IMT HYDERABAD

The Merger of Hewlett-Packard and Compaq (A&B): Strategy

Valuation and Deal Design
Case Analysis
Submitted by : Pankaj Gaurav
1/17/2014
Case Analysis: Merger of HP & Compaq: Strategy,
Valuation and Deal Design
1) What would a SWOT analysis reveal?
SWOT analysis of HP
STRENGTHS
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
OPPORUNITIES
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
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. 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
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.
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 4. Dell became strong competitor
through cost efficiency

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.

2) Was the merger strategy sound?

The strategy followed for the merger was not very sound because:
Proper due diligence was not exercised considering various factors
The shareholders and employees response was not taken into consideration which led to fall in the
market price and also lot of resistance from the stakeholders
Various issues like Capella’s role in the combined company was not fixed which resulted in Compaq
calling off the talks.
A proper due diligence for cultural integration was also not done pre merger which could result in
increased integration cost for the merged company.
Both companies were having different pricing strategy which could create a problem post merger.

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Positive aspects:
1. Such a merger be an opportunity to take a competitive advantage over its rivals like IBM
2. Development of markets
3. Propagated efficiencies
4. Allowances to use more resources
5. Better opportunities
Negative aspects
1. Legal contemplations
2. Compatibility problems
3. Fiscal catastrophes
4. Human resource differences
5. Lack of determination

3) What was the value of synergies?

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

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 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.

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

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 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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4) What was the appropriate valuation range for the merger?
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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5) Evaluate the deal terms
The HP-Compaq Merger Deal Terms Summary

Announcement Date 4-Sep-01

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
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
18.6% before merger
8.4% after merger
Purchase
Reverse Triangular Merger

The HP and Compaq Merger Deal Design:

Hewlett
Compaq
Packard

Stock (cash for fractional share)

Compaq Heloise
Shareholders Merger
Corp
Stock

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- free 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.

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6) Evaluate the 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.

There is a dilution in EPS of the shareholders of HP, post merger. The EPS per share HP prior to merger
is being diluted from $ 0.32 to $ ().34). Hence there is a reduction of 66 cents in the EPS and with EPS
in negative P/E ratio at CMP of $ 23.21 is infinity. This dilution is before the consideration of synergy
realization.

7) Critique the 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
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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”.

8) Evaluate the 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 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.

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9) Decide how 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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