SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998
COMMISSION FILE NUMBER 1-9026
COMPAQ COMPUTER CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 76-0011617
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
20555 SH 249, HOUSTON, TEXAS 77070
(281) 370-0670
(Address, including zip code, and telephone number, including
area code, of registrant's principal executive offices)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [ X ] No [ ]
The number of shares of the registrant's Common Stock, $.01 par value,
outstanding as of June 30, 1998, was approximately 1.7 billion.
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
COMPAQ COMPUTER CORPORATION
CONSOLIDATED BALANCE SHEET
(UNAUDITED)
ASSETS
JUNE 30, DECEMBER 31,
1998 1997
---------- -------------
(IN MILLIONS)
<S> <C> <C>
Current assets:
Cash and cash equivalents. . . . . . . . . . . . . . . . . $ 4,596 $ 6,418
Short-term investments . . . . . . . . . . . . . . . . . . - 344
Accounts receivable, net . . . . . . . . . . . . . . . . . 5,431 2,891
Inventories. . . . . . . . . . . . . . . . . . . . . . . . 2,202 1,570
Deferred income taxes. . . . . . . . . . . . . . . . . . . 1,981 595
Other current assets . . . . . . . . . . . . . . . . . . . 578 199
---------- -------------
Total current assets. . . . . . . . . . . . . . . . . 14,788 12,017
Property, plant and equipment, less accumulated depreciation. 2,855 1,985
Deferred income taxes . . . . . . . . . . . . . . . . . . . . 862 -
Intangible and other assets . . . . . . . . . . . . . . . . . 3,243 629
---------- -------------
$ 21,748 $ 14,631
========== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 3,614 $ 2,837
Income taxes payable . . . . . . . . . . . . . . . . . . . 201 195
Accrued restructuring costs. . . . . . . . . . . . . . . . 1,734 -
Other current liabilities. . . . . . . . . . . . . . . . . 5,017 2,170
---------- -------------
Total current liabilities . . . . . . . . . . . . . . 10,566 5,202
---------- -------------
Postretirement and other postemployment benefits. . . . . . . 398 -
---------- -------------
Minority interest . . . . . . . . . . . . . . . . . . . . . . 422 -
---------- -------------
Stockholders' equity:
Preferred stock, $.01 par value
(authorized: 10 million shares; issued: none)
Common stock and capital in excess of $.01 par value
(authorized: 3 billion shares; issued:
1,671 million shares at June 30, 1998 and
1,519 million shares at December 31, 1997) . . . . . . 6,724 2,096
Retained earnings . . . . . . . . . . . . . . . . . . . . 3,664 7,333
Treasury stock (at cost). . . . . . . . . . . . . . . . . (26) -
---------- -------------
Total stockholders' equity . . . . . . . . . . . . . . 10,362 9,429
---------- -------------
$ 21,748 $ 14,631
========== =============
</TABLE>
See accompanying notes to consolidated financial data.
1
<PAGE>
<TABLE>
<CAPTION>
COMPAQ COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF INCOME
(UNAUDITED)
SIX MONTHS QUARTER
ENDED JUNE 30, ENDED JUNE 30,
------------------ -----------------
1998 1997 1998 1997
-------- -------- -------- -------
(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Revenue:
Product sales. . . . . . . . . . . . . . . . $10,947 $10,573 $ 5,372 $5,405
Service revenue. . . . . . . . . . . . . . . 572 214 460 110
-------- -------- -------- -------
11,519 10,787 5,832 5,515
-------- -------- -------- -------
Cost of sales:
Cost of product sales. . . . . . . . . . . . 9,007 7,677 4,406 3,897
Cost of service revenue. . . . . . . . . . . 379 156 316 81
-------- -------- -------- -------
9,386 7,833 4,722 3,978
-------- -------- -------- -------
Selling, general, and administrative expense . . 1,836 1,309 1,051 670
Research and development costs . . . . . . . . . 494 387 249 198
Purchased in-process technology. . . . . . . . . 3,234 208 3,234 208
Restructuring and asset impairment charges . . . 393 - 393 -
Other income and expense, net. . . . . . . . . . (74) (19) (44) (4)
-------- -------- -------- -------
5,883 1,885 4,883 1,072
-------- -------- -------- -------
Income (loss) before provision for income taxes. (3,750) 1,069 (3,773) 465
Provision (benefit) for income taxes . . . . . . (134) 398 (141) 208
-------- -------- -------- -------
Net income (loss). . . . . . . . . . . . . . . . $(3,616) $ 671 $(3,632) $ 257
======== ======== ======== =======
Earnings (loss) per common share:
Basic. . . . . . . . . . . . . . . . . $ (2.35) $ .45 $ (2.33) $ .17
======== ======== ======== =======
Diluted. . . . . . . . . . . . . . . . $ (2.35) $ .43 $ (2.33) $ .17
======== ======== ======== =======
Shares used in computing earnings (loss) per
common share:
Basic. . . . . . . . . . . . . . . . . 1,539 1,497 1,556 1,500
======== ======== ======== =======
Diluted. . . . . . . . . . . . . . . . 1,539 1,547 1,556 1,552
======== ======== ======== =======
</TABLE>
See accompanying notes to consolidated financial data.
2
<PAGE>
<TABLE>
<CAPTION>
COMPAQ COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)
SIX MONTHS
ENDED JUNE 30,
-----------------
1998 1997
-------- -------
(IN MILLIONS)
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) . . . . . . . . . . . . . . . . . . . . . $(3,616) $ 671
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization. . . . . . . . . . . . . 272 256
Purchased in-process technology. . . . . . . . . . . . 3,234 208
Restructuring and asset impairment charges . . . . . . 393 -
Changes in operating assets and liabilities, net of
effects of purchased businesses:
Accounts receivable . . . . . . . . . . . . . . . . (261) 893
Inventories . . . . . . . . . . . . . . . . . . . . 644 (409)
Other current assets. . . . . . . . . . . . . . . . 17 (23)
Accounts payable. . . . . . . . . . . . . . . . . . (9) 469
Income taxes payable. . . . . . . . . . . . . . . . (128) (124)
Accrued restructuring costs . . . . . . . . . . . . (10) -
Other current liabilities . . . . . . . . . . . . . (26) 70
-------- -------
Net cash provided by operating activities . . . . . . . . . 510 2,011
-------- -------
Cash flows from investing activities:
Purchases of property, plant and equipment, net . . . . . . (257) (298)
Purchases of short-term investments . . . . . . . . . . . . - (968)
Proceeds from short-term investments. . . . . . . . . . . . 344 1,143
Acquisition of businesses, net of cash acquired . . . . . . (1,413) (268)
Other, net. . . . . . . . . . . . . . . . . . . . . . . . . (314) 35
-------- -------
Net cash used in investing activities . . . . . . . . . . . (1,640) (356)
-------- -------
Cash flows from financing activities:
Payments to retire debt . . . . . . . . . . . . . . . . . . (788) (293)
Purchase of treasury shares . . . . . . . . . . . . . . . . (26) -
Issuance of common stock pursuant to stock option plans . . 94 80
Dividends paid. . . . . . . . . . . . . . . . . . . . . . . (23) -
Other, net. . . . . . . . . . . . . . . . . . . . . . . . . - (37)
-------- -------
Net cash used in financing activities . . . . . . . . . . . (743) (250)
-------- -------
Effect of exchange rate changes on cash and cash equivalents. 51 29
-------- -------
Net increase (decrease) in cash and cash equivalents. . . . (1,822) 1,434
Cash and cash equivalents at beginning of period. . . . . . . 6,418 3,008
-------- -------
Cash and cash equivalents at end of period. . . . . . . . . . $ 4,596 $4,442
======== =======
</TABLE>
See accompanying notes to consolidated financial data.
3
<PAGE>
<TABLE>
<CAPTION>
COMPAQ COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS (CONTINUED)
(UNAUDITED)
SUPPLEMENTAL CASH FLOW INFORMATION
SIX MONTHS
ENDED JUNE 30,
----------------
1998 1997
-------- ------
(IN MILLIONS)
<S> <C> <C>
Acquisitions (Note 2)
Fair value of:
Assets acquired. . . . . . . $16,029 $ 362
Liabilities assumed. . . . . (7,014) (74)
Stock issued . . . . . . . . (4,284) -
Options issued . . . . . . . (249) (10)
-------- ------
Cash paid. . . . . . . . . . . 4,482 278
Less: cash acquired. . . . . . (3,069) (10)
-------- ------
Net cash paid for acquisition. $ 1,413 $ 268
======== ======
</TABLE>
See accompanying notes to consolidated financial data.
