SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 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)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE ON
TITLE OF EACH CLASS WHICH REGISTERED
---------------------- -----------------
Common Stock, $.01 par value New York Stock Exchange
Depositary shares each representing New York Stock Exchange
one-fourth of a share of 8-7/8%
Series A Cumulative Preferred Stock,
par value $1 per share
Debt Securities None
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: None
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 [ ].
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the voting stock held by non-affiliates of
the registrant on January 29, 1999 (assuming all officers and directors are
affiliates and based on the last sale price on the New York Stock Exchange as of
such date) was approximately $80 billion.
The number of shares of the registrant's Common Stock, $.01 par value,
outstanding as of January 29, 1999, was approximately 1.7 billion.
DOCUMENTS INCORPORATED BY REFERENCE
There is incorporated by reference in Part II and Part III of this Annual
Report on Form 10-K certain of the information contained in the registrant's
proxy statement for its annual meeting of stockholders to be held April 22,
1999, which will be filed by the registrant within 120 days after December 31,
1998.
_____________________________________________________________________________
PART I
ITEM 1. BUSINESS
GENERAL
Founded in 1982, Compaq Computer Corporation ("Compaq" or the "Company") is
a global information technology company. Compaq is the second largest computer
company in the world and the largest global supplier of computing systems.
Compaq develops and markets hardware, software, solutions and services,
including industry-leading enterprise computing solutions, fault-tolerant
business-critical solutions, networking and communication products, commercial
desktop and portable products and consumer PCs. Compaq products and services are
sold in more than 100 countries through subsidiaries and a network of authorized
Compaq marketing partners. Compaq markets its products and services primarily to
customers from the business, home, government, and education sectors.
RECENT AND PENDING ACQUISITIONS AND COMPANY FORMATION
In February 1999, Compaq announced the execution of a definitive merger
agreement with Zip2 Corporation, the leading provider of Internet platform
solutions for media companies and local e-commerce merchants. Completion of the
transaction is subject to customary conditions, including clearance under the
Hart-Scott-Rodino Antitrust Improvements Act.
In January 1999, Compaq announced a cash tender offer for all of the
outstanding shares of common stock of Shopping.com, an on-line retailer that
offers Internet shoppers an array of consumer products. In February the offer
was successfully concluded, with 96% of the shares tendered. Compaq is
proceeding with the steps necessary to complete the merger, which is anticipated
in March. The aggregate purchase price for Shopping.com is anticipated to be
approximately $220 million. Completion of the transaction is subject to certain
conditions, including clearance under the Hart-Scott-Rodino Antitrust
Improvements Act.
In January 1999, Compaq announced the formation of the AltaVista Company, a
wholly owned subsidiary established to become a leading Internet site for search
capabilities, localized information, e-commerce and e-services. Compaq will
contribute to the AltaVista Company the AltaVista search site and the associated
intellectual property, Shopping.com, Zip2 Corporation and certain additional
cash and assets. Compaq anticipates offering a portion of the AltaVista Company
to the public in 1999.
In June 1998, Compaq completed the acquisition of Digital Equipment
Corporation ("Digital"). This acquisition was accounted for under the purchase
method of accounting for an aggregate purchase price of $9.1 billion. Digital
was an industry leader in implementing and supporting networked business
solutions in multi-vendor environments based on high performance platforms and
had an established global service and support team. For further information see
Note 2 of the Notes to Consolidated Financial Statements.
In August 1997, Compaq merged with Tandem Computers Incorporated ("Tandem")
in a stock-for-stock transaction accounted for as a pooling of interests.
Tandem provided its customers with reliable, scaleable, fault-tolerant
enterprise computer systems and client/server solutions. In connection with the
merger, Compaq issued approximately 126 million shares of Compaq common stock,
based upon an exchange ratio of 1.05 shares of Compaq common stock for each
share of Tandem common stock. For further information see Note 2 of the Notes
to Consolidated Financial Statements.
In May 1997, Compaq completed a cash tender offer for Microcom, Inc.
("Microcom"), a manufacturer of remote access technologies and solutions, for
$288 million. For further information see Note 2 of the Notes to Consolidated
Financial Statements.
2
GEOGRAPHICAL SEGMENTS
Compaq continues to expand its worldwide presence through geographic
divisions in North America, Asia Pacific, Japan, Latin America, Greater China,
Europe, the Middle East and Africa. Each division operates as an individual
business unit. For further information on Compaq's operating segments,
including revenues for 1998, 1997 and 1996, see Management's Discussion and
Analysis of Financial Condition and Results of Operations and Note 12 of the
Notes to Consolidated Financial Statements.
North America
Through the North America division, Compaq delivers a broad range of
products and services in the U.S. and Canada.
Europe, Middle East and Africa
Compaq, which entered the European market in 1984 with wholly owned
subsidiaries in Germany, the United Kingdom and France, now also operates wholly
owned subsidiaries in Austria, Bahrain, Belgium, Czech Republic, Denmark,
Finland, Greece, Hungary, Italy, the Netherlands, Norway, Scotland, Spain, South
Africa, Sweden, Switzerland, Portugal and Poland. The European division also
covers the Middle East and Africa.
