Hidden Woes: Behind the Balance Sheet at Compaq.
When the world's largest PC maker, Compaq Computer Corp, revealed its $250m profit shortfall in the first quarter of this year, the financial world was stunned. Investors were caught unaware by the depth and apparent suddenness of Compaq's troubles, and the share price plummeted to $24, about half of its original 52-week high. Investors lost billions of dollars and financial analysts, who had been supporting the stock, complained they had been thoroughly misled.
But a closer, more conservative analysis of the quarterly filings that led up to the announcement reveal a different story - a story that demonstrates how misleading it can be to rely on earnings per share (EPS) as an adequate measure of corporate health. Compaq was, in fact, already in deep trouble by the first quarter of 1998, producing profits of just $16m on revenues of $5.6bn. "It will take another quarter of adjustment to put the company's core business on a track of improved profitability," said chief financial officer Earl Mason. This was a full 12 months before the disastrous shortfall that was to halve the share price and cost both chief executive Eckhard Pfeiffer and Mason their jobs.
The problem is that no one got to see the true results of the second quarter of 1998, or even the true results for that entire year, because of the distracting techniques that Compaq used to account for its acquisition of Digital Equipment Corp. The $9bn Digital deal was completed on June 11 1998, just before the close of Compaq's second quarter - its 'quarter of adjustment'. What the deal then triggered was an orgy of 'one-off' charges that reached $5bn in total, and which pushed the second quarter results into a $3.6bn loss, wiping out half of Compaq's entire retained earnings from its birth to the present day.
Compaq attributed this loss, and the complete $5bn package of charges, entirely to the acquisition of Digital's business. And analysts and investors on Wall Street, who seem perennially eager to discount such charges, appeared unfazed by the scale of these projected future costs. Unfortunately, in this instance, these acquisition charges probably went on to mask not only the terrible internal problems caused by buying Digital, but also the continuing trouble Compaq has had in executing its own business.
Some $3.2bn of the charges related to the immediate write-off of purchased 'in-process research and development', an accounting technique that has already been all but outlawed by US regulators but which, in this instance, is not the major source of worry. Far more sinister are the remaining $1.8bn of assorted charges that Compaq also pushed through the books under the title of 'the Digital acquisition'. Lurking within this total was a $393m provision for Compaq's own, internal costs, consisting of employee separations, facility closures and asset write downs.
Compaq claims this entire amount related to the Digital acquisition, but it is just as possible that in its 'quarter of adjustment' Compaq would have been forced to incur these costs anyway, taking it into a substantial operating loss for the year to date. The remaining $1.4bn of acquisition charges were linked more directly to Digital and, in a shrewd accounting maneuver, Digital was made to take this entire $1.4bn hit against its own (non-existent) profits before joining Compaq. Hence, the massive costs of integrating these two businesses slides on to Compaq's balance sheet as a provision against future costs, without ever touching the group's reported profits.
The net result of all this accounting was that, at the end of the second quarter of 1998, just $10m of actual spending on integration had been completed, leaving Compaq with a $1.7bn provision (roughly comparable to 1997's entire profits) with which to offset future costs.
Following the life of this provision then becomes relatively easy. In its third quarter, directly following the Digital acquisition, Compaq reported profits of $115m, $100m of which were derived from reducing the restructuring provision. The fourth quarter profits of $758m also coincided with a $524m reduction in the same provision.
And at the close of the fourth quarter, with the stock price testing new highs, Pfeiffer declared that the majority of the Digital integration was complete, while Mason proclaimed that Digital was already making a positive contribution to earnings.
With reference to Compaq's balance sheet at the time, both of these claims were incredible. The majority of the Digital integration was said to be complete, and yet $1.1bn of the projected integration costs (two thirds of the original total) had yet to be incurred. And in the midst of all this, Digital was apparently making a positive contribution to earnings, a claim that relied upon $524m of Digital's quarterly costs being entirely removed from the calculation.
What happened next was the inevitable first quarter climb down, followed by the rout of almost all of Compaq's senior managers.
And as the current quarter draws to a close, acting chief operating officer Michael Capellas has just announced that Compaq will soon be making yet more "substantial" restructuring charges. This is on top of the $1bn of outstanding charges already sitting on Compaq's balance sheet, waiting to be expensed against a Digital integration that is now over a year old. An integration that, according to the EPS story, was already contributing to Compaq's earnings. Alex Sloley is the Financial Editor of Computer Business Review.
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|Date:||Jul 19, 1999|
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