Accelerate earnings growth through $2



1. Introduction

Merger and Acquisition (M&A) activity has increased significantly since the early 1990’s. In recent years, merger and acquisition has been undertaken by computer firms as a business strategy to grow and create value. The merger of Hewlett-Packard (HP) and Compaq is one case out of many merger cases. In theory, through a merger and acquisition should create value for both target and acquiring companies. However, in reality, not every merger and acquisition creates value as it should. Hence, to understand whether the merger of HP and Compaq is a successful merger or not, this event study is conducted to exam the case of the merger of HP and Compaq companies.

2. Merger

Merger means two or more companies are combined as one company base on an agreeable decision. The main purpose of a merger is to create value. In order to create value, a synergy should exist in a merger. When firm A and B combine as firm C, and firm C’s value is exceed the combine value of firm A and B, we can say that there is a synergy existing. Synergy can come from increased efficiency, operating synergy, diversification, financial synergy, tax effect and strategic realignment.

According to book, “Takeovers, Restructuring, & Corporate Governance”, there are three types of mergers:

1. Horizontal Mergers:

Two firms operate and compete in the same kind of business merger as one company. This kind of merger will have a benefit of economies of scale. Horizontal mergers would decrease the number of firms, which for combined firms would be likely easier to plan for monopoly profits. Thus, horizontal mergers are regulated by the government.

2. Vertical Mergers:

Vertical mergers happen between companies in different production operation stages. Firms combined with vertical mergers could have benefit of economies of scope. A vertical merger Company can reduce cost on similar expenses, such as contracting and advertising, and share more efficient information within the same company.

3. Conglomerate Mergers:

Conglomerate mergers take place when companies involved in unrelated types of Business. The purpose for conglomerate mergers includes product line broaden and geographic market extension.

3. Event Background Information

About Hewlett-Packard (HP) Company

Hewlett-Packard Company was found in 1939 by two engineers, William R. Hewlett and David Packard. In 1957, the founders established the "HP Way", which is its corporate culture that focuses on employee satisfaction as the source of company success. Such as flex time and open communication between managers and employees are some of the by-products of the HP way.

HP is a global provider of computing and imaging solutions and services to consumers and business. The company's offerings cross IT infrastructure, personal computing and access devices, global services, and imaging and printing. HP's four core business groups are enterprise systems group, imaging and printing group, HP services, and personal systems group. Carly Fiorina, joined HP in July 1999, is chairman and chief executive officer of HP.

About Compaq Computer Corporation

The Compaq Corporation was founded by Rod Canion, Bill Murto and Jim Harris in February 1982, Houston, Texas. Their innovation was the world's first standards-based portable computer. Compaq is a manufacture of servers, workstations, networking products, desktop PCs and portable PCs. Compaq had an excellent reputation for compatibility and quality, reliability and technical innovation. By 1987, Compaq manufactured its millionth PC and achieved sales of US $1.2 billion, setting a record as the fastest company to reach more than US $1 billion sales. Early in 1995, Compaq reached its goal - the number one worldwide PC market share. Compaq reported worldwide revenues of US $31.2 billion for the full year of 1998. Michael Capellas is the CEO since 1999.

Merger of HP and Compaq Companies Background

On September 3, 2001, the news of merger of HP and Compaq companies was announced. HP is acquiring Compaq Computer in a stock swap valued around $25 billion. This is one of the largest deals in technology history. Compaq shareholders will receive 0.6325 shares of newly issued HP stock for each share of Compaq stock. HP shareholders will own about 64 percent and Compaq shareholders will own 36 percent of the combined companies. HP Chairman and Chief Executive Carly Fiorina will be CEO of the combined company, which holds the same title HP. Michael Capellas, chairman and CEO of Compaq, will be president. Capellas and four other members of Compaq's current board of directors will join HP's board upon closing. The combined company will have expected annual revenue of $87.4 billion, based on the past year's results. It will have operations in more than 160 countries and more than 145,000 employees. The companies estimate that cost savings will reach $2.5 billion annually. Analysts predict that layoffs will result from the buyout. The combined company will be the world's biggest maker of computers and printers, as well as the third-largest provider of technology services. The new HP will be able to tackle IBM and Sun Microsystems, while becoming more competitive against Dell Computer.

Timeline of the HP and Compaq merger

2001/06/22 Carly Fiotina visits Michael Capellas for licensing HP software issue, but wound up a merger talking.

2001/09/03 Hewlett-Packard announces it will buy Compaq Computer in a deal worth $25 billion.

2001/11/07 The Compaq Board of Directors meets and reaffirms its strong support for the proposed merger.

2002/01/17 Compaq shareowners vote on the merger proposal.

2002/03/05 The proposed merger gets a positive recommendation from Institutional Shareholder Services report.

2002/03/19 HP shareholders vote on the merger; HP declares victory in Compaq merger base on preliminary vote.

2002/03/28 Walter Hewlett files a lawsuit asking the Delaware Chancery Court to overturn the vote by HP shareholders to approve the deal.

2002/04/30 Walter Hewlett abandons his opposition after a Delaware judge rules that Hewlett-Packard's shareholder vote was legal

2002/05/01 HP announces final results of vote count; 838,401,376 HP shares were voted in favor of the deal, compared with 793,094,105 shares voted against the proposal.

2002/05/03 HP completed merger by acquiring Compaq Computer, valued at an estimated $19 billion.

Reasons for the Merger

The merger between HP and Compaq can be considered as a horizontal merger. The new HP would become very large in company size. Based on both companies' last four reported fiscal quarters, the new HP would have approximate pro forma assets of $56.4 billion, annual revenues of $87.4 billion and annual operating earnings of $3.9 billion. The merger is expected to generate cost synergies reaching approximately $2.5 billion annually and drive a significantly improved cost structure. The new HP would have operations in more than 160 countries and over 145,000 employees, which enhance its strength in international competition.