Asia Pacific
Compaq established Compaq Computer Asia Pacific Pte. Ltd. in 1991.
Headquartered in Singapore, Compaq's Asia Pacific subsidiaries are located in
Australia, Malaysia, New Zealand, Singapore and Thailand. Compaq products are
sold and supported throughout this region by Compaq offices in Korea, India,
Brunei, Indonesia, Philippines and Indochina.
Greater China
In 1997, Compaq established the Greater China Region as a separate
geographic region. The new division focuses on efforts in China, Hong Kong and
Taiwan.
Japan
In 1991, Compaq announced the opening of its wholly owned Japanese
subsidiary, Compaq K.K., headquartered in Tokyo. Compaq offers products and
services designed exclusively for the Japanese market.
Latin America
Compaq began operations in Latin America in 1989. The Company opened its
first wholly owned subsidiary in Latin America in Mexico, in 1991, and other
subsidiaries have since been opened in Argentina, Brazil, Chile, Columbia,
Venezuela and the Caribbean/Central America. Compaq has continued its expansion
in this region by appointing dealers in Bermuda, Bolivia, Cayman, Chile, Costa
Rica, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Panama, Paraguay,
Puerto Rico, Trinidad, Uruguay and the Virgin Islands.
3
COMPAQ PRODUCTS
Compaq develops its products through customer-focused, global product
groups which provide our customers with solutions for leadership in the emerging
Internet-based economy:
The ENTERPRISE COMPUTING GROUP designs and develops mainframes, servers,
workstations, fault-tolerant business-critical solutions, enterprise options,
enterprise solutions, Internet products, and networking products. Enterprise
Computing products accounted for approximately 35% of Compaq's worldwide revenue
in 1998.
The COMMERCIAL PC GROUP designs and develops commercial desktops,
portables, options, and small and medium business solutions. PC products
accounted for approximately 37% of Compaq's worldwide revenue in 1998.
The CONSUMER PC GROUP designs and develops consumer products, including
desktops, minitowers, portables, printers, and options. Consumer products
accounted for approximately 16% of Compaq's worldwide revenue in 1998.
In 1999, Compaq plans to continue its leadership role with products that
address new technologies, reliability, high performance, competitive price
points, and new markets.
PRODUCT DEVELOPMENT
Compaq is actively engaged in the design and development of additional
products and enhancements to its existing products. During 1998, 1997 and 1996,
Compaq spent $1.4 billion, $817 million, and $695 million, respectively, on
research and development. In addition, Compaq spent $3.2 billion and $208
million on in-process research and development in connection with acquisitions
in 1998 and 1997, respectively. As of the date of acquisition, the estimated
costs to be incurred to develop the Digital-related purchased in-process
technology into commercially viable products total approximately $3.1 billion in
the aggregate through the year 2005. Since computer technology develops
rapidly, Compaq's continued success is dependent on the timely introduction of
new products with the right price and features. Its engineering effort focuses
on new and emerging technologies as well as design features that will increase
manufacturing efficiency and lower production costs. In 1998, Compaq focused
significant attention on technological developments for enterprise computing,
high-availability and failsafe solutions, storage technology, enterprise systems
management, integration and configuration optimization, and internet and
intranet technologies.
Compaq's product development efforts are centered on aggressively
developing new areas in which Compaq can differentiate its products and add
value, focusing on innovative platform features, the integration of hardware and
software, and new related products and services. Because Compaq's business
intersects with a number of areas in which other companies have significantly
greater technological, marketing and service expertise, Compaq has focused on
alliances with third parties that have complementary products and skills as well
as acquisitions that target incremental business opportunities.
MANUFACTURING AND MATERIALS
Compaq's manufacturing operations consist of manufacturing finished
products and various circuit boards from components and subassemblies that
Compaq acquires from a wide range of vendors. Certain of Compaq's products are
manufactured by third party original equipment manufacturers ("OEMs").
4
Compaq utilizes two methods of fulfilling demand for products: building
products to order ("BTO") and configuring products to order ("CTO"). BTO
capabilities are employed to maximize manufacturing efficiencies by producing
high volumes of basic product configurations. CTO permits configuration of
units to the particular hardware and software customization requirements of
certain customers. Both BTO and CTO are designed to generate cost efficiencies
relating to just-in-time manufacturing, inventory management and distribution
practices.
Compaq believes that there is a sufficient number of competent vendors for
most components and subassemblies. A significant number of components, however,
are purchased from single sources due to technology, availability, price,
quality or other considerations. Order lead times and cancellation requirements
vary by supplier and component. Key components and processes currently obtained
from single sources include certain of Compaq's displays, operating systems,
microprocessors, application-specific integrated circuits and other custom
chips, and certain processes relating to construction of the housing for
Compaq's computers. In addition, new products introduced by Compaq may
initially utilize custom components obtained from only one source until Compaq
has evaluated whether there is a need for additional suppliers.