4
<PAGE>
COMPAQ COMPUTER CORPORATION
NOTES TO CONSOLIDATED FINANCIAL DATA
NOTE 1 - BASIS OF PRESENTATION
- -----------------------------------
The accompanying unaudited consolidated financial data as of June 30, 1998
and December 31, 1997 and for the three and six-month periods ended June 30,
1998 and 1997 have been prepared on substantially the same basis as Compaq's
annual consolidated financial statements. Compaq completed its acquisition of
Digital Equipment Corporation ("Digital") during the second quarter of 1998.
This acquisition was accounted for under the purchase method of accounting. The
financial information provided for the three-month and six-month periods ended
June 30, 1997 has been restated to reflect the acquisition of Tandem Computers
Incorporated in August 1997, which was accounted for as a pooling of interests.
In the opinion of Compaq, the data reflects all adjustments, consisting only of
normal recurring adjustments, necessary for a fair presentation of the results
for those periods and the financial condition at those dates. Certain prior
year amounts have been reclassified to conform to current year presentation.
NOTE 2 - ACQUISITION OF DIGITAL
- ------------------------------------
On June 11, 1998, Compaq consummated its acquisition of Digital. Digital
is an industry leader in implementing and supporting networked business
solutions in multi-vendor environments based on high performance platforms with
an established global service and support team. The aggregate purchase price of
$9.1 billion consisted of approximately $4.5 billion in cash, the issuance of
approximately 141 million shares of Compaq common stock valued at approximately
$4.3 billion and the issuance of approximately 25 million options to purchase
Compaq common stock valued at approximately $249 million. The cash component of
the purchase price was paid through the use of Compaq's general corporate funds.
The results of operations of Digital and the estimated fair value of the assets
acquired and liabilities assumed are included in Compaq's financial statements
from the date of acquisition.
The purchase price was preliminarily allocated to the assets acquired and
liabilities assumed based on Compaq's estimates of fair value. Compaq is
awaiting additional information related to the fair value of certain assets
acquired and liabilities assumed and the finalization of the Digital-related
restructuring plans. Management does not expect the finalization of these
matters to have a material effect on the purchase price allocation. The fair
value assigned to intangible assets acquired was based on a valuation prepared
by an independent third-party appraisal company and consists of purchased
in-process technology, proven research and development, the installed customer
base and trademarks. The amounts allocated to tangible and intangible assets
acquired less liabilities assumed exceeded the purchase price by approximately
$4.1 billion. This excess value over the purchase price was allocated to reduce
proportionately the values assigned to long-term assets and purchased in-process
technology in determining their ultimate fair values. As a result of the change
in fair values of the long-term assets, the deferred tax liability associated
with these assets was also adjusted.
5
<PAGE>
NOTE 2 - ACQUISITION OF DIGITAL (CONTINUED)
- -------------------------------------------------
The following table shows the amounts allocated to the long-term assets,
the allocation of the excess value over purchase price and the resulting
assigned values for the assets acquired as of June 11, 1998:
<TABLE>
<CAPTION>
EXCESS VALUE VALUE ASSIGNED
INITIAL OVER PURCHASE TO NET ASSETS
BALANCE SHEET CATEGORY VALUATION PRICE ACQUIRED
- ----------------------------------- -------------- ---------------- ---------------
<S> <C> <C> <C>
Property, plant and equipment . . . $ 1,465 $ (637) $ 828
Purchased in-process technology . . 5,722 ( 2,488) 3,234
Intangible assets:
Proven research and development 1,055 ( 459) 596
Installed customer base . . . . 2,150 ( 935) 1,215
Trademarks. . . . . . . . . . . 391 ( 170) 221
Other assets. . . . . . . . . . . . 662 ( 288) 374
Deferred tax liability. . . . . . . (1,073) 871 (202)
</TABLE>
Management estimates that $3.2 billion of the purchase price represents
purchased in-process technology that has not yet reached technological
feasibility and has no alternative future use. Accordingly, this amount was
immediately expensed in the Consolidated Statement of Income upon consummation
of the acquisition. The value assigned to purchased in-process technology,
based on a valuation prepared by an independent third-party appraisal company,
was determined by identifying research projects in areas for which technological
feasibility has not been established, including UNIX/Open VMS ($1.6 billion), NT
Systems ($800 million), storage ($2.7 billion) and Internet and others ($600
million). The value was determined by estimating the costs to develop the
purchased in-process technology into commercially viable products, estimating
the resulting net cash flows from such projects, and discounting the net cash
flows back to their present value. The discount rate includes a factor that
takes into account the uncertainty surrounding the successful development of the
purchased in-process technology. If these projects are not successfully
developed, future revenue and profitability of Compaq may be adversely affected.
Additionally, the value of other intangible assets acquired may become impaired.
The following table represents unaudited consolidated pro forma
information as if Compaq and Digital had been combined as of the beginning of
the periods presented. The pro forma data are presented for illustrative
purposes only and are not necessarily indicative of the combined financial
position or results of operations of future periods or the results that actually
would have resulted had Compaq and Digital been a combined company during the
specified periods. The pro forma results include the effects of the purchase
price allocation on depreciation of property, plant and equipment and
amortization of intangible assets, adjustments to reflect the reversal of
interest income resulting from the use of cash related to the acquisition of
Digital, and preferred stock dividends paid. The pro forma combined results
exclude acquisition-related charges for purchased in-process technology related
to Digital.
6
<PAGE>
NOTE 2 - ACQUISITION OF DIGITAL (CONTINUED)
- -------------------------------------------------
<TABLE>
<CAPTION>
SIX MONTHS
ENDED JUNE 30,
1998 1997
-------- -------
PRO FORMA UNAUDITED
(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C>
Revenue:
Product sales . . . . . . . . . . . . . . . . . $13,596 $14,403
Service revenue . . . . . . . . . . . . . . . . 3,304 3,161
-------- -------
Total revenue. . . . . . . . . . . . . . . . $16,900 $17,564
Net income (loss). . . . . . . . . . . . . . . . . . $ 530 $ 623
======== =======
Earnings (loss) per common share:
Basic . . . . . . . . . . . . . . . . . . . . . $ (.32) $ .38
======== =======
Diluted . . . . . . . . . . . . . . . . . . . . $ (.32) $ .37
======== =======
Shares used in computing earnings per common share:
Basic . . . . . . . . . . . . . . . . . . . . . 1,652 1,638
======== =======
Diluted . . . . . . . . . . . . . . . . . . . . 1,652 1,692
======== =======
</TABLE>
The net loss for the six months ended June 30, 1998, includes $291 million, net
of tax, in restructuring and asset impairment charges as described in Note 3 to
the Consolidated Financial Data.
NOTE 3 - RESTRUCTURING AND ASSET IMPAIRMENT CHARGES
- ----------------------------------------------------------
In June 1998, Compaq's management approved restructuring plans, which
include initiatives to integrate the operations of Compaq and Digital,
consolidate duplicative facilities, improve service delivery and reduce
overhead. Total accrued restructuring costs of $1.7 billion have been recorded
in the second quarter related to these initiatives, $1.4 billion of which
relates to Digital and was recorded as a component of the purchase price
allocation and $286 million relates to Compaq, which was charged to operations.
Management is in the process of finalizing its restructuring plans related to
Digital, and accordingly, the amounts recorded related to Digital are based on
management's current estimate of those costs. Management expects the Digital
restructuring plans to be finalized by the end of the year. Areas where
management estimates may be revised primarily relate to Digital employee
relocation costs, facility closure costs and other exit costs. Adjustments to
accrued restructuring costs related to Digital will be recorded as an adjustment
to the preliminary purchase price allocation.
Accrued restructuring charges include $1.1 billion ($999 million for
Digital and $132 million for Compaq) representing the cost of involuntary
employee separation benefits related to approximately 19,700 employees worldwide
(approximately 14,700 Digital employees and 5,000 Compaq employees). Employee
separation benefits include severance, medical and other benefits. Employee
separations will affect the majority of business functions, job classes and
geographies, with a majority of the reductions in North America and Europe. The
restructuring plans also include costs totaling $414 million ($272 million
related to Digital and $142 million related to Compaq) associated with the
closure of 13.2 million square feet of office, distribution and manufacturing
space, principally in North America and Europe. Other restructuring costs
include $99 million related to the relocation of Digital employees, with the
majority of this amount attributable to relocations in North America and Europe,
and $100 million primarily related to costs of terminating certain Digital
contractual obligations. Compaq expects that most of the restructuring actions
related to the plans will be completed within the next year.
