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 HP’s announcement in September 2001 that they would acquire Compaq in an all stock
purchase valued at $25 billion began the world’s 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 HP’s 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 HP’s stock fell by 18.7%
− Walter Hewett, member of HP’s 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 70’s, 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. Market Share

15 HP
Compaq
10
Dell
5 IBM

0
1999 2000 2001 2002 2003
Year

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

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SWOT Analysis of Compaq
STRENGTHS
1. Market leader in PCs
2. World’s leading supplier of
Storage systems
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
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
THREATS
1. Slimming industry margins
2. A rapidly changing environment
where technology has a short half-
life
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 WEAKNESSES
1. The new company can exploit the fast 1. Need to develop a direct distribution
growing trend of “storage area model for both the merging
networks” by using HP’s strength in companies as a whole
servers and Compaq’s expertise in 2. In spite of merging, consulting
storage services did not gain as much market
2. Strong brand recognition share as expected
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 THREATS
1. Merger could improve economics and 1. Dell increases pressure in low end
innovation through economies of server markets
scale 2. Dell also cuts prices in PCs to eat
2. Strengthen leadership in storage away market share from HPQ
3. Market growth in IT services 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 20859.15

HP's equity value = $23.21 * 1974m shares 45816.54

Value of HPQ (HP + Compaq) 66675.69

Compaq will own 36% of the combination = 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 2004 2005

Revenue 92.8 103.01

Revenue Gain/Loss -0.5 3.61

Cost Savings 0 0 2.5 2.575

Total Gain 2 6.18

Terminal value of synergies 53.05

0.00 0.00 2.00 59.23
Post Tax value of Synergy 0.00 0.00 1.52 45.01
2002 value of synergies 26.74

Assumptions
Revenue Growth Rate 11%
Perpetual Growth Rate 3%
Cost of Equity/Discount rate 15%
3.5% of
Synergy gain from Revenue 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 2003 2004 2005

Revenue 92.8 103.01

Revenue Gain/Loss -0.5 0.00

Cost Savings 0 0 2.5 2.575

Total Gain 2 2.58

Terminal value of synergies 22.10

0.00 0.00 2.00 24.68
Post Tax value of Synergy 0.00 0.00 1.52 18.75
2002 value of synergies 11.72

Assumptions
Revenue Growth Rate 11%
Perpetual Growth Rate 3%
Cost of Equity/Discount rate 15%
0% of
Synergy gain from Revenue 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 Pessimistic
% Synergy Shared by HP to % Synergy Shared by HP to
Compaq Compaq
50% Synergy 100% Synergy 50% Synergy 100% Synergy
Shared Shared Shared Shared
13.37 26.74 5.86 11.72
No of shares
outstanding 1.689 1.689 1.689 1.689
Per Share
Synergy 7.91 15.83 3.47 6.94
Pre-
Announcement
Stock Price of 12.
Compaq 35
Share Price
Range 20.26 28.18 15.82 19.29

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

The HP and Compaq Merger Deal Design:

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

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Evaluation of Exchange Ratio and Accretion/dilution impact
The final Exchange Ratio 0.6325 HPQ shares per Compaq share

Exchange ratio implied by the market as on 31 Aug, 2001 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 Market Price Market Price Average Implied Acquisition

ending Aug for Compaq of Compaq Exchange Premium paid by HP (in
31 2001 shares shares ratio %)
31-Aug-01 12.35 23.21 0.532 18.9
3 month 14.20 25.49 0.557 13.7
average
6 month 15.72 27.58 0.570 8.2
average
12 month 19.40 32.45 0.598 6.1
average

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 criteria’s 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 criteria’s 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 HP’s and Compaq’s 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 firm’s 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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