulations and legal issues can hamper the growth of the industry when foreign players are not allowed to enter into the market. Economic: Overall high economic growth in the developing markets provides an opportunity for the PC vendors to jump and extract profits by serving these countries. Also in developed economies, there is huge demand for more advanced and more innovative computers. Social: The demand for a product such as computer depends upon the social life of the people in that country. The higher the education standard, the higher the automation, the higher the level of technology, the higher the demand for computers. Technological: Computer industry is one of the most technologically inclined industries. Increased research and development have caused permanent innovation processes which lead to short product life cycles resulting in a faster depreciation of the products.

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Company Analysis:
SWOT Analysis of HP STRENGTHS The HP way symbolized innovation, integrity, flexibility and teamwork Long term dominance in imaging and printing Strong in high end servers Strong in UNIX market OPPORUNITIES End-to-end solutions strategy for server, storage and services businesses achieved through acquisitions of significant industry participants A merger with Compaq would be able to consolidate HP as a market leader Needed to build strong complementary business lines WEAKNESSES 1. Only 15% of HP PCs shipped directly to customers whereas Dell and Compaq shipped all PCs directly to customers 2. Did not rank in the Top 3 in PCs, storage and services THREATS 1. Slimming industry margins 2. Strong competition from peers like Dell, Lexmark and Epson which were selling lower-quality inexpensive printers

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SWOT Analysis of Compaq

STRENGTHS 1. Market leader in PCs 2. Worlds leading supplier of Storage systems

WEAKNESSES 1. Constant poor performance 2. Not strong in UNIX market 3. Compaq missed the online bus and its made-to-order system through its retail outlets failed to take off due to bad inventory management

OPPORUNITIES 1. As the cost of making portable and desktop computers decreases, new markets for these products will open including smaller businesses and consumers. 2. A merger with HP would achieve positive operating margins through economies of scale

THREATS 1. Slimming industry margins 2. A rapidly changing environment where technology has a short halflife 3. Improvements in technology by suppliers as well as rivals makes it necessary to continuously create new and better products that will either meet or exceed that of the competitions. 4. Dell became strong competitor through cost efficiency

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SWOT analysis of HP-Compaq STRENGTHS 1. The new company can exploit the fast growing trend of storage area networks by using HPs strength in servers and Compaqs expertise in storage 2. Strong brand recognition 3. Merger would create a full-service technology firm capable of doing everything from selling PCs and printers to setting up complex networks 4. Merger would eliminate redundant product groups and costs in marketing, advertising, and shipping, while at the same time preserving much of the two companies revenues. OPPORUNITIES 1. Merger could improve economics and innovation through economies of scale 2. Strengthen leadership in storage 3. Market growth in IT services WEAKNESSES 1. Need to develop a direct distribution model for both the merging companies as a whole 2. In spite of merging, consulting services did not gain as much market share as expected

THREATS 1. Dell increases pressure in low end server markets 2. Dell also cuts prices in PCs to eat away market share from HPQ 3.

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Synergy Value Analysis

For any firm to merge with any other firm the main motive or rationale is that the value of the combined entity should be greater than sum of the individual entities and the transaction cost. This excess value is basically referred to as synergy. For Synergy Valuation we have considered two methods (refer to the calculations below): Quick and Dirty method of valuation Discounted Cash flow method Quick and Dirty Valuation Model

Calculation of how much HP pays to Compaq at an exchange ratio of 0.6325 Using pre-merger announcement market valuations of each company Compaq's equity value = $12.35 per Compaq share * 1689m shares HP's equity value = $23.21 * 1974m shares Value of HPQ (HP + Compaq) Compaq will own 36% of the combination = 20859.15 45816.54 66675.69 24003.25

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. Assumptions: Assuming that the markets are efficient and the pre-announcement stock price reflects the true value of the firm

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.

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Discounted Cash flow method In this valuation model we have used two scenarios namely Optimistic: Includes gain from Revenues along with Cost Savings in Synergy Pessimistic: Included only Cost Savings in Synergy Optimistic View 2002 2003 Revenue

2004 92.8

2005 103.01

Revenue Gain/Loss Cost Savings 0 0

-0.5 2.5

3.61 2.575

Total Gain Terminal value of synergies Post Tax value of Synergy 2002 value of synergies 0.00 0.00 26.74 0.00 0.00

6.18 53.05 59.23 45.01

2.00 1.52

Assumptions Revenue Growth Rate Perpetual Growth Rate Cost of Equity/Discount rate Synergy gain from Revenue

11% 3% 15% 3.5% of Revenues

Traditionally HP's operating margin has been 4.5% but after merger it is projected to be 8%. Therefore the excess increase of 3.5% is synergy gain from revenues

So based on the optimistic scenario a synergy value of $ 26.74 billion is achieved.

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Pessimistic View 2002 Revenue

2003 2004

2005

92.8 103.01

Revenue Gain/Loss Cost Savings 0 0

-0.5 2.5

0.00 2.575

Total Gain Terminal value of synergies Post Tax value of Synergy 2002 value of synergies 0.00 0.00 11.72 0.00 0.00

2.58 22.10 24.68 18.75

2.00 1.52

Assumptions Revenue Growth Rate Perpetual Growth Rate Cost of Equity/Discount rate Synergy gain from Revenue

11% 3% 15% 0% of Revenues

So based on the pessimistic scenario a synergy value of $ 11.72 billion is achieved.