The merger will make the combined company a much stronger competitor. Together, the new HP will have a leading position in key growth markets, including server, storage, personal systems, imaging and printing, global services. After the merger, HP would have the top market share in printers, PCs, and storage. Also, HP would have the second-largest server business and third-largest tech-services organization. The merger deal will make new HP be able to innovate better and grow faster than either company could by itself. For example, after the merger, HP will be able to build better internet systems with Compaq’s super-reliable Himalaya servers and its clustering software, which enables many servers to operate as a single entity. The new HP will double size of their sale force, increasing account coverage and sales opportunities worldwide.

4. Event Study

Hypothesis:

Base on the theory of merger and acquisition, a merger should create value for the combined company if there is any synergy. The merger of HP and Compaq should create value for their shareholders according to their merger analysis. All the shareholders should be optimistic about this deal and the announcement should be good news. Therefore, my hypothesis for this event study is that there should be a large and positive abnormal return on the announcement date of the HP and Compaq merger.

Steps in Measurement of Cumulative Abnormal Returns:

The cumulative abnormal return (CAR) is used in this event study because it can capture the total firm-specific stock return for the whole period when market responds to new information. Also CAR is a better indicator than abnormal return because abnormal return can be affected by leakage of information.

In this study, the mean adjusted return method is first used, and later the market adjusted return method is used for verifying the result form mean adjusted return method. For mean adjusted return method, first, I chose the event period from 40 days before the announcement of merger, September 3, 2001, to 40 days after the announcement. After the event period is decided, daily stock price return for Compaq and HP can be calculated. Next, the predicted return is calculated by averaging the daily return of Compaq and HP stock performance from -240 days to -40 days. Third step is to calculate the residual by using daily stock price return in the event period minus the predicted return. Finally, the cumulative abnormal return (CAR) can be calculated by adding the daily residual (see Table1).

For market adjusted return method, the predicted return is the daily stock price return of S&P500 in the event period. Then, using daily stock price return of Compaq and HP in the event period deducts the predicted return to get the residual. Finally, CAR is calculated by adding daily residual (see Table 1).

Absolute Gains and Losses:

We also can look at the absolute gains or losses to exam how the total market value responding to the merger announcement. The absolute dollar gain or loss at time t is equal to CAR at time t multiply the market value of the firm at a date prior to the event period. The market value for Compaq on day -41 is $127 million, and for HP is $159 million. So, using the formula, we can obtain the absolute event gains or losses for both Compaq and HP (see Table 3).

|Table 3 Absolute Event Gains(losses) ($Million) |  |

|  | | | |  |

|  | |Target | |Acquirer |

|  |  |Compaq |  |HP |

|Market value at -41 |$127 | |$159 |

|On day +1 | | | |  |

|CAR | |-0.19272 | |-0.24482 |

|Dollar Gain(loss) |($24.48) | |($38.93) |

|On day +40 | | |  |

|CAR | |-0.21145 | |-0.21180 |

|Dollar Gain(loss) |($26.85) |  |($33.68) |

5. Result and Conclusion

According to my hypothesis of this event study, I expect to see a huge increased in CAR Base on the announcement date of the merger of HP and Compaq. However, my excel model show me the opposite result of my hypothesis.

In the beginning of the CAR measurement, I apply the mean adjusted method. Form the chart of CAR for Compaq Company (see Figure 1), the CAR before the announcement is a ransom walk pattern. The CAR values are up and down, but they all have a value of CAR above 0 except -31 day. However, on the day of the announcement of merger, the CAR value decreases to -13.50%. At the same time, when looking at the chart of CAR for acquiring company, HP (see figure 2), I find that CAR of HP has the similar pattern as CAR of Compaq. Before the announcement, the CAR is jumping up and down between -5.24% and 7.77%. But, on day 0, the CAR decreases to -20.54%.

In order to verify my calculation on the mean adjusted model is correct, I apply the market adjusted return method to find the CAR and make the CAR chart again. I find the CAR pattern of market adjusted method has similar trend to the pattern of mean adjusted model. Both CAR values of Compaq and HP decrease substantially on the announcement date, which indicates a large and negative abnormal return. Also, in table 3, the absolute loss for Compaq on day +1 is $24.48 million and on day +40 is -26.85 million. And for HP on day +1 is -$38.93 million and on day +40 is -$33.68 million.

In conclusion, there are several concepts that I have learned in this case. First of all, a successful merger can only occur with a right synergy created. The merger of HP and Compaq destroys their shareholder value even though both company claim that cost synergy can create value for them. But this synergy will not really show its effect until 2004. Second of all, the HP and Compaq merger proves the theory in the books that horizontal merger can make a firm to gain larger in size, but there is not definite that a firm can have the benefit of the economies of scale. Finally, according to the BusinessWeek article, Mergers Why Most Big Deals Don’t Pay Off, there are several reasons why mergers go wrong. I find the HP and Compaq merger can be categorized under one of them: “Overestimate likely cost savings and synergies, setting themselves up for poor performance and shareholder disappointments in the future.”

Reference

Prentice Hall. 2001. Takeovers, Restructuring, & Corporate Governance. J. Fred Weston, Juan A. Siu, and Brian A. Johnson.

David Henry, “Mergers Why Most Big Deals Don’t Pay Off” BusinessWeek October 14, 2002

McGraw-Hill Irwin. 2002. Invesmets. Bodie, Kane, and Marcus

Staff Writer. “HP-Compaq merger means more job cuts.” Online. Internet. Available

Ashok Kumar. “Taking a second look at HP-Compaq” Online. Internet. Available

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