7
<PAGE>
NOTE 3 - RESTRUCTURING AND ASSET IMPAIRMENT CHARGES (CONTINUED)
- ----------------------------------------------------------------------
The accrued restructuring costs and amounts charged against the provision
as of June 30, 1998, were as follows (dollars in millions):
<TABLE>
<CAPTION>
- --------------------------------- ------------- -------- ----------- -----
CURRENT
YEAR
COMPAQ DIGITAL SPENDING TOTAL
- --------------------------------- ------------- -------- ----------- -----
<S> <C> <C> <C> <C>
Employee separations. . . . . . . $ 132 $ 999 $ (4) $1,127
Facility closure costs. . . . . . 142 272 (6) 408
Relocation. . . . . . . . . . . . - 99 - 99
Other exit costs. . . . . . . . . 12 88 - 100
- --------------------------------- ------------- -------- ----------- -----
Total accrued restructuring costs $ 286 $ 1,458 $ (10) $1,734
- --------------------------------- ------------- -------- ----------- -----
Number of employee separations
due to restructuring actions 46
- --------------------------------- ------------- -------- ----------- -----
</TABLE>
During the quarter, Compaq also recorded a $107 million charge related to
asset impairments. The asset impairments resulted from the writedown to fair
market value less costs to sell for assets taken out of service and held for
sale or disposal. The majority of this charge relates to the impairment of $74
million of intangible assets associated with the acquisition of a company during
1995 that developed, manufactured, and supplied fast ethernet hubs, switches and
related products. In May 1998, management decided to close the manufacturing
facility and abandon the technologies acquired through this acquisition and
discontinue all related products.
NOTE 4 - CERTAIN BALANCE SHEET COMPONENTS
- -----------------------------------------------
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
--------- -------------
(IN MILLIONS)
<S> <C> <C>
INVENTORIES:
Raw materials and work-in-process . . $ 943 $ 767
Finished goods. . . . . . . . . . . . 1,259 803
--------- -------------
$ 2,202 $ 1,570
========= =============
PROPERTY, PLANT & EQUIPMENT:
Land. . . . . . . . . . . . . . . . . $ 423 $ 185
Buildings and leasehold improvements. 2,483 1,076
Machinery and equipment . . . . . . . 3,834 2,392
Construction-in-process and other . . 452 373
--------- -------------
7,192 4,026
Less accumulated depreciation . . . . 4,337 2,041
--------- -------------
$ 2,855 $ 1,985
========= =============
</TABLE>
8
<PAGE>
NOTE 4 - CERTAIN BALANCE SHEET COMPONENTS (CONTINUED)
- ------------------------------------------------------------
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
--------- -------------
<S> <C> <C>
INTANGIBLES AND OTHER ASSETS:
Installed customer base, net . . . . $ 1,212 $ -
Proven research and development, net 591 -
Trademarks, net. . . . . . . . . . . 221 3
Other intangibles and goodwill, net. 490 139
Other assets . . . . . . . . . . . . 729 487
--------- -------------
$ 3,243 $ 629
========= =============
OTHER CURRENT LIABILITIES:
Salaries, wages and related items. . $ 770 $ 123
Deferred revenue . . . . . . . . . . 929 31
Accrued warranty . . . . . . . . . . 680 423
Accrued royalties. . . . . . . . . . 216 132
Other accrued expenses . . . . . . . 2,158 1,280
Current portion of long-term debt. . 264 181
--------- -------------
$ 5,017 $ 2,170
========= =============
</TABLE>
The estimated lives for property, plant and equipment are 30 years for
buildings and range from 3 to 10 years for machinery and equipment. Leasehold
improvements are amortized over the shorter of the useful life of the
improvement or the life of the related lease. The estimated lives of proven
research and development, installed customer base, and trademarks are 5 years,
15 years and 5 years, respectively.
NOTE 5 - TENDER OFFER FOR NOTES AND DEBENTURES
- ------------------------------------------------------
In June 1998, Compaq completed a cash tender offer for Digital debt
securities with a fair value of $879 million, including accrued interest.
Compaq paid an aggregate of $799 million (including accrued interest) for the
notes and debentures tendered. The untendered balance of the notes and
debentures is included in other current liabilities.
NOTE 6 - PENSION, POSTRETIREMENT AND OTHER POSTEMPLOYMENT BENEFITS
- --------------------------------------------------------------------------
Upon consummation of the Digital acquisition, Compaq assumed certain of
Digital's defined benefit and defined contribution plans. The Digital employees
who were eligible to participate in the Digital plans at the time of the
acquisition are eligible to participate in these plans. The benefits generally
are based on years of service and compensation during the employee's career.
Pension cost is based on estimated benefit formulas.
Additionally, Compaq assumed the defined benefit postretirement plans that
provide medical and dental benefits for Digital's retirees and their eligible
dependents in the U.S and certain other locations. The majority of Digital's
non-U.S. subsidiaries do not offer postretirement benefits other than pensions
to retirees.
9
<PAGE>
NOTE 7 - TREASURY STOCK
- ---------------------------
On April 23, 1998, the Board of Directors authorized a systematic stock
repurchase program to acquire up to 100 million shares of Compaq's common stock.
Compaq implemented this program on May 4, 1998. Compaq repurchased
approximately 892,000 shares through June 30, 1998, for approximately $26
million.
NOTE 8 - OTHER INCOME AND EXPENSE
- ---------------------------------------
Other income and expense consisted of the following:
<TABLE>
<CAPTION>
SIX MONTHS, QUARTER ENDED
ENDED JUNE 30, JUNE 30,
-------------- --------------
1998 1997 1998 1997
------ ------ ------ ------
(IN MILLIONS)
<S> <C> <C> <C> <C>
Interest and dividend income. . . . . $(171) $(119) $ (86) $ (63)
Interest (income) expense associated
With hedging . . . . . . . . . . . . 2 (3) 3 (1)
Other interest expense. . . . . . . . 75 66 35 32
Currency (gains) losses, net. . . . . (2) 12 (6) 9
Minority interest dividend. . . . . . 1 - 1 -
Other, net. . . . . . . . . . . . . . 21 25 9 19
------ ------ ------ ------
$ (74) $ (19) $ (44) $ (4)
====== ====== ====== ======
</TABLE>
NOTE 9 - COMPREHENSIVE INCOME
- ---------------------------------
Comprehensive income (loss) is comprised of two components: net income and
other comprehensive income. Other comprehensive income refers to revenues,
expenses, gains and losses that under generally accepted accounting principles
are recorded as an element of stockholders' equity and are excluded from net
income. Compaq's other comprehensive income is comprised of foreign currency
translation adjustments from certain subsidiaries. Comprehensive income for the
six months ended June 30, 1998 and 1997, respectively, is insignificant and
therefore is not disclosed in the balance sheet as a separate component of
stockholders' equity. The components of comprehensive income (loss) are listed
below:
<TABLE>
<CAPTION>
SIX MONTHS, QUARTER ENDED
ENDED JUNE 30, JUNE 30,
---------------- ----------------
1998 1997 1998 1997
-------- ------ -------- ------
(IN MILLIONS)
<S> <C> <C> <C> <C>
Net income (loss) . . . . . $(3,616) $ 671 $(3,632) $ 257
Other comprehensive loss. . (5) (13) (2) (3)
-------- ------ -------- ------
Comprehensive income (loss) $(3,621) $ 658 $(3,634) $ 254
======== ====== ======== ======
</TABLE>
NOTE 10 - EARNINGS PER COMMON SHARE
- -----------------------------------------
Basic earnings per common share is computed using the weighted average
number of shares outstanding during the period. Diluted earnings per common
share is computed using the weighted average number of shares outstanding
adjusted for the incremental shares attributed to outstanding options to
purchase common stock. Diluted loss per share is based only on the weighted
average number of shares outstanding during the period. Incremental common
stock equivalent shares of 60 million and 59 million were not used in the
calculation of diluted earnings per common share in the six and three months
ended June 30, 1998, respectively, due to the net loss for the periods.
10
<PAGE>
NOTE 10 - EARNINGS PER COMMON SHARE (CONTINUED)
- ------------------------------------------------------
Incremental common stock equivalent shares of 50 million and 52 million were
used in the calculation of diluted earnings per common share in the six and
three months ended June 30, 1997, respectively.
Stock options to purchase 11 million shares and 50 million shares of common
stock for the six-month periods and 13 million shares and 53 million shares of
common stock for the three-month periods ended June 30, 1998 and 1997,
respectively, were outstanding but not included in the computation of diluted
earnings per common share because the option exercise price was greater than
the average market price of the common shares, and therefore, the effect would
be antidilutive.
