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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 1. STRENGTHS The HP way symbolized innovation, integrity, flexibility and teamwork Long term dominance in imaging and printing Strong in high end servers Strong in UNIX market OPPORUNITIES End-to-end solutions strategy for server, storage and services businesses achieved through acquisitions of significant industry participants A merger with Compaq would be able to consolidate HP as a market leader Needed to build strong complementary business lines 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

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SWOT Analysis of Compaq STRENGTHS 1. Market leader in PCs 2. Worlds leading supplier of Storage systems

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

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

THREATS 1. Slimming industry margins 2. A rapidly changing environment where technology has a short halflife 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 The new company can exploit the fast growing trend of storage area networks by using HPs strength in servers and Compaqs expertise in storage Strong brand recognition Merger would create a full-service technology firm capable of doing everything from selling PCs and printers to setting up complex networks 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. WEAKNESSES 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

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OPPORUNITIES 1. Merger could improve economics and innovation through economies of scale 2. Strengthen leadership in storage 3. Market growth in IT services 2) Was the merger strategy sound?

THREATS 1. Dell increases pressure in low end server markets 2. Dell also cuts prices in PCs to eat away market share from HPQ 3.

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 Capellas 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 HP's equity value = $23.21 * 1974m shares Value of HPQ (HP + Compaq) Compaq will own 36% of the combination = 20859.15 45816.54 66675.69 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 Revenue

2003

2004 92.8

2005 103.01

Revenue Gain/Loss Cost Savings 0 0

-0.5 2.5

3.61 2.575

Total Gain Terminal value of synergies Post Tax value of Synergy 2002 value of synergies 0.00 0.00 26.74 0.00 0.00

6.18 53.05 59.23 45.01

2.00 1.52

Assumptions Revenue Growth Rate Perpetual Growth Rate Cost of Equity/Discount rate Synergy gain from Revenue

11% 3% 15% 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.

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Pessimistic View 2002 Revenue

2003 2004 92.8

2005 103.01

Revenue Gain/Loss Cost Savings 0 0

-0.5 2.5

0.00 2.575

Total Gain Terminal value of synergies Post Tax value of Synergy 2002 value of synergies 0.00 0.00 11.72 0.00 0.00

2.58 22.10 24.68 18.75

2.00 1.52

Assumptions Revenue Growth Rate Perpetual Growth Rate Cost of Equity/Discount rate Synergy gain from Revenue

11% 3% 15% 0% of 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 % Synergy Shared by HP to Compaq 50% Synergy 100% Synergy Shared Shared 13.37 26.74 1.689 7.91 1.689 15.83

Pessimistic % Synergy Shared by HP to Compaq 50% Synergy 100% Synergy Shared Shared 5.86 11.72 1.689 3.47 1.689 6.94

No of shares outstanding Per Share Synergy PreAnnouncement Stock Price of Compaq Share Price Range Valuation Range

12. 35 20.26 28.18 15.82 19.29

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 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 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 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 Shareholders
Stock

Heloise Merger Corp

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 Compaqs assets through a wholly owned subsidiary, thereby limiting HPs exposure to Compaqs liabilities.
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6) Evaluate the exchange ratio and accretion/ dilution impact?


The final Exchange Ratio Exchange ratio implied by the market as on 31 Aug, 2001 Exchange ratio implied by the 12 month market performance of HP and Compaq stocks 0.6325 HPQ shares per Compaq share 0.5356 HPQ shares per Compaq share 0.598 HPQ shares per Compaq share

Period ending Aug 31 2001 31-Aug-01 3 month average 6 month average 12 month average

Market Price for Compaq shares 12.35 14.20 15.72 19.40

Market Price of Compaq shares 23.21 25.49 27.58 32.45

Average Exchange ratio 0.532 0.557 0.570 0.598

Implied Acquisition Premium paid by HP (in %) 18.9 13.7 8.2 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. 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 criterias 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 criterias 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 HPs and Compaqs 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 firms 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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