Like other participants in the computer industry, Compaq ordinarily
acquires materials and components through a combination of blanket and scheduled
purchase orders released to position the supplier to support Compaq's
requirements for periods averaging 90 to 120 days. From time to time Compaq has
experienced significant price increases and limited availability of certain
components that are available from multiple sources. At times Compaq has been
constrained by parts availability in meeting product orders and future
constraints could have an adverse effect on Compaq's operating results. On
occasion, Compaq acquires component inventory in anticipation of supply
constraints. A restoration of component availability and resulting decline in
component pricing more quickly than anticipated could have an adverse effect on
Compaq's operating results.
MARKETING AND DISTRIBUTION
Compaq's hardware products are sold to large and medium-sized business and
government customers primarily through dealers, value-added resellers and
systems integrators and to small business and home customers principally through
dealers and consumer channels. In response to changing industry practices and
customer preferences, Compaq is continuing its expansion of distribution
establishments. Compaq also sells hardware products directly through its sales
force and to small businesses and home customers through Compaq's Internet web
page at www.compaq.com as well as through its mail order business that features
--------------
a variety of personal computers, printers and software products.
COMPAQ SERVICES
The COMPAQ SERVICES GROUP provides innovative, proactive life-cycle
services that meet a wide variety of information technology infrastructure
business requirements. Compaq Services accounted for 12% of Compaq's worldwide
revenue in 1998. Compaq offers a comprehensive portfolio of professional
services and support through a global network of approximately 27,000 employees
as well as 30,000 service delivery partners to help customers plan, design,
implement, and manage and maintain their information technology solutions.
Compaq sells its services directly to businesses and in alliances with
other third party service providers. Compaq's service offerings include
business critical services and high availability support for multivendor
software and hardware products. Professional services include information
systems consulting; technical and application design services; systems
integration and project management services; network design, integration and
support services; and outsourcing and resource management services.
5
Compaq has established a number of service alliances with companies in the
information technology industry. To support customers' migration to Windows
NT-based platforms, Compaq has trained, and Microsoft has certified, a
professional services workforce of approximately 2,300 engineers dedicated to
providing comprehensive systems integration and service solutions. Under
Compaq's alliance with MCI Communications Corporation and Microsoft, MCI
delivers Internet and Intranet products and services to MCI subscribers based
upon Compaq's Alpha servers, Microsoft's Windows NT operating system, and
Microsoft Exchange (TM) and Internet Explorer software products, and is backed
by Compaq's support and systems integration services. Compaq is a leading
provider of messaging and collaboration solutions in the global enterprise
environment, and is the leading integrator of Microsoft Exchange, with more than
400 major accounts worldwide. Compaq also has been designated as a preferred
service provider by Computer Associates International, Inc.
Compaq provides support and warranty repair to its hardware customers
through full-service computer dealers and independent third-party service
companies and through its service organization. Compaq offers its customers
CompaqCare, which includes a number of customer service and support programs,
most notably one to three-year limited warranties on PC products and, in the
U.S., round-the-clock telephone technical support for Compaq hardware products.
FINANCIAL SERVICES
In 1997, Compaq created a leasing company, Compaq Capital Corporation
("Compaq Capital"), to provide financing to facilitate and enhance the sale of
Compaq products and services on a worldwide basis. Compaq Capital is rapidly
creating a worldwide leasing/financing network through independent operations
and joint venture relationships. In July 1997, Compaq Capital commenced leasing
operations in North America and in October 1997, Compaq Capital implemented
leasing operations in Europe. Additional Compaq Capital leasing operations
rolled out to selected Asia Pacific locations in January 1998 and to certain
countries in Latin America in the third quarter of 1998.
During 1998, Compaq Capital purchased from G.E. Capital Corporation a lease
portfolio for $361 million. The underlying equipment consists primarily of
Digital manufactured equipment. Also during 1998, Compaq Capital purchased
certain assets and assumed certain liabilities of Dana Commercial Credit
Corporation's computer equipment leasing business. The purchase price was $50
million. The assets acquired consist primarily of direct financing leases
related to Compaq manufactured equipment.
PATENTS, TRADEMARKS, AND LICENSES
Compaq and its subsidiaries held 2,800 patents and had 2,600 patent
applications pending with the United States Patent and Trademark Office at the
close of 1998, as well as related international patents and patent applications.
In addition, Compaq has registered certain trademarks in the United States and
in a number of foreign countries. Compaq believes that patent and trademark
protection plays an important part in its business and complements the
technological expertise, innovative talent and marketing abilities of its
employees.
Compaq has from time to time entered into cross-licensing agreements with
other companies holding patents to technology related to Compaq's products, as
well as with companies using technology related to patents held by Compaq.
Compaq holds cross licenses with various companies, including IBM, Texas
Instruments, and Intel.
SEASONALITY
General economic conditions have an impact on Compaq's business and
financial results. From time to time, the markets in which Compaq sells its
products experience weak economic conditions that may negatively affect sales.