NOTE 11 - LITIGATION
- -----------------------
Five class action lawsuits have been filed in the United States District
Court for the Southern District of Texas, Houston Division. The actions are
purported class actions of all persons who purchased Compaq common stock from
July 10, 1997 through March 6, 1998, and the named defendants include the
Company and certain of its current and former officers and directors. The
complaints allege that the defendants violated Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by, among
other things, withholding information and making misleading statements about
channel inventory and factoring of receivables in order to inflate the market
price of Compaq's common stock, and further alleges that certain of the
individual defendants sold Compaq common stock at these inflated prices. A
motion for the appointment of lead counsel and the consolidation of the
purported class action lawsuits is pending. The plaintiffs seek monetary
damages, interest, costs and expenses. The Company intends to defend the suits
vigorously.
Several purported class action lawsuits were filed against Digital during
1994 alleging violations of the federal securities laws arising from alleged
misrepresentations and omissions in connection with Digital's issuance and sale
of Series A 8-7/8% Cumulative Preferred Stock and Digital's financial results
for the quarter ended April 2, 1994. During 1995, the lawsuits were
consolidated into three cases, which were pending before the United States
District Court for the District of Massachusetts. On August 8, 1995, the
Massachusetts federal court granted the defendants' motion to dismiss all three
cases in their entirety. On May 7, 1996, the United States Court of Appeals for
the First Circuit affirmed in part and reversed in part the dismissal of the two
cases, and remanded for further proceedings.
NOTE 12 - DIGITAL SUMMARIZED UNAUDITED FINANCIAL INFORMATION (DIGITAL
- -----------------------------------------------------------------------------
STAND-ALONE)
- ------------
In March 1994, Digital sold to the public 16 million Depositary shares
under a shelf registration, each representing a one-fourth interest in a share
of the Series A Preferred Stock, par value $1.00 per share. Dividends on the
Series A Preferred Stock accrue at the annual rate of 8-7/8%, or $35.5 million
per year. The Series A Preferred Stock is not convertible into, or exchangeable
for, shares of any other class or classes of stock. The Series A Preferred
Stock is not redeemable prior to April 1, 1999. On or after April 1, 1999,
Compaq, at its option, may redeem shares of the Series A Preferred Stock, for
cash at the redemption price per share of $100 ($25 per depository share), plus
accrued and unpaid dividends. Compaq has guaranteed the dividend payments,
redemption price and liquidation preference of the Digital Series A Preferred
Stock. At June 30, 1998, there were declared and unpaid dividends of $8.9
million.
The summarized unaudited financial information for Digital and its
consolidated subsidiaries is presented below. This summarized financial data was
derived from the fiscal period end financial statements of Digital prepared on a
stand-alone basis in conformity with generally accepted accounting principles
11
<PAGE>
NOTE 12 - DIGITAL SUMMARIZED UNAUDITED FINANCIAL INFORMATION (DIGITAL
- -----------------------------------------------------------------------------
STAND-ALONE)
- ------------
and does not give affect to purchase accounting adjustments. The stand-alone
Digital information is not necessarily indicative of the future results of
Digital. The Digital information does not necessarily reflect the results that
Digital would have realized had the acquisition not occurred. Separate
financial statements and other disclosures concerning Digital are not deemed
by management to be meaningful to holders of the Series A Preferred Stock.
<TABLE>
<CAPTION>
JUNE 27, DECEMBER 27,
1998 1997
--------- -------------
(IN MILLIONS)
<S> <C> <C>
Current assets. . . . . $ 5,028 $ 6,428
Noncurrent assets . . . 4,296 2,365
Current liabilities . . 3,629 3,487
Noncurrent liabilities. 1,877 1,910
Stockholders' equity. . 3,818 3,396
</TABLE>
<TABLE>
<CAPTION>
SIX MONTHS ENDED QUARTER ENDED
------------------ ------------------
June 27, June 28, June 27, June 28,
1998 1997 1998 1997
-------- -------- -------- --------
(IN MILLIONS)
<S> <C> <C> <C> <C>
Product sales. . . . . . . . . . $ 3,399 $ 3,830 $ 1,717 $ 1,994
Service revenues . . . . . . . . 3,026 2,947 1,517 1,469
Gross margin - product sales . . 1,122 1,390 535 742
Gross margin - service revenues. 931 915 444 457
Net income (loss). . . . . . . . 284 175 (58) 124
</TABLE>
12
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the
consolidated interim financial statements.
RESULTS OF OPERATIONS
The following table presents, as a percentage of revenue, certain selected
financial data for the three- and six-month periods ended June 30, 1998 and
1997.
<TABLE>
<CAPTION>
SIX MONTHS, QUARTER ENDED
ENDED JUNE 30, JUNE 30,
--------------- ---------------
1998 1997 1998 1997
------- ------ ------- ------
<S> <C> <C> <C> <C>
Revenue:
Product sales . . . . . . . . . . . . . . . 95.0% 98.0% 92.1% 98.0%
Service revenue . . . . . . . . . . . . . . 5.0 2.0 7.9 2.0
------- ------ ------- ------
100.0 100.0 100.0 100.0
------- ------ ------- ------
Cost of sales:
Cost of product sales . . . . . . . . . . . 78.2 71.2 75.6 70.7
Cost of service revenue . . . . . . . . . . 3.3 1.4 5.4 1.4
------- ------ ------- ------
81.5 72.6 81.0 72.1
------- ------ ------- ------
Product sales gross margin. . . . . . . . . . . 16.8 26.9 16.6 27.4
Service sales gross margin. . . . . . . . . . . 1.7 0.5 2.4 0.5
------- ------ ------- ------
18.5 27.4 19.0 27.9
------- ------ ------- ------
Selling, general and administrative expenses. . 15.9 12.1 18.0 12.2
Research and development costs. . . . . . . . . 4.3 3.6 4.3 3.6
Purchased in-process technology . . . . . . . . 28.1 1.9 55.5 3.8
Restructuring and asset impairment charges. . . 3.4 - 6.7 -
Other income and expense, net . . . . . . . . . (0.6) (0.1) (0.8) (0.1)
------- ------ ------- ------
51.1 17.5 83.7 19.5
------- ------ ------- ------
Income (loss) before provision for income taxes (32.6)% 9.9% (64.7)% 8.4%
======= ====== ======= ======
</TABLE>
OVERVIEW
Compaq's recent emphasis on acquisitions, combined with significant
operational growth, has expanded and enhanced its business model, which is built
on open industry-standard products with leading enterprise technology and a
global service offering providing enterprise solutions leadership. As one of
the top three global information technology companies, Compaq is an industry
leader committed to delivering superior customer value through standards-based,
partner-leveraged computing that features world class services, support and
market-segment focused solutions, particularly in communications, manufacturing
and finance. Compaq is a strategic information technology partner to customers
of all sizes providing product offerings that range from handheld computers to
powerful failsafe computer servers.
The Company recorded several charges during the second quarter in
connection with the June 11, 1998 Digital acquisition and closing of certain
Compaq facilities (see notes 2 and 3 to consolidated financial data). These
charges, net of related taxes, included $3.2 billion for the write-off of
13
<PAGE>
purchased in-process technology, $291 million for restructuring and asset
impairment charges related to Compaq employee separations and elimination of
certain Compaq facilities, and $139 million for other operating adjustments.
These operating adjustments were primarily for incremental pricing actions on
certain Digital products to integrate them with Compaq products in the
marketplace and the higher cost of sales as a result of fair value adjustments
for acquired Digital products sold since the acquisition date.
The Digital acquisition was accounted for as a purchase transaction.
Accrued restructuring costs of $1.4 billion related to Digital employee
separations, elimination of duplicate facilities, employee relocations, and
other exit costs was included as part of the purchase price allocation.
REVENUES
During the second quarter of 1998, Compaq continued its transition to the
Optimized Distribution Model, reducing channel inventories and adopting a
market "pull" strategy based on customer demand. As anticipated, this
transition in the Compaq business model negatively impacted revenue for the
second quarter, as the Company increased its focus on sales out of the channel.
Revenue growth during the second quarter increased 5.7%, year over year, while
unit sales into the channel increased 17.0% during the same period. The
disproportionate revenue growth as compared to unit shipment growth is primarily
due to promotional activities needed to support the transition period. Unit
sales out of the channel indicated strong demand for Compaq products during the
second quarter increasing 36%, year over year. Revenue growth in products
versus services, and by geographic component for the quarter and year to date,
is set forth below.
