Mind Your Own Business, Boys

By Daren Fonda/Dallas

Carly Fiorina has long struck a tone of defiant self-assurance, and it's beginning to seem justified. The CEO of tech giant Hewlett-Packard proved adept at playing Wall Street hardball, leading her company's ferociously contested proxy battle to buy Compaq Computer for $19 billion. She promised big benefits from that acquisition and last week began to deliver them. HP's quarterly earnings report showed the company stemming losses in its most troubled divisions--PCs and corporate computer systems--and surpassing its cost-cutting goals. HP shares have surged 72% since early October, including 15% last week.

Fiorina has quieted some of those she calls her "cynics and doubters," who had whispered that a woman with a marketing background was not fit to run HP. But she still faces formidable challenges, starting with generating profits in PCs and corporate "enterprise systems" at her newly merged company, which posted $35 billion in revenues in its first six months. Can she go from being a Churchillian leader, adept at giving a "We will never surrender" speech, to being more of a Lou Gerstner, IBM's former CEO, who was able not only to slash costs and jettison unpromising lines of business but also to steer the company toward new prospects and profits?

Since HP's president, Michael Capellas, a respected operations manager and Compaq's last CEO, quit to run WorldCom in mid-November, Fiorina must now take full responsibility for HP's bottom line at a time when she must parry new threats from IBM and Dell. Both have spent the past year bulking up major parts of their businesses, while HP has been on a low-cal diet, trying to restore its flabby enterprises to health. As analyst Bill Shope of J.P. Morgan Chase puts it, "IBM is trying to squeeze HP at the upper end of the market, while Dell is challenging it at the lower end. HP has carved a spot in the middle, but it's not clear if that's where it should be."

Fiorina's supporters think HP in the middle will be a hit show. The rationale for acquiring Compaq has not changed, they argue. By buying Compaq's vast product portfolio, R.-and-D. muscle, direct-sales channel and 34,000 tech-service pros, HP could thwart IBM and Dell. "Analysts are waiting for us to put points on the scoreboard," says Michael Winkler, Fiorina's executive vice president for operations. (Fiorina declined to be interviewed.)

In terms of cost cutting, those points are accumulating. HP has shuttered nine assembly plants, cut 12,500 jobs and "rationalized" its product offerings, reducing them to 65,000 from 85,000. Result: $650 million in savings since the merger, which helped HP offset losses in its divisions that make PCs and enterprise-computing gear. "I'm keeping my shares," says Ben Rosen, Compaq's former chairman and a large shareholder. "HP is going to get so lean that earnings surprises will be on the upside."

Yet cutting jobs is easy compared with boosting profits while a lean and hungry rival like Dell is gnawing at you. From 2001's third quarter to this year's, Dell gained market share in two of Compaq's core segments: PCs and large corporate computers known as servers. Moreover, Dell figures that it can leverage its low-cost, direct-sales model to profit from just about any tech product whose components have in effect become commodities. Dell is angling to sell everything from personal digital assistants to its own brand of printers and ink cartridges, as well as an increasing array of networking gear, storage devices and services. "Dell is targeting just about every profit pool HP has," says industry analyst Julie Giera of the Giga Information Group.

Printing is shaping up as a crucial war zone. HP's imaging and printing division is a diamond mine, yielding $3.2 billion in profits in its past fiscal year. Most of that money comes not from printers but from sales of ink and toner cartridges that owners of HP printers buy almost exclusively from HP. While the firm barely breaks even on inkjet-printer sales, HP makes profit margins of about 60% on those cartridges, according to Charles Wolf, an analyst at Needham & Co.

Dell wants a slice of those printing profits and at the same time wants to crimp HP's cash flow: the money HP makes from selling cartridges helps subsidize its profitless PC and enterprise-computing divisions, which, with Compaq, lost $1.7 billion in the two companies' past fiscal year. "Michael Dell will bomb the market," says Wolf. "He'll be happy to make an 18% margin, which HP can't afford."

Also in a bid to strike at HP, Dell is pumping up its slate of services. Backtracking on its self-help model, Dell recently extended an agreement with EDS to provide higher levels of support to PC users--a way for Dell to potentially make more money from PC sales and take a larger slice of the services market. Taking care of high-powered servers could become more lucrative too. Dell figures that as machines running on Intel chips and Windows or Linux software continue to improve and drop in price, so too will prices to install and service them, falling to the kinds of commodity levels at which Dell might maintain an edge. Rivals fear that because Dell's overall business is thriving, the firm will be able to afford to take a lower margin on such services and drive down prices across the board.