Although Compaq does not consider its business to be highly seasonal, Compaq in
general experiences seasonally higher sales and earnings in the second half of
the year. Should Compaq's retail business expand relative to its other
businesses, Compaq could experience an increase in the seasonality of its
business and financial results could become more dependent on retail business
fluctuations.
6
CUSTOMERS
One customer accounted for 8% of sales for 1998. During this period, no
other customer of Compaq accounted for more than 3% of sales. In 1998, Compaq's
five largest resellers represented approximately 19% of Compaq's sales.
BACKLOG
Compaq's resellers typically purchase products on an as-needed basis and
resellers frequently change delivery schedules and order rates depending on
market conditions. Unfilled orders can be, and often are, canceled at will and
without penalties. In Compaq's experience, the actual amount of unfilled orders
at any particular time is not a meaningful indication of its future business
prospects since orders rapidly become balanced as soon as supply begins meeting
demand. Forecasting demand for newly introduced products is complicated by the
availability of different product models, which may include various types of
built-in peripherals and software, and configuration requirements, such as
language localization, in certain markets. As a result, while overall demand
may be in line with Compaq's projections, local market variations can lead to
differences between expected and actual demand and result in delays in shipment.
Should Compaq be unable to meet demand for its products on a timely basis,
customer satisfaction and sales could be adversely affected.
COMPETITION
The computer industry is intensely competitive with many U.S., Japanese and
other international companies vying for market share. The market continues to be
characterized by rapid technological advances in both hardware and software
developments that have substantially increased the capabilities and applications
of information management products and have resulted in the frequent
introduction of new products. Because of the complexity of computer systems and
business and because of reliance upon the interaction of a variety of hardware
and software products, customers increasingly look for a broad band of product
and service offerings from a single vendor who takes overall responsibility for
the interoperability of the system. The principal elements of competition are
product performance, product quality and reliability, service and support,
price, marketing and distribution capability and corporate reputation. While
Compaq believes that its products and services compete favorably based on each
of these elements, Compaq could be adversely affected if its competitors
introduce innovative or technologically superior products, offer a more
attractive combination of products and services, or offer their products at
significantly lower prices than Compaq. Compaq's results could also be adversely
affected should it be unable to implement effectively its technological and
marketing alliances with other companies, such as Microsoft, Intel, Novell,
Oracle and SAP, among others; and to manage the competitive risks associated
with these relationships.
ENVIRONMENTAL LAWS AND REGULATIONS
Compaq recognizes that operating in a manner that is compatible with the
environment is good for its community, employees, customers and business. Compaq
integrates numerous environmental features in the product design and
manufacturing process that reduce the potential environmental impact during the
lifecycle of its products and its products are designed and manufactured to meet
a variety of the world's environmental standards and expectations. Compaq uses
no chlorofluorocarbons ("CFCs") in its worldwide manufacturing operations and
undertakes ongoing environmental programs, including waste reduction, energy
conservation, recycling and design for the environment. Compaq maintains a
worldwide environmental health and safety audit program. The audit program
includes management system and compliance evaluations.
7
The acquisitions of Tandem and Digital have increased Compaq's
environmental liability risks. Compaq is incurring costs in connection with the
investigation and remediation of certain properties that it acquired in these
business combinations. Pursuant to the Comprehensive Environmental Response,
Compensation and Liability Act of 1980 ("CERCLA," also known as "Superfund"),
Compaq is sharing in the cost of cleaning up certain sites listed on the federal
National Priorities List of Superfund Sites. Compliance with laws enacted for
protection of the environment to date has had no material effect upon Compaq's
capital expenditures, earnings or competitive position. Compaq does not
anticipate any material adverse effects in the future based on the nature of its
operations and the purpose of environmental laws and regulations. However,
environmental cleanup periods are protracted in length and environmental costs
in future periods are subject to changes in environmental remediation
regulations, therefore, there can be no assurance that such laws or future laws
will not have a material adverse effect on Compaq.
YEAR 2000 TRANSITION
Compaq's Year 2000 program is discussed in "Management's Discussion and Analysis
of Financial Condition and Results of Operations - Factors That May Affect
Future Results - Year 2000 Compliance."
EMPLOYEES
At December 31, 1998, Compaq had approximately 71,000 full-time regular
employees and approximately 19,000 temporary and contract workers engaged in
manufacturing operations, engineering, research and development, marketing,
sales, service and administrative activities. In connection with the Digital
acquisition, Compaq began to restructure its combined workforces during the
second quarter of 1998. Compaq anticipates that it will have 68,000 regular
employees by the end of June 1999. Compaq believes that its ability to attract
and appropriately retain skilled personnel is critical to its success.
Accordingly, Compaq has developed competitive human resources policies
consistent with its business plan.