Total operating revenue increased $732 million, or 6.8%, for the six months
ended June 30, 1998 over the comparable period in 1997. Revenue from product
sales for the six months ended June 30, 1998 increased $374 million, or 3.5%,
from the same period in 1997. Service revenue increased $358 million for the
first six months of 1998 over the prior year primarily due to the acquisition of
Digital. Total operating revenue from North America, including Canada,
decreased 3.6% for the six-month period ending June 30, 1998, compared to the
same period in 1997. European operating revenue increased 23.4%, while other
international revenue increased 5.5% for the first six months of 1998, compared
to the same period in the prior year. International operating revenue,
excluding Canada, represented 65% of total operating revenue for the six-month
period of 1998.
Total operating revenue increased $317 million, or 5.7%, for the three
months ended June 30, 1998 over the comparable period in 1997. Revenue from
product sales for the three months ended June 30, 1998 decreased $33 million, or
0.6%, from the same period in 1997. Service revenue increased $350 million for
the second quarter of 1998 over the prior year primarily due to the acquisition
of Digital. Total operating revenue from North America, including Canada,
decreased 11.8% for the three-month period ending June 30, 1998 compared to the
same period in 1997. European operating revenue increased 29.3%, while other
international revenue increased 17.0% in the second quarter of 1998, compared to
the same period in the prior year. International operating revenue, excluding
Canada, represented 65% of total operating revenue for the quarter ended June
30, 1998.
Without the inclusion of Digital products and services from the date of
acquisition, total operating revenue declined 3.7% and 14.7% for the six and
three-month periods ended June 30, 1998 compared to the same periods in 1997,
respectively, while total product unit shipments increased 24.9% and 10.7%,
respectively, over the same periods. Price reductions and promotional
activities primarily on commercial products in North America more than offset
the increases in product unit shipments. The price reductions and promotional
actions were taken to reduce channel inventories to achieve Compaq's Optimized
Distribution Model goal of four weeks of channel inventory by June 30, 1998,
as well as to respond to competitive pricing conditions. Increases in unit
shipments occurred in all geographies and in all segments, and were particularly
strong in the consumer sector.
14
<PAGE>
GROSS MARGIN
Gross margin as a percentage of sales decreased to 18.5% from 27.4% for the
six-month period of 1998 and 1997, respectively, and decreased to 19% in the
second quarter of 1998 compared to 27.9% in the comparable period of 1997.
Product gross margin as a percentage of product sales declined to 17.7% from
27.4% for the six-month period. The decrease in product gross margin resulted
primarily from significant pricing and promotion actions taken in the North
American market to adjust the business model to meet the goals of Compaq's
Optimized Distribution Model over the six-month period. Service gross margin as
a percentage of service revenue increased to 33.7% from 27.1% for the first six
months of 1998 and 1997, respectively, and increased to 31.3% from 26.4% in the
second quarter of 1998 compared to the same period in 1997. The increase in
service gross margin is primarily attributable to the inclusion of Digital for
the last two weeks of June.
OPERATING EXPENSES
Compaq's selling, general and administrative expense increased to 15.9% of
sales in the year to date period as compared with 12.1% in the same period of
1997. Selling, general and administrative expense increased to 18.0% of sales
in the second quarter compared with 12.2% in the same period of 1997. The
increase in Compaq's selling, general and administrative expense is primarily
due to the impact of the pricing and promotional actions on sales during the
six-month period. Historically, Digital has maintained a higher cost structure
than Compaq. Compaq anticipates that for the remainder of 1998, selling,
general and administrative expense will increase as a percentage of revenue and
in absolute dollars due to the impact of Digital's existing cost structure, new
product introductions, the expansion of its advertising and promotion programs
and increases in investments in the area of service and support. Compaq plans
to achieve a more competitive cost structure through implementation of its
restructuring plans, which include initiatives to integrate operations of Compaq
and Digital, consolidate duplicative facilities, improve service delivery and
reduce overhead. Compaq expects the impact of the restructuring actions to
reduce expenses over the long term.
Research and development costs increased to 4.3% of sales for the six
months and second quarter of 1998, compared to 3.6% in the corresponding periods
of 1997. The increase in research and development costs is primarily
attributable to the inclusion of Digital for two weeks of the period. Compaq is
committed to continuing a significant research and development program to
support current operations and meet the demands of new product introductions.
PURCHASED IN-PROCESS TECHNOLOGY
Upon consummation of the Digital acquisition, Compaq immediately expensed
$3.2 billion representing purchased in-process technology that has not yet
reached technological feasibility and has no alternative future use (see note 2
to consolidated financial data). The value was determined by estimating the
costs to develop the purchased in-process technology into commercially viable
products, estimating the resulting net cash flows from such projects, and
discounting the net cash flows back to their present value. The discount rate
includes a factor that takes into account the uncertainty surrounding the
successful development of the purchased in-process technology. If these
projects are not successfully developed, future revenue and profitability of
Compaq may be adversely affected.
The resulting net cash flows from such projects are based on Compaq
management's estimates of revenues, cost of sales, research and development
costs, selling, general and administrative costs, and income taxes from such
projects. These estimates are based on the following assumptions:
The estimated revenues project average compounded annual revenue growth
rates of 8% to 39% during 1998-2001 depending on the product areas. For
instance, UNIX/Open VMS compounded annual growth rates are 8% and storage rates
are 39%. Estimated total revenues from the purchased in-process product areas
15
<PAGE>
peak in the year 2001 and decline rapidly in 2002-2005 as other new products are
expected to enter the market. These projections are based on Compaq management's
estimates of market size and growth (that are supported by independent market
data), expected trends in technology (such as new families of products in the
external storage product area) and the nature and expected timing of new product
introductions by Digital and its competitors. These estimates also include
growth related to Compaq utilizing certain Digital technologies in conjunction
with Compaq's products, Compaq's marketing and distributing the resulting
products through Compaq's resellers and Compaq's enhancing the market's response
to Digital's products by providing incremental financial support and stability.
The estimated cost of sales as a percentage of revenues is expected to be
lower than Digital's on a stand-alone basis (66% in fiscal 1997) primarily due
to Compaq's expected ability to achieve more favorable pricing from key
component vendors and production efficiencies due to economies of scale through
combined operations. As a result of these savings, the estimated cost of sales
as a percentage of revenues is expected to decrease by 1% to 6% from Digital's
historical percentage, depending on the product areas.
The combined company is expected to benefit from more favorable pricing from key
component vendors within three to six months and production efficiencies due to
economies of scale within six months to a year of the closing of the
transaction. As a result of these savings, the estimated costs of sales as a
percentage of revenues for the UNIX/Open VMS and storage markets, the two most
significant product areas of purchased in-process technology, are expected to
decrease up to 6% from Digital's historical percentages.
The estimated selling, general and administrative costs are expected to
more closely approximate Compaq's cost structure (approximately 12% of revenues
in 1997), which is lower than Digital's cost structure (approximately 24% of
revenues in fiscal 1997). Cost savings are expected to result primarily from
the changes related to the restructuring actions discussed in Note 3, as well as
savings resulting from the distribution of Digital's products through Compaq's
resellers (i.e., sales of higher volume products with lower direct selling
costs) and efficiencies due to economies of scale through combined operations
(i.e., consolidated marketing and advertising programs). These cost savings are
expected to be realized primarily in 1999 and thereafter. A significant portion
of these savings is attributable to the restructuring actions, half of which are
expected to occur in 1998 and half in 1999.
Discounting the net cash flows back to their present value is based on the
weighted average cost of capital (WACC). The WACC calculation produces the
average required rate of return of an investment in an operating enterprise,
based on various required rates of return from investments in various areas of
that enterprise. The WACC assumed for Compaq, as a corporate business
enterprise, is 12% to 14%. The discount rate used in discounting the net cash
flows from purchased in-process technology ranged from 22% for UNIX/OpenVMS, NT
Systems and storage to 40% for advanced development projects. This discount
rate is higher than the WACC due to the inherent uncertainties in the estimates
described above including the uncertainty surrounding the successful development
of the purchased in-process technology, the useful life of such technology, the
profitability levels of such technology and the uncertainty of technological
advances that are unknown at this time.
In addition, the value assigned to purchased in-process technology for
Microcom, Inc., which Compaq acquired in June 1997, was determined by
identifying research projects in areas including modems, remote access
technologies and others, for which technological feasibility has not been
established, estimating the costs to develop the purchased in-process technology
into commercially viable products, estimating the resulting cash flows from such
projects, and discounting the net cash flows back to the present value. The
discount rate includes a factor that takes into account the uncertainty
surrounding the successful development of the purchased in-process technology.