Does Dell hold a hand of aces? HP doesn't think so. In printing, says Mark Stouse, HP's director of opposition research, most printer and ink-cartridge sales go through dealers and retail stores, sales channels that have not been Dell's focus. And despite a decade of competition from lower-priced rivals such as Canon, Epson and Lexmark (Dell's partner to manufacture its printers and cartridges), HP remains the printer champ.

In services, HP thinks its soup-to-nuts packages will prevent Dell from encroaching on its small-and medium-size business clients. Dell is just starting to ramp up its service offerings, and HP has broad experience working with such partners as Accenture and KPMG, helping clients better manage their tangle of PCs, servers and storage devices.

Compaq client Charlie Orndorff is a believer. As chief information officer for Crossmark, a sales-and marketing-support firm based in Dallas, Orndorff spends the bulk of his $15 million IT budget on tech support for Compaq handheld devices, PCs, servers and storage networks. "Dell approached me," he says, "but all my engineers are HP certified, and adding brands with other certification requirements for a slightly lower price on the hardware wasn't compelling enough."

Even if Fiorina can thwart Dell's attack in hardware and services, that still leaves IBM gunning for her other flank in higher-end corporate computer systems and services. IBM retained its market share in servers through this year's second quarter, while Compaq's share has eroded slightly, enabling IBM to pull to a tie in terms of global revenues, according to IDC. IBM CEO Sam Palmisano recently said the company would invest $10 billion to enable clients to purchase computing power "on demand," signaling to HP and other rivals that Big Blue is planning a war of attrition. With its $3.5 billion purchase of PricewaterhouseCoopers Consulting earlier this year, IBM acquired 30,000 business consultants, as well as their clients in such markets as finance, retail and government.

Having PWC helped IBM win exclusive negotiating rights for a $5 billion deal with J.P. Morgan Chase this month. HP did not bid for that job, and in February neither HP nor Compaq was able to beat IBM for a $4 billion contract with American Express. Says Doug Elix, chief of IBM Global Services: "HP reminds us of where we were 10 years ago when we were building our services and got into outsourcing. It takes a long time to build services that have the breadth ours do." As evidence that it can tackle IBM in large outsourcing jobs, HP points to a $1.3 billion deal that it signed in September with the Canadian Imperial Bank of Commerce.

Some investors remain skeptical that Fiorina will be able to return HP to the brisk growth that it achieved in the 1990s, especially since her chief lieutenant, Capellas, has departed. Admired for his tech knowledge and ability to get chummy with chief information officers, Capellas has skills that were supposed to complement Fiorina's--a part of the pitch both executives made to persuade shareholders to vote for the merger.

It appears, however, that they did not intend to work together for long beyond their goal of merging their firms. In HP's proxy fight to acquire Compaq, several institutional shareholders voted for the deal because of a recommendation by Institutional Shareholder Services, a proxy advisory firm that blessed the merger; it gave its approval partly on the assumption that "key managers from each company will assume important posts after the merger." Explains Patrick McGurn, general counsel for ISS: "We were left with the impression that we were getting two leaders for the price of one. There was never a time when Capellas said to us that he was hedging his bets."

Capellas, who says he went to WorldCom partly because "there's appeal to being a CEO," was not offered incentives to stick around at HP. In December 2001, Compaq's board amended his severance package so that if he resigned from the merged firm within a year, he would receive a lump-sum payment--worth a previously agreed-to $14 million--within 10 days of his departure. When he left, he also received $1.6 million as part of a loan-forgiveness plan. After the merger, his employment contract was not renegotiated to entice him to stay.

Capellas started job hunting this summer, says an industry insider knowledgeable about HP's inner workings, partly because the firm's reorganization had left him with little to do. Two other executives have largely directed day-to-day operations, says this source, while Capellas spent most of his time on the road, reassuring large clients. Capellas, however, says he was approached by WorldCom executives at a birthday party in October and that "at no point did I job search." With five division heads reporting to him, he says, he was very much responsible for directing the integration of the two companies. As for his severance package, Capellas says, "Changes were made to all the management team's contracts. The basic terms weren't changed; only the timing of payments was."

HP's bulls are betting that Fiorina does not need Capellas to boost HP's profits. Capellas is a "good friend who brought many talents and a lot of enthusiasm to this endeavor," she said in a memo to employees. She also noted, "I have great confidence in our ability to continue to execute the strategies and plans we have put in place." It was vintage Fiorina, warning her cynics and doubters that they're not going to make any money by underestimating her.