HP entered into an agreement with Compaq Computer Corporation in September 2001. In this definitive agreement, HP is going to purchase all of Compaq’s common shares outstanding, and pay a total price of 0. 6325 shares of its common stock for each share of Compaq’s common stock. To evaluate this transaction for the benefits of HP’s shareholders, we use the excess earnings model to forecast HP’s stock price if it standalone, CPQ’s stock price as a separate company and the stock price after the merger.
Then we make a comparison between HP’s stock price when it operates alone and the stock price after the merger to make the decision of merger. HP as Standalone HP had 3 principal business segments – Imaging and Printing Systems (IPG), Computing Systems and IT Services. The market of IPG, HP’s core business, was very competitive with respect to pricing and the introduction of new products. Since IPG market has become mature, the gross margin decreased from $13,824 in year 2000 to $11,752 million in 2001. On the other side, the revenue of IT Services grew 6% in the fiscal year of 2001.
The growth revenue from IT services is due to the increased investment in it since HP settled on a strategy of developing its IT services business by mid-2000. We assume that, on the one hand, the IPG’s revenue is going to decline in the future because of the competitive market and the declining pricing and that the IT services business is not able to get high percentage of growth in revenue except another company will help HP to improve its IT services business. On the other hand, sales outside U. S made up more than half of HP’s revenues and HP’s historical growth record is stable in a long term.
Concerning that the global economic environment would be improved in the future and the advantage of global selling, we then make assumptions that the revenue growth rate would be 5. 5% and the ROE would be 15% in the model. Therefore, the model stock price would be $10. 9 per common share. (See Exhibit 1) Compaq as Standalone Compaq Computer Corporation was a company that started itself as a personal computer company in the year 1982. CPQ’s principal business segments are Enterprise Computing, Access and Compaq Global Services.
It was the large manufacturer of personal computing devices worldwide and have good reputation in the market. However, due to Compaq faced a downturn in consumer demand and a high competition market for commercial PCs and its commitment to lower channel (CPQ’s resellers and distributors) inventory, CPQ’s revenue declined 21% in the fiscal year of 2001. We assume that the estimated revenue growth rate used in the model is 2%, which is taking the considerations of the economic weakness and the negative growth trend in the long run.
ROE is 2% compared with -1%, which is the terrible historical average ratio over the past five years. Based on the valuation model, the Compaq’s estimated stock price is $3. 1 per share. (See Exhibit 2) The Merger of HP and Compaq Obviously, there are some strategic benefits of the merger. Firstly, both of the companies focused on growing their computing systems business and IT services business. HP increased the investment on IT services and CPQ created the Compaq Global Solutions to enhance the IT services.
Secondly, the two companies had strengths in the areas that they could become a major force in the market after the merger. Last but not the least, there are also the financial benefits the shareholders could benefit. Through major cost savings and improved profitability of business, management had projected annual cost savings of $2. 5 billion by mid-2004 even taking into account revenue losses of $4. 1 billion in 2004. Although HP and Compaq can get some benefits on the processing of merger, there are more risks and uncertainties in this merger.
The two companies may lose their own advantage and fail to get the competitive advantages they had expected. In addition, HP’s core valued employees may leave the companies because of the mergers. Based on the above considerations, the Ke ratio of the merger company will be 11. 54%. Furthermore, for the revenue growth and ROE of the merger company, there are more risks than benefits. HP’s revenue may have a recession curve in the short term. Although the merger will bring cost savings of $2. 5 billion, HP cannot realize these expected benefits immediately.
Other than this, there were questions on the organization culture as well. If HP could not manage its organization properly, integration would only add on to the difficulties. The biggest factor of all is that to integrate the culture existing in the two companies would be a very difficult job. Based on all the considerations, we assume that the revenue growth rate after the merger would be 3. 5% and the ROE would be 11%. And as a result, the combined stock price would be 9. 0. (See Exhibit 3). Conclusion
Based on the results of the valuation model, we made the assumption to project the financial performance for HP, CPQ and the combined company, which is reflected in the stock price. As shown in Exhibit 4, the shareholders of HP will have the loss of 1. 85 which is negative. In the contrary, the shareholders of Compaq will earn the benefits of 2. 52 from the merger. In the view of what have analyzed above, as an advisor for HP’s shareholders, I don’t recommend that HP go ahead with this merger acquisition of Compaq.
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