16
<PAGE>
If these projects are not successfully developed, the sales and
profitability of the combined company may be adversely affected in future
periods. Additionally, the value of other intangible assets acquired may become
impaired. Compaq expects to begin to benefit from the purchased in-process
technology in late 1998.
RESTRUCTURING AND ASSET IMPAIRMENT CHARGES
In June 1998, Compaq's management approved restructuring plans, which
include initiatives to integrate operations of Compaq and Digital, consolidate
duplicative facilities, improve service delivery and reduce overhead. Total
accrued restructuring costs of $1.7 billion have been recorded in the second
quarter related to these initiatives, $1.4 billion of which relates to Digital
and was recorded as a component of the purchase price allocation and $286
million relates to Compaq which was charged to operations. Management is in the
process of finalizing its restructuring plans related to Digital, and
accordingly, the amounts recorded related to Digital are based on management's
current estimates of those costs. Management expects the Digital restructuring
plans to be finalized by the end of the year. Areas where management estimates
may be revised primarily relate to Digital employee relocation costs, facility
closure costs and other exit costs. Adjustments to accrued restructuring costs
related to Digital will be recorded as an adjustment to the preliminary purchase
price allocation.
Accrued restructuring charges include $1.1 billion ($999 million for
Digital and $132 million for Compaq) representing the cost of involuntary
employee separation benefits related to approximately 19,700 employees worldwide
(approximately 14,700 Digital employees and 5,000 Compaq employees). Employee
separation benefits include severance, medical and other benefits. Employee
separations will affect the majority of business functions, job classes and
geographies, with a majority of the reductions in North America and Europe. The
restructure plans also include costs totaling $414 million (approximately $272
million related to Digital and $142 million related to Compaq) associated with
the closure of 13.2 million square feet of office, distribution and
manufacturing space, principally in North America and Europe. Other exit costs
include $99 million related to the relocation of Digital employees, with the
majority of this amount attributable to relocations in North America and Europe,
and $100 million primarily related to costs of terminating certain Digital
contractual obligations. Compaq expects that most of the contemplated
restructuring actions related to the plan will be completed within the next
year.
During the quarter, Compaq also recorded a $107 million charge related to
asset impairments. The asset impairments resulted from the writedown to fair
market value less costs to sell for assets taken out of service and held for
sale or disposal. The majority of this charge relates to the impairment of $74
million of intangible assets associated with the acquisition of a company during
1995 that developed, manufactured, and supplied fast ethernet hubs, switches and
related products. In May 1998, management decided to close the manufacturing
facility and abandon the technologies acquired through this acquisition and
discontinue all related products. Management anticipates that additional asset
impairments may result in the future as restructuring plans are implemented and
additional assets are taken out of service and held for abandonment and sale.
Additional increases in depreciation expense may occur as asset lives are
adjusted as a result of the integration process.
Compaq's cost of sales and selling, general and administrative costs are
expected to increase in the short term, as a result of the Digital acquisition,
as a percentage of revenue and in absolute dollars. Compaq expects the impact
of the restructuring actions to reduce expenses over the longer term.
17
<PAGE>
OTHER ITEMS
Compaq had other income of $74 and $19 million for the six months and $44
million and $4 million in the second quarter of 1998 and 1997, respectively.
This difference was primarily due to an increase in interest and dividend income
related to higher combined cash and short-term investment balances, partially
offset by increased interest expense.
The translation gains and losses relating to the financial statements of
certain of Compaq's international subsidiaries, net of offsetting gains and
losses associated with hedging activities related to the net monetary assets of
these subsidiaries, are included in other income and expense and were a net gain
of $6 million in the second quarter of 1998, compared to a net loss of $9
million in the second quarter of 1997.
LIQUIDITY AND CAPITAL RESOURCES
Compaq's working capital decreased to $4.2 billion at June 30, 1998,
compared to $6.8 billion at December 31, 1997, primarily as a result of the
acquisition of Digital, completion of a tender offer for the Digital notes and
debentures and accrued restructuring costs.
Compaq's cash, cash equivalents, and short-term investments decreased to
$4.6 billion at June 30, 1998, from $6.4 billion at December 31, 1997, primarily
due to the cash payment made to acquire Digital net of cash received in the
acquisition, and completion of a tender offer for the Digital notes and
debentures. Approximately $73 million of accounts receivable were sold in the
second quarter of 1998, compared to $1.1 billion in the quarter ended December
31, 1997. From time to time, Compaq may sell accounts receivables when it is
economically beneficial to do so. Inventory levels increased to $2.2 billion,
compared to $1.6 billion at December 31, 1997, primarily due to the acquisition
of Digital partially offset by changes in production planning as a result of
Compaq's transition to the Optimized Distribution Model. For the six months
ended June 30, 1998, cash expenditures for restructuring activities were
$10 million. Future cash expenditures for currently planned restructuring
activities are estimated to be $1.7 billion.
In May 1998, Compaq implemented a systematic stock repurchase program to
acquire up to 100 million shares of Compaq's common stock. Compaq repurchased
approximately 892,000 shares through June 30, 1998, for approximately $26
million. In June 1998, Compaq utilized approximately $4.5 billion in cash to
complete the acquisition of Digital and $799 million, including interest, in
cash to complete a tender offer for the Digital notes and debentures. Cash used
for the purchase of property, plant, and equipment totaled $257 million. Compaq
estimates that capital expenditures for land, buildings, and equipment during
the remainder of 1998 will be $360 million. In June 1998, Compaq acquired a ten
percent preferred equity position in a business venture with Time Warner,
Advance/Newhouse, MediaOne and Microsoft for approximately $213 million in cash.
The venture will provide Internet services and intends to accelerate the
delivery of broadband services over cable modems to consumers and small
businesses under the Road Runner brand.
Compaq currently expects to fund expenditures for capital requirements as
well as liquidity needs from a combination of available cash balances,
internally generated funds and financing arrangements. Compaq from time to time
may borrow funds for actual or anticipated funding needs or because it is
economically beneficial to borrow funds instead of repatriating funds in the
form of dividends from Compaq's foreign subsidiaries. Compaq has a $4 billion
syndicated credit facility (of which $1 billion expires in September 1998 and $3
billion expires in September 2002) that was unused at June 30, 1998. Compaq has
established a commercial paper program, supported by the syndicated credit
facility, which was unused at June 30, 1998. Compaq believes that these sources
of credit provide sufficient financial flexibility to meet future funding
requirements. Compaq continually evaluates the need to establish other sources
of working capital and will pursue those it considers appropriate based upon
Compaq's needs and market conditions.
18
<PAGE>
Other planned uses of cash include the efforts to develop the purchased
in-process technology related to the Digital acquisition into commercially
viable products. This primarily consists of the completion of all planning,
designing, prototyping, high-volume manufacturing verification and testing
activities that are necessary to establish that the product can be produced to
meet its design specifications, including functions, features and technical
performance requirements. Bringing the purchased in-process technology to
market also includes developing firmware and diagnostic software, device driver
development, and testing the technology for compatibility and interoperability
with commercially viable products. The estimated costs to be incurred to
develop the Digital-related purchased in-process technology into commercially
viable products are approximately $3.1 billion in the aggregate through the year
2005: $60 million in 1998, $510 million in 1999, $660 million in 2000, $630
million in 2001, $520 million in 2002, $400 million in 2003, $210 million in
2004 and $90 million in 2005. In addition, the estimated costs to be incurred to
develop the Microcom purchased in-process technology into commercially viable
products is approximately $500 million to be incurred through the year 2001.
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (FAS 133). FAS 133 is effective January 1,
2000 for Compaq. FAS 133 requires that all derivative instruments be recorded
on the balance sheet at fair value. Changes in the fair value of derivatives
are recorded each period in current earnings or other comprehensive income,
depending on whether a derivative is designated as part of a hedge transaction
and, if it is, the type of hedge transaction. The ineffective portion of all
hedges will be recognized in current-period earnings.
Compaq has not yet determined the impact that the adoption of FAS 133 will have
on its earnings or statement of financial position.
19
<PAGE>
FACTORS THAT MAY AFFECT FUTURE RESULTS
Compaq participates in a highly volatile industry that is characterized by
fierce industry-wide competition for market share. Industry participants
confront aggressive pricing practices, continually changing customer demand
patterns, growing competition from well-capitalized high technology and consumer
electronics companies, and rapid technological development carried out in the
midst of legal battles over intellectual property rights and the application of
antitrust laws. In accordance with the provisions of the Private Securities
Litigation Reform Act of 1995, the cautionary statements set forth below discuss
important factors that could cause actual results to differ materially from the
projected results contained in the forward-looking statements in this report.
