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

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Case Analysis: Merger of HP & Compaq: Strategy, Valuation and Deal Design

1) What would a SWOT analysis reveal?

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 SWOT Analysis of Compaq STRENGTHS WEAKNESSES

1. Market leader in PCs 1. Constant poor performance 2. World’s leading supplier of 2. Not strong in UNIX market

Storage systems 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 1. Slimming industry margins and desktop computers decreases, 2. A rapidly changing environment

new markets for these products where technology has a short half-

will open including smaller life

businesses and consumers. 3. Improvements in technology by

2. A merger with HP would achieve suppliers as well as rivals makes it

positive operating margins necessary to continuously create

through economies of scale 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

Optimistic

Pessimistic

per share value

% 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

1.689 1.689

1.689 1.689

outstanding

Per Share

7.91 15.83

3.47 6.94

Synergy

Pre-

Announcement

Stock Price of 12.

Compaq 35

Share Price

20.26 28.18

15.82 19.29

Range

Valuation

34.23 47.59

26.72 32.58

Range

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 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:

Stock (cash for fractional share)

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.

Compaq Hewlett

Packard

Compaq

Shareholders

Heloise

Merger

Corp

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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.