ITEM 2. PROPERTIES
Compaq's principal administrative facilities and a manufacturing facility
are located on the 1,000-acre Compaq Campus in Houston, Texas. With the
acquisition of Digital, Compaq now owns or leases administrative, sales,
service, research and development, warehouse, and manufacturing facilities in
over 700 cities in 58 countries worldwide. Compaq's principal international
manufacturing facilities are in Scotland, Singapore, and Brazil, and its
principal domestic manufacturing facilities are in California, New Hampshire and
Texas. Compaq owns and leases customer service call centers worldwide, the
largest of which are in Massachusetts, Georgia, Texas and Ireland.
Compaq's real estate portfolio grew to approximately 32 million square feet
of occupied space worldwide at the time of the acquisition of Digital. In June
1998, Compaq's management approved restructuring plans which included
initiatives to integrate operations of Compaq and Digital, consolidate
duplicative facilities, improve service delivery and reduce overhead. Compaq is
in the process of restructuring approximately 8.9 million square feet of
occupied space. That space along with the 4.3 million square feet of unoccupied
space acquired with the Digital acquisition, gives Compaq a total restructure
portfolio of approximately 13.2 million square feet of space. The continued
implementation of these restructuring plans should lower the total active square
feet of space to 24 million worldwide.
8
ITEM 3. LEGAL PROCEEDINGS
Information regarding legal proceedings is set forth in Note 13 of the
Notes to Consolidated Financial Statements under the subheading "Litigation,"
which information is hereby incorporated by reference.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET FOR COMMON STOCK. Compaq's common stock is listed on the New York Stock
Exchange and trades under the symbol CPQ. As of January 29, 1999, Compaq had
approximately 89,000 shareholders of record. The reported high and low closing
stock prices, as reported on the NYSE Composite Transaction Tape, were as
follows:
1998 1997
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High Low High Low
------ ------ ------ ------
1st Quarter $36.44 $23.25 $17.35 $14.40
2nd Quarter 32.44 24.06 21.63 14.40
3rd Quarter 37.50 27.94 39.13 20.38
4th Quarter 44.31 24.06 38.63 26.66
DIVIDENDS AND DIRECT STOCK PURCHASE PLAN. Compaq paid its first quarterly
dividend of $ 0.015 per share to shareholders of record on December 31, 1997 and
increased this dividend to $0.02 per share with the dividend payment to
shareholders of record on December 31, 1998. Compaq anticipates that the cash
dividend will continue to be paid on a quarterly basis. Compaq has established
a direct stock purchase plan through which stockholders may reinvest their
dividends and invest additional amounts directly in Compaq common stock.
Additional information about the direct stock purchase plan is available at
www.compaq.com/corporate/ir/shareplan.html.
- ------------------------------------------
9
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following income statement and balance sheet data have been derived
from the Company's consolidated financial statements. The information set forth
below is not necessarily indicative of the results of future operations and
should be read in conjunction with the consolidated financial statements and
notes thereto appearing elsewhere in this Form 10-K.
Year ended December 31 (In millions, except per share amounts) 1998 1997 1996 1995 1994
============================================================== ========== ======== ======= ======= =======
STATEMENT OF INCOME
Revenue:
Products. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 27,372 $24,122 $19,611 $16,308 $12,274
Services. . . . . . . . . . . . . . . . . . . . . . . . . . . 3,797 462 398 367 331
---------- -------- ------- ------- -------
Total revenue . . . . . . . . . . . . . . . . . . . . . . . 31,169 24,584 20,009 16,675 12,605
---------- -------- ------- ------- -------
Cost of sales:
Products. . . . . . . . . . . . . . . . . . . . . . . . . . . 21,383 17,500 14,565 12,026 8,671
Services. . . . . . . . . . . . . . . . . . . . . . . . . . . 2,597 333 290 265 214
---------- -------- ------- ------- -------
Total cost of sales . . . . . . . . . . . . . . . . . . . . 23,980 17,833 14,855 12,291 8,885
---------- -------- ------- ------- -------
Selling, general and administrative expense. . . . . . . . . . 4,978 2,947 2,507 2,186 1,859
Research and development costs . . . . . . . . . . . . . . . . 1,353 817 695 552 458
Purchased in-process technology(1) . . . . . . . . . . . . . . 3,196 208 - 241 -
Restructuring and asset impairment charges(2). . . . . . . . . 393 - 52 - -
Merger-related costs(3). . . . . . . . . . . . . . . . . . . . - 44 - - -
Other income and expense, net. . . . . . . . . . . . . . . . . (69) (23) 17 79 50
---------- -------- ------- ------- -------
9,851 3,993 3,271 3,058 2,367
---------- -------- ------- ------- -------
Income (loss) before provision for income taxes. . . . . . . . (2,662) 2,758 1,883 1,326 1,353
Provision for income taxes . . . . . . . . . . . . . . . . . . 81 903 565 433 365
---------- -------- ------- ------- -------
Net income (loss). . . . . . . . . . . . . . . . . . . . . . . $ (2,743) $ 1,855 $ 1,318 $ 893 $ 988
========== ======== ======= ======= =======
Earnings (loss) per common share:
Basic. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1.71) $ 1.23 $ 0.90 $ 0.62 $ 0.70
Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1.71) $ 1.19 $ 0.87 $ 0.60 $ 0.68
Shares used in computing earnings (loss) per
common share:
Basic. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,608 1,505 1,472 1,442 1,405
Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . 1,608 1,564 1,516 1,492 1,463
Cash dividends per common share. . . . . . . . . . . . . . . . $ 0.065 $ 0.015 $ - $ - $ -
FINANCIAL POSITION
Current assets . . . . . . . . . . . . . . . . . . . . . . . . $ 15,167 $12,017 $10,089 $ 7,462 $ 6,037
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . 23,051 14,631 12,331 9,637 7,862
Current liabilities. . . . . . . . . . . . . . . . . . . . . . 10,733 5,202 4,741 3,580 2,918
Non-current liabilities(4) . . . . . . . . . . . . . . . . . . 967 - 300 300 300
Stockholders' equity . . . . . . . . . . . . . . . . . . . . . 11,351 9,429 7,290 5,757 4,644
<FN>
(1) Represents non-recurring, non-tax deductible charges associated with purchased in-process technology of
$3.2 billion in connection with the Digital acquisition in 1998, and $208 million and $241 million in
connection with acquisitions in 1997 and 1995.
