May 8, 2002

Open Source may help save HP-Compaq deal

Author: JT Smith

- by Jack Bryar -

As HP and Compaq struggle to make their unlikely merger work, there's a lot riding on the deal for both HP's CEO, Carly Fiorina and her new "subordinate," President Mike Capellas. Both have a lot invested on how the deal plays out, and it is not entirely
clear who will run the company a year from now. One essential factor may be
whether Capellas' advocacy of Open Source helps save HP's computer business.
Some commentators suggested that the HP/Compaq merger project "Abelard" was well named. Before this deal, the most famous Abelard in
history was a medieval French monk, forcibly castrated by a mob after
having sex with Heloise, one of his students. It hasn't got quite that
rough in the boardroom, but the mob may not be through with Fiorina
quite yet. At every level, the merged company's CEO is being challenged
by her subordinates, her investors, and her financiers.

One of the most striking details of the merger is the extent to
which Compaq, supposedly the junior partner in the deal, seems to be coming
out on top as the deal is executed. Headed for the boneyard is HP's
NetServer line. The "New HP" will adopt Compaq's Proliant servers,
running the client's choice of Windows, Linux, or bare bones. HP will also dump
its Journada line of PDAs in favor of the iPAQ. Capellas said aloud
what many observers thought when he announced, in advance of the
official HP announcement, "You are what you eat. The New HP in many ways will
resemble the old Compaq."

Not only is the hardware mostly Compaq. So is much of
the mid-level management team. For example, HP's channel chief Kevin
Gilroy has been moved over to concentrate on reselling consumer HP boxes at
Kmart and Staples. Compaq's Dan Vertrees will run the high-profile job of
handling the enterprise integration and VAR markets. Outside the United States, Compaq
executives are heading up many of the country manager positions. In India, for
example, every division except printing will be run by an ex-Compaq exec.

Fiorina may well prefer ex-Compaq managers to her own managers, many
of whom have been downright hostile to their CEO. During the course of
the merger, the tech press was flooded by letters from retirees and
employees suggesting that Fiorina is little more than an East Coast "suit" who
doesn't appreciate HP's "engineering leadership." Polls conducted by merger
opponent Walter Hewlett found that HP employees were opposed to the deal.
Fiorina's stint at Lucent Technologies, where she positioned a tired
communications company saddled with tons of old-technology big iron into one of the
biggest telecom IPOs of the dot-com boom, has not helped her reputation with the
"old bulls" in the HP engineering and R&D staff. It has not done much
for her reputation among many institutional investors, who bought lots
of bad paper, and who have long memories.

That negative sentiment nearly sank the merger. Once investors began
lining up against the merger, Fiorina only won the deal by declaring war against the Hewlett family. Most observers believe the
deal went through because the company had stalled so long that many
institutional investors feared a complete implosion if the merger failed. All the
same, the deal nearly didn't get done. Fiorina only got a majority after one German
investment bank changed its vote. The final tally was 838,401,376 shares in favor,
793,094,105 shares against. In an era when most mergers are typically
approved by 9:1 ratios, this is no vote of confidence.

While Fiorina may have gotten her merger, the investment community is
still throwing rocks at both the new company and its leader. Several
investment analysts greeted news of the merger by re-iterating their "neutral"
rating, which, in consultant-speak means, "run for the hills." Bear Stearns'
Andrew Neff and Naveen Bobba expressed their doubts about Fiorina's ability
to execute the merger plan, scathingly suggesting that she needed to
move from PowerPoint slides to reality. Some of HP's "friends" were even
more negative. The one analyst who gave the company a "buy" rating asked why
the company chose HPQ as its new corporate ticker symbol when both "YUK"
and "PU" were available.

Credit market types are even less impressed. George King at Alliance
Capital Management said that the only debate among his peers was "just
how negative it will be." Moody's Investor Service recently put the
company's unsecured debt on review for a possible downgrade. Fitch Ratings Service
assigned an F1 rating to the newly merged company's commercial paper
program and gave HP a rating outlook of negative. While
unpromising, this actually represents a slight upgrade from an even more negative
opinion during the last few months.

There is a good reason for much of this negative sentiment. According
to Dataquest, HP suffered a 35% drop in demand for its workstations in
the last year. By comparison, Compaq only lost 1% of its business. In
any other year that would not be much to brag about, but this was a year
when most players not named Dell or IBM suffered double-digit losses. The
combined HP and Compaq dominate PC sales in stores and through resellers, but
their market share has been falling off -- rapidly in some cases. HP's share of
the PC market has dropped 6% in just the last month. Compaq's decline
has been less abrupt, although its store sales have fallen by more than a
third over the last year and it has lost share among commercial customers as
well.

The situation places Capellas in an interesting position, not
much different from the one that emerged when he took over at Compaq
originally. Capellas, who built a reputation as a skilled corporate infighter, has
been happily driving up expectations in a way that further exposes his
new boss. Most analysts have suggested that the company will take
anywhere from 18 to 36 months to recover, and that only deep cost cutting will
justify the merger. However, Capellas stated that the company had only a "six
month window" in which to justify the merger, and that "the only reason for
making a big strategic move like this is to gain leadership." He add that the
market should judge HP (and presumably, his boss) by the degree to which
the merger "stimulates innovation" by HP's unhappy engineers, not by how
much it saves in costs.

Capellas has also made a number of other interesting statements
deviating from the official HP catechism. While the company's official position is
that it will continue to support both its PC lines and storage
solutions, Capellas has pointed out the merged company will start with an
unwieldy line card of nearly 10,000 products. The company announced Tuesday that
it will support its HP and Alpha Unix servers, and will rely on a triad of
Linux, Windows, and proprietary platforms. However, the week before, Capellas
told reporters that products like HP's HP-UX were all but dead,
declaring, "You're going to see Linux and Windows absolutely eviscerate the
midrange Unix market." He also managed to dismiss HP's investment in proprietary
components, stating that HP would focus on "Microsoft Windows, Linux and
Intel chips."

While contradicting the boss is generally a poor career move,
Capellas' situation is somewhat different. The investment community was already
spooked by the large sell-off at Sun Microsystems when Ed Zander
"retired." Several of the institutional investors who finally did vote for the
merger have warned that they would look "very negatively" at any exodus of
"senior managers" resulting from the merger. If the merger is to succeed, it
will have to do so by growing the computer side of the business, and the most
prominent computer guy in the combined entity is Capellas.

A lot that future growth may depend on how just how well the company
manages Open Source. As Grant Gross noted in a column last week, HP's solutions team recently won a
number of high-profile deals with workstations running Linux. While the
company's efforts to win design and imaging deals with companies such as the
DreamWorks movie studio captured most of the headlines, the Linux sale at the U.S.
Department of Energy was more significant. One of the few places HP has maintained
market dominance is in engineering environments, especially
computer-assisted instrumentation. Linux is a natural winner in this environment.

If HP is to rebuild its workstation and computer integrated solutions business,
it will need to do so using superior, Compaq-based hardware, and Linux
code. Now that Capellas has emerged as the Open Source advocate with the
highest pay grade at HP, he will certainly want to make sure HP
continues to feature Linux solutions and that those deals are high-profile money makers
for the company. Success at HP will be important for the future of Open
Source, and for the future of Capellas.

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