62317203 HP Case Analysis

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.

of 16

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

of 16

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.

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.

Worldwide Annual PC Market Share (1999-2003)

0

5

10

15

20

1999 2000 2001 2002 2003

Year

Pct. Market Share

HP

Compaq

Dell

IBM

of 16

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.

of 16

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.

of 16

Company Analysis:

SWOT Analysis of HP

STRENGTHS WEAKNESSES 1. “The HP way” symbolized

innovation, integrity, flexibility and teamwork

2. Long term dominance in imaging and printing

3. Strong in high end servers 4. Strong in UNIX market

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

OPPORUNITIES THREATS 1. “End-to-end” solutions strategy for

server, storage and services businesses achieved through acquisitions of significant industry participants

2. A merger with Compaq would be able to consolidate HP as a market leader

3. Needed to build strong complementary business lines

1. Slimming industry margins 2. Strong competition from peers like

Dell, Lexmark and Epson which were selling lower-quality inexpensive printers

of 16

SWOT Analysis of Compaq

STRENGTHS WEAKNESSES 1. Market leader in PCs 2. World’s leading supplier of

Storage systems

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 THREATS

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

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

of 16

SWOT analysis of HP-Compaq

STRENGTHS WEAKNESSES 1. The new company can exploit the fast

growing trend of “storage area networks” by using HP’s strength in servers and Compaq’s 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.

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

OPPORUNITIES THREATS 1. Merger could improve economics and

innovation through economies of scale

2. Strengthen leadership in storage 3. Market growth in IT services

1. Dell increases pressure in low end server markets

2. Dell also cuts prices in PCs to eat away market share from HPQ

3.

of 16

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.

of 16

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%

Synergy gain from Revenue 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.

of 16

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%

Synergy gain from Revenue 0% of

Revenues

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

of 16

Appropriate Valuation Range for the Merger

All figures in billion $ except per share value Optimistic Pessimistic

% Synergy Shared by HP to

Compaq % Synergy Shared by HP to

Compaq

50% Synergy Shared

100% Synergy Shared

50% Synergy Shared

100% Synergy 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 Compaq

12.35

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.

The HP-Compaq Merger Deal Terms Summary:

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 and Packard Families

Accounting Method

Merger method

The HP and Compaq Merger Deal Design:

The main part of the deal was its merger method i.e., Reverse

Heloise Merger Corporation, created solely for merging with Compaq. This resulted in tax

reorganization in which HP would control all of Compaq’s assets th

thereby limiting HP’s exposure to Compaq’s liabilities.

Compaq Merger Deal Terms Summary:

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

Ownership of Hewlett 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,

Heloise Merger Corporation, created solely for merging with Compaq. This resulted in tax

reorganization in which HP would control all of Compaq’s assets through a wholly owned subsidiary,

thereby limiting HP’s exposure to Compaq’s liabilities.

Page 12 of 16

Triangular Merger. A subsidiary,

Heloise Merger Corporation, created solely for merging with Compaq. This resulted in tax- free

rough a wholly owned subsidiary,

of 16

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 HP and Compaq stocks

0.598 HPQ shares per Compaq share

Period ending Aug 31 2001

Market Price for Compaq shares

Market Price of Compaq shares

Average Exchange ratio

Implied Acquisition Premium paid by HP (in %)

31-Aug-01 12.35 23.21 0.532 18.9 3 month average

14.20 25.49 0.557 13.7

6 month average

15.72 27.58 0.570 8.2

12 month average

19.40 32.45 0.598 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.

of 16

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

of 16

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.

62317203 HP Case Analysis

Documents

Transcript of 62317203 HP Case Analysis