(2) Represents a $393 million charge for restructuring and asset impairments in 1998 in connection with the
Digital acquisition and the closing of certain Compaq facilities, and a $52 million charge related to
restructuring actions taken by Tandem during 1996.
(3) Represents a $44 million non-recurring, non-tax-deductible charge in 1997 related to the Tandem merger.
(4) Includes $422 million of minority interest in 1998 related to Digital preferred stock.
10
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the
consolidated financial statements.
RESULTS OF OPERATIONS
The following table presents, as a percentage of revenue, selected
consolidated financial data for each of the three years ended December 31.
Year ended December 31 1998 1997 1996
================================================ ========= ======= =======
Revenue:
Products. . . . . . . . . . . . . . . . . . . . 87.8% 98.1% 98.0%
Services. . . . . . . . . . . . . . . . . . . . 12.2 1.9 2.0
--------- ------- -------
Total revenue . . . . . . . . . . . . . . . . 100.0 100.0 100.0
Cost of sales:
Products. . . . . . . . . . . . . . . . . . . . 78.1 72.5 74.3
Services. . . . . . . . . . . . . . . . . . . . 68.4 72.1 72.9
Total cost of sales . . . . . . . . . . . . . 76.9 72.5 74.2
Gross margin:
Products. . . . . . . . . . . . . . . . . . . . 21.9 27.5 25.7
Services. . . . . . . . . . . . . . . . . . . . 31.6 27.9 27.1
Total gross margin. . . . . . . . . . . . . . 23.1 27.5 25.8
Selling, general and administrative expenses . . 16.0 12.0 12.5
Research and development costs . . . . . . . . . 4.3 3.3 3.5
Purchased in-process technology(1) . . . . . . . 10.2 0.9 -
Restructuring and asset impairment charges(2). . 1.3 - 0.3
Merger-related costs(3). . . . . . . . . . . . . - 0.2 -
Other income and expense, net. . . . . . . . . . (0.2) (0.1) 0.1
--------- ------- -------
31.6 16.3 16.4
--------- ------- -------
Income (loss) before provision for income taxes. (8.5)% 11.2% 9.4%
--------- ------- -------
<FN>
(1) Represents non-recurring, non-tax-deductible charges associated with
purchased in-process technology of $3.2 billion in connection with the Digital
acquisition in 1998 and $208 million in 1997 in connection with the Microcom
acquisition.
(2) Represents a $393 million charge for restructuring and asset impairments in
1998 in connection with the Digital acquisition and the closing of certain
Compaq facilities, and a $52 million charge related to restructuring actions
taken by Tandem during 1996.
(3) Represents a $44 million non-recurring, non-tax-deductible charge in 1997
related to the Tandem merger.
OVERVIEW
Compaq's completion of recent acquisitions has resulted in an expanded and
enhanced business model, focused on open industry-standard products, leadership
enterprise technology and solutions and a full line of global service offerings.
As the second largest computing company in the world and the largest global
supplier of computer systems, Compaq delivers customer value through
standards-based, partner-leveraged computing that features 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 devices to
powerful failsafe computers.
11
The year 1998 was transitional for Compaq. During the first half of the
year, the Company accelerated the implementation of the optimized distribution
model towards the goal of moving from a build to stock operating model to a
build-to-order/configure-to-order model.
During the second half of the year Compaq undertook a major integration
effort following the acquisition of Digital in June 1998. These integration
efforts included product migration strategies, sales force integration, service
organization integration, consolidation of duplicative facilities, employee
separations and relocations, and the integration of the internal information
systems of the combined companies.
The Company recorded several charges in connection with the Digital
acquisition and closing of certain Compaq facilities (see Notes 2 and 3 of the
Notes to Consolidated Financial Statements). These charges included
approximately $3.2 billion for the write-off of purchased in-process technology
and $393 million for restructuring and asset impairment charges related to
Compaq employee separations and elimination of certain Compaq facilities.