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Appropriate Valuation Range for the Merger

All figures in billion $ except per share value

Optimistic % Synergy Shared by HP to Compaq 50% Synergy 100% Synergy Shared Shared 13.37 26.74 1.689 7.91 1.689 15.83

Pessimistic % Synergy Shared by HP to Compaq 50% Synergy 100% Synergy Shared Shared 5.86 11.72 1.689 3.47 1.689 6.94

No of shares outstanding Per Share Synergy PreAnnouncement Stock Price of Compaq Share Price Range Valuation Range

12. 35 20.26 28.18 15.82 19.29

34.23

47.59

26.72

32.58

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-Annoucement Price of the target company + Synergy per share On the basis of the above relationship HP can offer share price in the range of $ 15.82- 28.18. Also based on these estimates the valuation range of the deal comes to 26.72 billion 47.59 billion.

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The HP-Compaq Merger Deal Terms Summary: Compaq

Announcement Date Name of the merged entity Chairman and CEO President Ticker symbol change Form of payment Exchange Ratio Ownership in merged company Ownership of Hewlett Packard Families Accounting Method Merger method 4-Sep-01 Hewlett Packard Carly Fiorina Michael Capellas From HWP to HPQ Stock 0.6325 HPQ shares to each Compaq Shareholder 64% - former HWP shareholders 36% - former CPQ shareholders and 18.6% before merger 8.4% after merger Purchase Reverse Triangular Merger

The HP and Compaq Merger Deal Design:

The main part of the deal was its merger method i.e., Reverse Triangular Merger. A subsidiary, Reverse-Triangular Heloise Merger Corporation, created solely for merging with Compaq. This resulted in tax free taxreorganization in which HP would control all of Compaqs assets through a wholly owned subsidiary, through thereby limiting HPs exposure to Compaqs liabilities.

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Evaluation of Exchange Ratio and Accretion/dilution impact

The final Exchange Ratio Exchange ratio implied by the market as on 31 Aug, 2001 0.6325 HPQ shares per Compaq share 0.5356 HPQ shares per Compaq share

Exchange ratio implied by the 12 month market performance of 0.598 HPQ shares per Compaq share HP and Compaq stocks

Period ending Aug 31 2001 31-Aug-01 3 month average 6 month average 12 month average

Market Price for Compaq shares 12.35 14.20 15.72 19.40

Market Price of Compaq shares 23.21 25.49 27.58 32.45

Average Exchange ratio 0.532 0.557 0.570 0.598

Implied Acquisition Premium paid by HP (in %) 18.9 13.7 8.2 6.1

The exchange ratio decided for the deal is 0.6325, which is decided based on 40 months average (Exhibit-10). However, if we observe from the above table, the exchange ratio is changing depending on the time horizon taken. Since, the exchange ratio is fixed at 0.6325; the premium paid will also differ on the basis of time horizon taken into consideration for calculating the same.

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Is this deal A Merger of Equals?

As per theory Merger of equals combines two firms that have equal power. The board of directors and senior management of the old companies get absorbed and hold positions in the new company. Also the shareholders of the old companies share the prospective synergies equally. Considering the above theoretical criterias and using the figures from the table above (Pessimistic Scenario, 50 % Synergy division) the share price which HP should offered to Compaq is $ 15.82 , very close to the existing deal value of $ 14.68. Also the total deal value as per this scenario turns out to be $ 26.72 billion (close to the current deal value of $ 25 billion). So based on these criterias and figures calculated it can be inferred to be a Merger of Equals. Now considering the flip side of the coin i.e. considering an Optimistic Scenario, 50% Synergy value sharing we get a share price of $20.26 and a deal value of 34.23 Billion, which is significantly different and high compared to the current deal value. So based on these it appears not be a Merger of Equals deal. Also if we take the quick and dirty calculation method into consideration there also a significant premium has been paid to Compaq which negates the very criteria of equal premium sharing in Merger of Equals.

Evaluation of Integration Plan

HP has realized the difficulties and complexity of integrating the enterprises as the two companies differ in their culture and competencies in areas of operation. Thus, they have established an integration office to go through the whole process. The proposed integration plan called for a consolidation of HPs and Compaqs product lines into four major operating groups namely, services, imaging and printing, access devices, and information technology infrastructure. This implies that redundant and overlapping product groups would be eliminated and would result in cost savings.

According to the projected plan, the new company would remain competitive in individual product segments and the merger would results in a full-service technology firm capable of integrating hardware and software into solutions while providing services at the same time. Also, the management of both companies believe that since HP and Compaq are at 8th and 9th
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positions respectively, in the IT service market share, the combined firms rank would jumped to 3rd.

However, the above projections reflect the optimistic perspective of the management of both the companies. The synergies to achieve in individual segments as projected (Exhibit 5) are difficult to achieve as the synergy risk is very high. The assumption that combined entity would reach to 3rd rank in IT services is just an over optimism on the part of management as they are ignoring the fact that other competitors, such as Dell and IBM are very strong in market and they will also react to the merger and try to reduce their costs and improve their operations. Also, considering the fact that in 2002- 2004 there has been revenue loss due to the merger of personal computer business and enterprise business. In addition the markets have reacted negatively to the deal.

Vote or Not to Vote

The share price of HP dropped in the wake of the announcement of the deal, but considering the synergy values the deal is expected to generate in the range of $ 11.72 billion $ 26.74 billion, the shareholders stand to benefit if the deal goes through in the long run. Thus as a shareholder of the company it should vote for the deal. Though one of the board of Directors of the company Mr. Walter Hewett and the Packard foundation (both jointly holding 18.6 % shares of the company) are opposing the deal but it cannot be ascertained with certainty their assumptions and also their motives of opposing the deal since they stand to loose in terms of equity dilution (their holding reduces to 8.4%) post the deal.

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