Will HP Seek to Merge with Dell?

It has come to that point in time when former great computer companies in the twilight of their years should consider a marriage of convenience that ends the current competitive fratricide and allows for the conservation of dwindling resources going forward as they fight their multi-front war against IBM, Apple and the Chinese PC players Lenovo and Asus. And yet it is very odd to think that a $125B company (HP) must merge with a $60B company (Dell) just to survive. But then again, we live in a world that continues to demand vertical integration with a preferred Ecosystem.

Back in the 1970s and even into the mid 1980s, things appeared to be going swimmingly for not just IBM but the remaining five major mainframe manufacturers known as the BUNCH (Burroughs, Sperry-Univac, NCR, Control Data and Honeywell). Then the PC came on the scene and the above BUNCH consolidated or were sold off and within 5 years it was just IBM and minicomputer maker DEC who in the late 1990s would be acquired by Compaq in their desperate attempt to scale to Big Blue heights in the Enterprise Market. HP had similar visions when they acquire Compaq in September 2001 for $25B. See where I am going?

But wait there’s more…..

A merger between HP and Dell would provide short-term relief as they scale back their duplicate marketing, sales and engineering operations in Austin and Houston that provide the necessary cash flow that pretties up the CFO’s income statement and balance sheet leading into the ultimate of all mega-acquisition scenarios: A purchase by a Chinese High Tech Firm like Lenovo, who in 2004 acquired IBM’s PC business.

The economics of the computer market, like all large markets is driven by scale and vertical integration of key value added components. The PC world appeared to thrive on a horizontal model in the 1980s and 1990s but in reality from the day IBM introduced the PC, the margins of system makers marched lower as the Microsoft and Intel’s duopoly in effect took over the role of the efficient, value-added vertical supplier. At first Compaq and IBM tried to assuage the margin compression by leveraging lower cost Taiwan ODMs, mimicking the model Dell had honed and refined. However now it has reached the point where operating margins are so thin (Dell’s are 7.1% overall and 2.7% on consumer PCs while HP’s is 8.6% overall and 5.2% in PCs) that they can’t compete long term with what will be two or three highly leveraged, vertically integrated PC firms.

The risk to Dell and HP is even greater than the threat from Lenovo, Asus and the rest of the pack as they try to move more aggressively in the software and services business. In other words a full frontal attack on IBM, who has been ramping revenue and margins nicely over the past few years. IBM’s operating margins are now at 49%, significantly ahead of HP and Dell. Now as we move from Enterprise to the Cloud where IBM can effectively manage a Fortune 500’s operations or Apple can plug in consumers or Amazon can efficiently set up e-commerce store fronts for small businesses, the question is where does HP and Dell make their mark.

In some ways HP’s former CEO Leo Apotheker was right in trying to urgently reform the company by dismantling and selling off the PC business. However, the PC business represented one wall of a house of cards that when removed effectively crashed the whole of the enterprise business. Customers started fleeing to IBM and Dell leaving HP sales guys in the dust. Furthermore the loss of revenue and minor profits would have impacted the servicing of the massive $22.5B debt load that Mark Hurd took on to buy back shares and give the appearance of rising earnings when it was lining his pockets with inflated stock prices. Where was the Board when Hurd went short term tactical instead of creating big moats that generate long term value?

The lights won’t go out overnight for a company that generates what is now $30B in revenue a quarter, but what tends to happen in the computer industry as seen with the BUNCH and DEC is that a slow run feeds on itself until one day you reach a cliff. By then the options become few. All this being said, a merger of HP and Dell would need Michael’s approval and he may believe that the unraveling of HP will allow him to remain independent for a while longer.

FULL DISCLOSURE: I am Long AAPL, INTC, IBM, QCOM, ALTR