Market Environment. Compaq expects the personal computer market to expand
in 1998 in line with third party research organizations' forecasts of unit
growth in the range of 15% to 16%. The Company expects the enterprise market to
expand with the development of internet and intranet enterprise applications and
the corporate MIS migration from legacy systems to client/server systems. With
its acquisition of Tandem Computers Incorporated in the third quarter of 1997
and the acquisition of Digital Equipment Corporation in the second quarter of
1998, the Company confronts a challenge in building the high-end UNIX solutions
market while continuing to advance the sphere of NT-based solutions to achieve
the lowest cost of ownership and the highest computing value for its customers.
Although Compaq has programs, products and services focused on meeting market
demand, gaining market share profitably and maintaining gross margins, Compaq's
ability to achieve these goals is subject to the risks set forth in this
discussion.
Competitive Environment. Competition remains fierce in the information
technology industry with a large number of competitors vying for market share.
Competition creates an aggressive pricing environment, which continues to put
pressure on gross margins. A number of PC companies sell directly to end users
and, particularly in the U.S., direct sales have increased as a percentage of
the total PC market. Compaq has established a variety of programs designed to
increase its manufacturing, distribution, and business process efficiencies to
enable it to compete more effectively. In June 1998, Compaq announced that its
earnings in the second quarter would be at break even and that the third quarter
would be transitional, focused both on the integration of Digital businesses and
the achievement of synergies. In the first half of 1998, Compaq implemented
programs to further increase its competitiveness against direct sellers. The
success of these programs depends upon Compaq's ability to continue its
successful working relationship with its resellers, to maintain and increase its
service business, to both predict and react quickly to market responses by its
competitors, and to continue the implementation of its Optimized Distribution
Model, the goal of which is to implement more efficient component supply,
manufacturing, and distribution strategies to increase overall efficiencies.
Risks of Newly Acquired Businesses. As a result of Compaq's acquisition of
Digital, it will expand its service offerings and enterprise solutions. This
expansion, however, includes a number of risks associated with Digital's
business. Compaq believes that the Digital acquisition will enhance its
operating results, but as with any significant acquisition or merger, it
confronts challenges in retaining key employees, maintaining key industry
alliances, synchronizing product roadmaps and business processes, and
integrating logistics, marketing, product development, services and
manufacturing operations to achieve greater efficiencies. While Compaq intends
to increase its service revenue through this acquisition, there are risks
associated with this new business, which include jeopardizing Compaq's long-term
relationships with third party resellers while it provides services directly to
end-user customers, as well as reducing service revenue in the short term due to
the cancellation of Digital's existing service contracts by Compaq's
competitors. Compaq has also made certain estimates in connection with the
value of purchased in-process technology. If these projects are not
successfully developed, its future revenue and profitability may be adversely
affected and the value of other intangibles could be reduced. This risk is more
fully discussed under "Purchased In-Process Technology." Compaq plans to
continue to use strategic acquisitions and mergers to assist in the growth of
its business.
20
<PAGE>
Third Party Relationships. Compaq works with third parties in strategic
alliances to facilitate product offerings, product development, and
compatibility, in various manufacturing, configuring and shipping capacities,
and as suppliers of components and services in non-core competencies. Although
it tries to achieve strong working relationships with parties who share its
industry goals and have adequate resources to fulfill their responsibilities,
these relationships lead to a number of risks. First, these companies may suffer
financial or operational difficulties that affect their performance, which could
lead to delays in product announcements and gaps in component supplies. Second,
major companies from which the Company purchases components or services (such as
Intel, Microsoft, Cisco and IBM) may be competitors in other areas, which could
affect pricing, new product development or future performance. Third,
difficulties in coordinating activities may lead to gaps in delivery and
performance of products. Finally, companies from which Compaq purchases
components may be subject to legal challenges that impede their ability to ship
their products in a timely manner. A number of regulatory authorities are
currently investigating allegations of violations of antitrust laws by Microsoft
and Intel. Any delays in shipments of new products resulting from such
investigations could delay shipments of Compaq's products as well as negatively
impact customer demand stemming from new product generations.
Inventory. In the event of a drop in worldwide demand for computer
products, lower-than-anticipated demand for one or more of Compaq's products,
difficulties in managing product transitions, or component pricing movements,
there could be an adverse impact on inventory levels, cash, and related
profitability.
Rapid Technology Cycles. Compaq believes the computer industry will
continue to drive rapid technology cycles. In planning product transitions, it
evaluates the speed at which customers are likely to switch to newer products.
The contrast between prices of old and new products, which is related to
component costs, is a critical variable in predicting customer decisions to move
to the next generation of products. Because of the lead times associated with
its volume production, should Compaq be unable to gauge the rate of product
transitions accurately, there could be an adverse impact on inventory levels,
cash, and profitability. In addition, as a result of the Tandem and Digital
acquisitions, Compaq is engaged in direct sales of computer systems with
software developed to meet customers' specific needs. The long-term nature of
such contracts exposes Compaq to risks associated with changing customer needs
and expectations.
Product Transitions. In each product cycle, Compaq confronts the risk of
delays in production that could impact sales of newer products while it manages
the inventory of older products and facilitates the sale of older inventory held
by resellers. To ease product transitions, Compaq carries out pricing actions
and marketing programs to increase sales by resellers. It provides currently for
estimated product returns and price protection that may occur under reseller
programs and under floor planning arrangements with third-party finance
companies. Should the Company be unable to sell the inventory of older products
at anticipated prices, should it not anticipate pricing actions that are
necessary, or if dealers hold higher than expected amounts of inventory subject
to price protection at the time of planned price reductions, there could be a
resulting adverse impact on sales, gross margins, and profitability.
Systems Implementation. The Company continues to focus on making business
and information management processes more efficient in order to increase
customer satisfaction, improve productivity and lower costs. In the event of a
delay in implementing improvements, there could be an adverse impact on
inventory levels, cash and related profitability. In connection with these
efforts, Compaq is moving many of its systems from a legacy environment of
proprietary systems to client-server architectures as well as integrating
systems from newly acquired businesses. Integrating the systems at Digital and
Tandem has further complicated this process. Should the transition to new
systems not occur in a smooth and orderly manner, the Company could experience
disruptions in operations, which could have an adverse financial impact.
21
<PAGE>
Technology Standards and Key Licenses. Participants in the computer
industry generally rely on the creation and implementation of technology
standards to win the broadest market acceptance for their products. Compaq must
successfully manage and participate in the development of standards while
continuing to differentiate its products and services in a manner valued by
customers. While industry participants generally accept, and may encourage, the
use of their intellectual property by third parties under license, when
intellectual property owned by competitors or suppliers becomes accepted as an
industry standard, the Company must obtain a license, purchase components
utilizing such technology from the owners of such technology or their licensees,
or otherwise acquire rights to use such technology, which could result in
increased costs. Compaq has entered into license agreements with key industry
participants, including Intel, Microsoft and Texas Instruments. There can be no
assurance that it will be able to negotiate terms that give it a competitive
market advantage under the license agreements that are necessary to operate its
business in the future.
Production Forecasts. In managing production, Compaq must forecast
customer demand for its products. Should the Company underestimate the supplies
needed to meet demand, it could be unable to meet customer demand. Should it
overestimate the supplies needed to meet customer demand, cash and profitability
could be adversely affected. Many of the components used in Compaq's products,
particularly microprocessors and memory, experience steep price declines over
their product lives. If the Company is unable to manage purchases and
utilization of such components efficiently to maintain low inventory levels
immediately prior to major price declines, it could be unable to take immediate
advantage of such declines to lower product costs, which could adversely affect
sales and gross margins. Furthermore, should prices for components increase
unexpectedly, Compaq's gross margin could be adversely affected.
Credit Risks. Compaq's primary means of distribution is through
third-party resellers. It continually monitors and manages the credit it extends
to resellers and attempts to limit credit risks by broadening distribution
channels, utilizing certain risk transfer arrangements and obtaining security
interests. Compaq's business could be adversely affected in the event that the
financial condition of third-party computer resellers erodes. Upon the financial
failure of a major reseller, the Company could experience disruptions in
distribution as well as a loss associated with the unsecured portion of any
outstanding accounts receivable. Geographic expansion, particularly
manufacturing operations in developing countries, such as Brazil and China, and
the expansion of sales into economically volatile areas such as Asia Pacific,
Latin America and other emerging markets, subject Compaq to a number of economic
and other risks, such as financial instability among resellers in these regions.