REVENUE
Revenue for 1998 increased approximately $6.6 billion or 26.8% over the
prior year as compared with an increase of $4.6 billion or 22.9% during 1997.
The increase in 1998 revenue was largely driven by the acquisition of Digital.
The increase in 1997 revenue was driven primarily by internal growth.
Products revenue for 1998 increased approximately $3.3 billion or 13.5%
over the prior year as compared with an increase of $4.5 billion or 23.0% during
1997. Products revenue in 1998 reflected a growth in worldwide unit sales of
25.1%, compared to 42.9% in 1997. Growth in options revenue was 15.9% in 1998
compared to 43.7% in 1997. The increase in 1998 was primarily the result of the
Digital acquisition and strong growth in the consumer business. Offsetting this
growth was the expected short-term reduction in revenues relating to the impact
of significant pricing and promotional actions taken in conjunction with the
Company's transition to the optimized distribution model, the implementation of
product migration strategies for Intel-based, Digital-branded personal
computers, and the realignment of the sales and marketing organizations of the
newly combined companies throughout the world.
Products revenue for North America in 1998 grew $310 million or 2.4% over
the prior year as compared with an increase of $2.7 billion or 25.4% during
1997. Products revenue in North America represented 49.0%, 54.3% and 53.3% of
total products revenue in 1998, 1997 and 1996, respectively. Products revenue
growth in 1998 related to the acquisition of Digital and strong year-over-year
growth in the consumer business, partially offset by a decline in commercial
products revenue. The decline in commercial products revenue related to the
aggressive price reductions and promotional activities implemented primarily in
North America in the first half of 1998 due to the transition to the optimized
distribution model, lower than expected sales out of the channel, and to respond
to competitive pricing conditions. The third and fourth quarter revenues were
negatively impacted by the implementation of product migration strategies and
the realignment of the sales and marketing organizations as described above.
Products revenue growth in 1997 related to strong year-over-year growth in both
the commercial and consumer markets, with the most significant commercial
product growth relating to enterprise products, most notably servers and
workstations.
Products revenue for Europe, Middle East and Africa ("EMEA") in 1998 grew
$2.4 billion or 30.2% over the prior year as compared with an increase of $1.4
billion or 21.6% during 1997. Products revenue in EMEA represented 37.0%, 32.3%
and 32.6% of total products revenue in 1998, 1997 and 1996, respectively.
Products revenue growth in EMEA in 1998 was the result of both the acquisition
of Digital and strong year-over-year growth in consumer and commercial products
revenue, partially offset by more competitive pricing. Products revenue in 1997
reflected an overall improvement in market share and strong year-over-year
revenue growth in each of the product areas, the most significant of which
related to enterprise products.
12
Services revenue for 1998 increased approximately $3.3 billion over the
prior year as compared with an increase of $64 million during 1997. Services
revenue growth for 1998 was almost entirely due to the acquisition of Digital.
With the acquisition of Digital, Compaq now has a world class services
organization with market-focused solutions and high availability support,
particularly in the communications, manufacturing and finance industries.
Services revenue for 1997 and 1996 related primarily to professional services
provided by Tandem.
Services revenue for North America in 1998 grew $1.2 billion over the prior
year as compared with an increase of $4 million during 1997. Services revenue
in North America represented 35.3%, 36.4% and 41.2% of total services revenue in
1998, 1997 and 1996, respectively. Services revenue for EMEA in 1998 grew $1.6
billion over the prior year as compared with an increase of $43 million during
1997. Services revenue in EMEA represented 47.2%, 32.5%, and 26.9% of total
services revenue in 1998, 1997 and 1996, respectively.
GROSS MARGIN
Gross margin as a percentage of revenue was 23.1% in 1998, down from 27.5%
in 1997 and 25.8% in 1996. Products gross margin as a percentage of products
revenue was 21.9%, 27.5% and 25.7% for 1998, 1997 and 1996, respectively. The
decrease in gross margin in 1998 resulted largely from significant pricing and
promotional actions taken by Compaq primarily in the North American market
during the first and second quarters of 1998 to meet the goals of the Company's
optimized distribution model and to respond to competitive pricing conditions.
Gross margins improved during the third and fourth quarters, partially offset by
the impacts of the implementation of product migration strategies and the
realignment of the sales and marketing operations. The increase in gross
margins in 1997 primarily resulted from a higher proportion of sales of
enterprise products and options, production and logistics cost savings, and
overall asset management improvements.
Products gross margin as a percentage of products revenue in North America
was 21.5%, 27.4% and 26.6% for 1998, 1997 and 1996, respectively. The decrease
in 1998 products gross margin resulted largely from the significant pricing,
promotional and other actions taken by Compaq as noted above. Products gross
margin as a percentage of products revenue in EMEA was 26.3%, 27.7% and 26.1%
for 1998, 1997 and 1996, respectively. The decrease in EMEA 1998 products gross
margin was primarily related to the Digital product integration.
