The necessity for this deal lies in the analysis of the dynamics of the PC market. In 2001, the total PC market has contracted for the first time. Dell took advantage of these deteriorating market conditions to launch a price war based on their manufacturing efficiency. Compaq and HP's inability to compete on price with Dell, has left them both suffering significant falls in their market share.
"Big has always been perceived as beautiful in the PC market," says Andrew Ball, research analyst at Frost & Sullivan. "The dominant manufacturer is in the position to drive downwards the costs of their suppliers. Thus, HP and Compaq found themselves facing a vicious circle. Market share loss contributes to difficulty obtaining the best deal with suppliers. The resulting pressure on prices, in turn, leads to further market share loss. The merger between the two companies is the only way to escape this quagmire."
Ball continues: "The danger in this deal is the result of two faultlines. First of all, the difficulty of achieving the integration between the two companies needs to be hurdled. This will be one of the most complex mergers ever undertaken in a market environment that is particularly challenging. This market's landscape means that the margin for error in managing the integration is minimal. If the new HP fails to meet the efficiencies that they have publicised, the company will not be given the benefit of the doubt by shareholders and users."
The second faultline is that it leaves the new HP still dependent on a PC market whose current key trends are pricing pressure and a decline in unit sales. The company's largest single combined revenue stream at $29bn is tied to a market in decline. At the same time, the growth market of IT services is still as distant as ever for the combined company. Compaq's much trumpeted transition from a hardware company to a service company has barely begun. Whilst Compaq has achieved 23% of revenue from services, many of these services involve basic support and maintenance. This is business with a low price margin and is quite different to the high value consulting that attracted HP to PriceWaterhouseCoopers.
Therefore, it is clear therefore that even if the new HP is able to achieve the efficiencies that it is seeking, this will only be of value if it can channel the freed resources into faster growing markets. It is difficult to imagine a more challenging scenario. Frost & Sullivan present their perception of a best case and worst case scenario below. If the new HP is closer to the best case than the worst case scenario, it will deserve all the plaudits that it gets.
Best Case
The merger is tough, but economies of scale and synergies in R&D, procurement, marketing and administrative spending pay off and lead to better margins within two years. Dell cannot sustain their price war against the new HP, and is marginalised in niche US markets. The new HP emerges as the leader in hardware and uses the margin of safety that it enjoys in hardware to manage its shift into higher value services.
Worst Case
The merger is never finalised as a result of a clash of cultures between the two companies and differing production models. The new company has to cut more staff than expected to stay afloat, sending staff morale plummeting. The share price tumbles and investors demand radical action lowering staff morale still further. Dell, disciplined and solitary, cleans up in the PC space and IBM continues to lead in high-value IT. The new HP ends up in the purgatory of a half-finished merger when confidence and funding finally run out. Their hardware business collapses and competitors buy up the chunks that remain.