Compaq generally has experienced longer accounts receivable cycles in emerging
markets, in particular Asia Pacific and Latin America, when compared to U.S. and
European markets. In addition, geographic expansion subjects Compaq to
political and financial instability of the countries into which Compaq expands,
including currency devaluation and interest rate fluctuations. The Company
continues to evaluate business operations in these regions and attempt to take
measures to limit risks in these areas.
Year 2000 Compliance. Compaq believes the cost of administering its Year
2000 readiness program, exclusive of any customer claims, will not have a
material adverse impact on future earnings. Since there is no uniform
definition of Year 2000 "compliance" and since all customer situations cannot be
anticipated, particularly those involving third party products, Compaq may see
an increase in warranty and other claims as a result of the Year 2000
transition. Such claims, if successful, could have a material adverse impact on
future results. See "Item 1. Business - Year 2000 Transition" in Compaq's
Form 10-K for the year ended 1997 for additional information.
22
<PAGE>
Projects to address Compaq's internal information systems currently are
underway, and Compaq is in the process of replacing some of its older systems
with new systems that are able to handle the Year 2000 transition. It will
continue to review internal system requirements and to correct further issues as
they are identified. Although Compaq's evaluation of these systems is still in
process, it believes that the impact of the Year 2000 transition on its internal
systems will not have a material adverse impact on future results. In addition,
Compaq's task force is evaluating the impact of Year 2000 compliance of
suppliers, is asking suppliers about compliance, and is establishing Year 2000
compliance requirements for suppliers. Since the compliance of suppliers
depends upon their cooperation, failures remain a possibility and could have a
material adverse impact on future results.
Tax Rate. Compaq currently has a 26% effective tax rate, before the effect
of non-deductible purchased in-process technology and merger-related costs and
expects this rate will continue at approximately the same level throughout 1998.
Compaq benefits from a tax holiday in Singapore that expires in 2001, with a
potential extension to August 2004 if certain cumulative investment levels and
other conditions are met. Compaq's tax rate is heavily dependent upon the
proportion of earnings that is derived from its Singaporean manufacturing
subsidiary and its ability to reinvest those earnings permanently outside the
U.S. If the earnings of this subsidiary as a percentage of Compaq's total
earnings were to decline significantly from anticipated levels, or should
Compaq's ability to reinvest these earnings be reduced, Compaq's effective tax
rate would exceed the current estimate. In addition, should Compaq's
intercompany transfer pricing with respect to its Singaporean manufacturing
subsidiary require significant adjustment due to audits or regulatory changes,
Compaq's overall effective tax rate could increase.
Currency Fluctuations. Compaq's risks associated with currency
fluctuations are discussed in Item 3 below.
Because of the foregoing factors, as well as other variables affecting
Compaq's operating results, past financial performance should not be considered
a reliable indicator of future performance, and investors should not use
historical trends to anticipate results or trends in future periods.
ITEM 3. MARKET RISKS
Compaq is exposed to market risks, which include changes in U.S. and
international interest rates as wells as changes in currency exchange rates as
measured against the U.S. dollar and each other. It attempts to reduce these
risks by utilizing financial instruments, including derivative transactions,
pursuant to company policies.
Compaq uses market valuations and value-at-risk valuation methods to assess
market risk of its financial instruments and derivative portfolios. It uses J.P.
Morgan's RiskMetrics to estimate the value-at-risk based on estimates of
volatility and correlation of market factors drawn from J.P. Morgan's
RiskMetrics data sets as of June 30, 1998. Its measured value-at-risk from
holding derivative and other financial instruments, using a 95% confidence level
and assuming normal market conditions at June 30, 1998, was immaterial.
The value of the U.S. dollar affects Compaq's financial results. Changes
in exchange rates may positively or negatively affect Compaq's sales (as
expressed in U.S. dollars), gross margins, operating expenses, and retained
earnings. Compaq engages in hedging programs aimed at limiting in part the
impact of currency fluctuations. Using primarily forward exchange contracts,
Compaq hedges those assets and liabilities that, when remeasured according to
generally accepted accounting principles, impact the income statement. For
certain markets, particularly Latin America, Compaq has determined that ongoing
hedging of non-U.S. dollar net monetary assets is not cost effective and instead
attempts to minimize currency exposure risk through working capital management.
There can be no assurance that such an approach will be successful, especially
in the event of a significant and sudden decline in the value of local
currencies. From time to time, Compaq purchases foreign currency option
contracts as well as short-term forward exchange contracts to protect against
currency exchange risks associated with the anticipated sales of Compaq's
23
<PAGE>
international marketing subsidiaries, with the exception of Latin America and
certain other subsidiaries that reside in countries in which such activity would
not be cost effective or local regulations preclude this type of activity.
These hedging activities provide only limited protection against currency
exchange risks. Factors that could impact the effectiveness of Compaq's hedging
programs include accuracy of sales forecasts, volatility of the currency
markets, and availability of hedging instruments. All currency contracts that
are entered into by Compaq are components of hedging programs and are entered
into for the sole purpose of hedging an existing or anticipated currency
exposure, not for speculation. Although Compaq maintains these programs to
reduce the impact of changes in currency exchange rates, when the U.S. dollar
sustains a strengthening position against currencies in which Compaq sells
products or a weakening exchange rate against currencies in which Compaq incurs
costs, Compaq's sales or costs are adversely affected.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See Note 11 to Consolidated Financial Data.
All other items specified by Part II of this report are inapplicable and
accordingly have been omitted.
24
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
August 14, 1998 COMPAQ COMPUTER CORPORATION
/s/ Earl L. Mason
--------------------
Earl L. Mason, Senior Vice President
and Chief Financial Officer
(as authorized officer and as principal
financial officer)
25
<PAGE>
<TABLE>
<CAPTION>
COMPAQ COMPUTER CORPORATION
STATEMENT REGARDING COMPUTATION OF PER SHARE EARNINGS
SIX MONTHS QUARTER
ENDED JUNE 30, ENDED JUNE 30,
---------------- ----------------
1998 1997 1998 1997
-------- ------ -------- ------
(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
BASIC EARNINGS PER SHARE
Shares used in computing earnings per common share:
Weighted average number of shares outstanding . . . . . 1,539 1,497 1,556 1,500
======== ====== ======== ======
Earnings:
Net income (loss) . . . . . . . . . . . . . . . . . . . $(3,616) $ 671 $(3,632) $ 257
======== ====== ======== ======
Basic earnings (loss) per common share . . . . . . . . . . . $ (2.35) $ .45 $ (2.33) $ .17
======== ====== ======== ======
DILUTED EARNINGS PER COMMON SHARE
Shares used in computing diluted earnings per common share:
Weighted average number of shares outstanding . . . . . 1,539 1,497 1,556 1,500
Incremental shares attributed to
Outstanding options . . . . . . . . . . . . . . . - 50 - 52
-------- ------ -------- ------
1,539 1,547 1,556 1,552
======== ====== ======== ======
Earnings:
Net income (loss) . . . . . . . . . . . . . . . . . . . $(3,616) $ 671 $(3,632) $ 257
======== ====== ======== ======
Diluted earnings (loss) per common share . . . . . . . . . . $ (2.35) $ .43 $ (2.33) $ .17
======== ====== ======== ======
</TABLE>
See accompanying notes to consolidated financial data.
26
<PAGE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM COMPAQ
COMPUTER CORPORATION'S CONSOLIDATED BALANCE SHEET AND CONSOLIDATED STATEMENT OF
INCOME FOR THE PERIOD ENDED JUNE 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1000000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 4596
<SECURITIES> 0
<RECEIVABLES> 5431
<ALLOWANCES> 0
<INVENTORY> 2202
<CURRENT-ASSETS> 14788
<PP&E> 2855
<DEPRECIATION> 0
<TOTAL-ASSETS> 21748
<CURRENT-LIABILITIES> 10566
<BONDS> 0
<COMMON> 6724
0
0
<OTHER-SE> 3638
<TOTAL-LIABILITY-AND-EQUITY> 21748
<SALES> 10947
<TOTAL-REVENUES> 11519
<CGS> 9007
<TOTAL-COSTS> 9386
<OTHER-EXPENSES> 5957
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (74)
<INCOME-PRETAX> (3750)
<INCOME-TAX> (134)
<INCOME-CONTINUING> (3616)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (3616)
<EPS-PRIMARY> (2.35)
<EPS-DILUTED> (2.35)
</TABLE>