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Wednesday, April 21, 1999

An Investment Opinion
by Louis Corrigan

Compaq's Management Broke Compact

Morality tales leave us feeling a righteous satisfaction because things end as they should, with villainous characters getting their due. That's why I felt joyful when I first heard the news that leading PC and enterprise computing firm Compaq (NYSE: CPQ) had booted CEO Eckhard Pfeiffer and CFO Earl Mason from their jobs over the weekend. They deserved it.

The proximate cause of this shakeup was Compaq's surprise Q1 earnings disappointment, but that was simply the final shoe to fall. As I've said several times, these guys repeatedly exhibited disdain for individual investors by disclosing material news to a handful of analysts and money managers. The capricious and arrogant way they handled disclosure not only flouted the spirit of the securities laws but proved indicative of broader problems regarding these executives' integrity and judgment. Bottom line: the Pfeiffer-Mason regime had lost credibility. That's why investors initially bid up Compaq shares Monday morning. Whatever challenges the company faces -- and they're no doubt significant -- a change in leadership was simply long overdue.

Let's review a little history. In September 1997, a member of Compaq's top management appeared at an investment conference and told a small group of Wall Street professionals that the firm was raising its year 2000 revenue target by 25%, from $40 billion to $50 billion. With these institutional investors racing to the phones, the stock hopped to a 14% gain by the opening of trading the next day. No question, this was the kind of material information an investor would want to know before making an investment decision. The only trouble was, Compaq never bothered to issue a press release with this news. Investors had to rely on a secondhand account offered by Dow Jones, which got the news from an analyst attending the meeting. A day late, 14% short.

Of course, Compaq hasn't just kept good news confined to select investors. reported last June that Mason told a closed-door meeting of professional investors at the PaineWebber Growth & Technology conference that the firm was "headed toward a money-losing quarter, according to two people who attended the session." At the time, analysts were looking for earnings of $0.01 a share, as Compaq was still suffering through an inventory glut. While many companies still close their "breakout Q&A sessions to reporters, few ever close their actual presentations, which Compaq did in this case.

More recently, Compaq shares got hit in February after another case of selective disclosure. According to a recent Bloomberg report, Credit Suisse First Boston analyst Michael Kwatinetz was touring Compaq's facility in February with a small group of investors when a Compaq executive (Mason, by some accounts) confessed that PC sales had shown "softness" in January. Kwatinetz immediately cut his estimates, with other analysts quickly following. This was basically an unannounced earnings warning.

This news becomes more interesting in light of the fact that Mason sold 265,000 shares of Compaq for more than $12 million on February 1. That's an average price of over $46 per share, nearly double today's close of $24. Did Mason already know Compaq would miss its Q1 earnings estimates? The attorneys behind a raft of shareowner lawsuits will certainly try to make the case. Although lawsuits are a dime a dozen following huge price declines in tech stocks, the plaintiffs here just might have a chance.

Of course, the credibility of both Mason and Pfeiffer has been in doubt for a while. On January 21, 1998, Pfeiffer said he expected a "strong 1998" with "improve[d] profitability." Yet, the firm was just six weeks away from pre-announcing an absolutely disastrous first quarter due to massive amounts of excess inventories in its reseller channel. Indeed, even as Compaq was talking up a move to a build-to-order model a la Dell (Nasdaq: DELL), with accompanying projected improvements in asset management, inventories were getting even more out of hand.

That's one reason Compaq's stock could hardly get off the mat after being pummeled during the October 1997 market break. Potential trouble soon began registering not just with short-sellers but with analysts, too. The Wall Street Journal ran a "Heard on the Street" column on February 12, 1998 addressing two questionable transactions that had an air of deceit about them. Compaq had factored $732 million in receivables in both the third and fourth quarter of 1997. That is, it had sold to a third party, at a discount, some of its uncollected customer bills. Factoring allows a firm to collect cash now rather than later, thus reducing the days sales outstanding while improving cash flow. Although a legitimate asset management tool, factoring is rare in the PC industry. In this case, it seemed designed to spruce up Compaq's performance metrics while hiding the fact that channel inventories were actually getting worse rather than better.

Donaldson, Lufkin & Jenrette analyst Kevin McCarthy noted at the time that without these transactions, Compaq's return on invested capital (ROIC) "would have been essentially flat over the past three quarters instead of posting sequential improvement." In the summer of 1997, Mason had told analysts that a move toward a build-to-order model would push ROIC from 50% to over 100%, as inventories would fall from ten weeks to three. However, management was simply failing to deliver on its ambitious goals. To hide the extent of that failure, the firm was pumping inventory into the channel and thus off its books while giving resellers favorable terms to take it. Compaq was then factoring the huge receivables to hide what was really going on. None of this was illegal, but it was suspicious.

Pfeiffer took over the helm of Compaq in 1991, when the firm was in disarray. He's credited with turning the company into the top PC manufacturer by volume and a major technology success story of the 1990s. Yet, after Mason's arrival at Compaq from Inland Steel in May 1996, the company seemed to grow increasingly addicted to over-promising and under-delivering. Management has found it hard to be straight with investors. The recent Q1 earning warnings was another case in point. Compaq's management blamed the trouble mostly on weak overall demand for PCs. For its part, Dell immediately responded, "I don't think so." As Dale Wettlaufer has rightly pointed out, PCs represent a much smaller part of Compaq's business since it acquired Digital Equipment Corp. (DEC) and Tandem. So management's account again seemed inadequate.

There's no question that Pfeiffer and Mason have mismanaged Compaq. At the most basic level, Compaq is still building PCs for the channel while Dell is building to order and gobbling up market share. Moreover, Compaq has tried to maintain its channel partners while also selling direct, merely creating a confused business model rather than improved service. All of this has ensured that Compaq suffers from a price/profit disadvantage on the PC front, especially in an environment of falling component prices.

But Compaq hasn't just failed to address Dell's competitive advantage on the manufacturing/distribution end. It's tried to use DEC's service wing to refocus its entire business around providing enterprise computing solutions, a la IBM (NYSE: IBM). Digesting huge acquisitions are a challenge. Trying to refocus a company around acquired assets is doubly challenging. Yet to do so while a competitor is kicking your butt in your supposed core competency represents, at best, the hope that strategic bravado can compensate for operating inefficiencies. Yet, the strategy only compounded those inefficiencies.

The notion that such deal-making would answer the competitive threat from Dell was a case of managerial hubris. Yet, such hubris was apparent at every turn. Last summer, the company launched a pointless $300 million branding campaign that said, "Look how much money we're willing to blow." Compaq devoted more millions to high-speed cable outfit RoadRunner, which has stumbled along pretty aimlessly. It blew another $220 million in cash buying the suspect, part of a cynical strategy to repackage its Alta Vista search engine, which it has shown no more ability to exploit than DEC had, and cash in on the Internet. Wipe away all the hype, and it's clear that Compaq has been in trouble for over two years.

While money managers were angry that Compaq warned of the Q1 shortfall only after the quarter actually ended, that disclosure mistake simply reflects lots of others that were arguably more serious for being highly selective. Investors should simply run from companies that indulge in selective disclosure because it represents such a fundamental violation of the compact that exists between owner and manager. If you can't trust management to treat you like an owner, then you can't trust management. Period. It's a signal of fundamental troubles with a company's top leadership. That's why I always thought it laughable that Business Week would honor Compaq's board of directors as among the best. Let's be clear: the board was asleep. The problems with Pfeiffer and Mason have been a long time coming, and the board did nothing until had suffered plenty.

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