Compaq profit pressure yields 'hold-buy' views

Electronic News, March 16, 1992

Pressure on Compaqu's earnings has spread analyst sentiment between "hold" and "buy" as many await the outcome of the computer firm's new distribution program.

"While it is difficult to accurately predict just when Compaq earnings will turn around," notes Rick Martin of The Chicago Corp., "we are convinced that it is on the right track and that its strategy will eventually lead to accelerating growth.

"Compaq," he says, "is entering the third phase of its corporate life. The first phase focused on unique products that set it apart in the marketplace. The second focused on geographic expansion which resulted in explosive international growth from 1988 through 1990. The third phase focuses on expanding distribution channels to penetrate markets that are only minimally saturated -- primarily the small market.

"Fundamental changes are required for success. Simply cutting prices would be devastating to Compaq's profitability, so the answer is to introduce low-price, entry-level systems that have a cost structure to support the price points demanded by the small business market," the analyst says.

He adds that the company also has to sharply reduce its cost structure to remain profitable. "We expect gross margins to drift up from the recent levels in spite of the introduction of much more aggressive entry-level systems in the spring. Compaq plans to reduce its cost of goods by at least 15 to 20 percent through more aggressive purchasing, redesigning its systems for cost rather than function and reducing overhead."

For 1992, Mr. Martin expects Compaq to net $3.30 a share, and for 1993 sees earnings of $3.95 a share.

Mr. Martin rates the stock a "buy," with a target price in the high 40s.

Dough van Dorsten of Shearson Lehman, while also noting that Compaq's current strategy, including price cuts, will put pressure on near-term profits, says "This is the right pricing action to get Compaq computers moving well in the reseller and distribution channels. Overall, we view these actions as good news."

Due to the lower prices and probable negative currency impact on the March, 1992, earnings results, however, Mr. Dorsten is shaving his first-quarter 1992 and full-year 1992 EPS estimates to 60 cents and $3.06 from 66 cents and $3.15, respectively.

"We believe the latest round of price cuts will spur demand for Compaq's PCs -- dealers and distributors have cited to us a need for more aggressive pricing from Compaq.

"We believe expectations of price cuts and lower profit margins have been in the stock price for the last several weeks, keeping the share price from moving up as other technology stocks have risen."

The analyst says he would be a buyer of Compaq shares and would become more aggressive on weakness.

Andy Neff of Bear, Stearns thinks the company's turnaround effort could take somewhat longer than expected in view of the competitive environment and the level of change required and is maintaining a "hold."

"Specifically, some of the steps needed could come later than we anticipated by at least a few months. In addition, margins could be under pressure because the company, will have to spend aggressively as the product mix shifts to lower-margin products. Most of these steps are necessary to turn the company around and could mean that 1992 will remain a period of transition.

"Compaq," Mr. Neff notes, "is facing in 1992 what Apple faced in 1991 -- a significant restructuring in its business model as it moves down the down staircase with lower-price products. This scenario implies lower profit margins in the near term, because it implies that the company will face declining gross margins from a shifting product mix while it must invest to build a new brand at the low end.

"For a longer-term perspective, the company has plenty of cash and can afford to work through the transition, but it bears watching. At mid-year, it could have nearly $7 a share in cash and little debt. Furthermore, it has a large base business with a $3 billion run rate."