Services gross margin as a percentage of services revenue was 31.6%, 27.9%
and 27.1% for 1998, 1997 and 1996, respectively. The increase in services gross
margin in 1998 is primarily attributable to the acquisition of Digital.
OPERATING EXPENSES
Research and development costs increased $536 million or 65.6% in 1998 as
compared to 1997, primarily due to the acquisition of Digital. Research and
development costs increased $122 million or 17.6% in 1997 as compared to 1996.
Compaq is committed to maintaining a significant level of research and
development investment in support of its activities as a full-service enterprise
computing company, offering leadership technologies and products for the future.
In addition, Compaq spent approximately $3.2 billion in 1998 and $208 million in
1997 on purchased in-process technology in connection with the Digital and
Microcom acquisitions.
13
Compaq's selling, general and administrative expense increased $2.0 billion
or 68.9% in 1998 as compared to 1997, primarily due to the acquisition of
Digital. Compaq's selling, general and administrative expense increased $440
million or 17.6% in 1997 as compared to 1996. As a percentage of revenue,
selling, general and administrative expense was 16.0%, 12.0% and 12.5% in 1998,
1997 and 1996, respectively, and in absolute dollars was $5.0 billion, $2.9
billion, and $2.5 billion in 1998, 1997 and 1996, respectively. The increase
as a percentage of revenue and absolute dollars in 1998 over 1997 is primarily
due to the acquisition of Digital and the support of significant new product
introductions, expansion into new markets and increases in our investment in
services. In the fourth quarter of 1998, operating expenses as a percentage of
revenue began to decline due to implementation of the restructuring plans and
the realization of synergies for the combined companies. The decrease in
selling, general and administrative expense as a percentage of revenue in 1997
reflected efforts to manage operating expense growth relative to revenue and
gross margin levels. The increase in the amount of expense resulted from
domestic and international selling expense associated with higher unit volumes
as well as expense incurred in connection with the introduction of new products,
the entry into new markets, the expansion of distribution channels and a greater
emphasis on customer service and technical support.
PURCHASED IN-PROCESS TECHNOLOGY
Upon consummation of the Digital acquisition in June 1998, Compaq
immediately expensed approximately $3.2 billion representing purchased
in-process technology that had not yet reached technological feasibility and had
no alternative future use (see Note 2 of Notes to Consolidated Financial
Statements). 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 values. The discount rate includes a factor that
takes into account the uncertainty surrounding the successful development of the
purchased in-process technology.
The resulting net cash flows from such projects were based on Compaq
management's estimates of revenue, cost of sales, research and development
costs, selling, general and administrative costs, and income taxes from such
projects. These estimates were based on the following assumptions:
- - The estimated revenues projected average compounded annual revenue growth
rates of 8% to 39% during 1998-2001, depending on the product areas. For
instance, UNIX/OpenVMS compounded annual growth rates were 8% and storage
rates were 39%. Estimated total revenue from the purchased in-process
product areas were expected to peak in the year 2001 and decline rapidly in
2002-2005 as other new products were expected to enter the market. These
projections were based on Compaq management's estimates of market size and
growth (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 included
growth estimates related to Compaq utilizing certain Digital technologies
in conjunction with Compaq's products, Compaq's marketing and distribution
of 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.
14
- - The estimated cost of sales as a percentage of revenue was expected to be
lower than Digital's on a stand-alone basis (66% in Digital's 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 revenue was
expected to decrease by 1% to 6% from Digital's historical percentage,
depending on the product areas.
The combined company was expected to benefit from more favorable pricing
from key component vendors and production efficiencies due to economies of
scale. As a result of these savings, the estimated cost of sales as a
percentage of revenues for the UNIX/OpenVMS and storage markets, the two
most significant product areas of purchased in-process technology, were
expected to decrease up to 6% from Digital's historical percentages.
- - The estimated selling, general and administrative costs were expected to
more closely approximate Compaq's cost structure (approximately 12% of
revenues in 1997), which was lower than Digital's cost structure
(approximately 24% of revenues in Digital's fiscal 1997). Cost savings were
expected to result primarily from the changes related to the restructuring
actions discussed in Note 3 of Notes to Consolidated Financial Statements,
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 were expected to be realized primarily in
1999 and thereafter. A significant portion of these savings were expected
to be achieved through the adoption and execution of restructuring plans
during 1998 and 1999.
Discounting the net cash flows back to their present value was 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, was 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 was 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 were unknown.
If these projects are not successfully developed, the revenue and
profitability of the Company may be adversely affected in future periods.
Additionally, the value of other intangible assets acquired may become impaired.
Compaq began to benefit from the purchased in-process technology in 1998 and
is continuously monitoring its development projects. Management believes that
the assumptions used in the valuation of purchased in-process technology
reasonably estimate the future benefits attributable to the purchased in-process
technology. No assurance can be given that actual results will not deviate from
those assumptions in future periods.
Similarly, the value assigned to purchased in-process technology for
Microcom, Inc., which Compaq acquired in May 1997, was determined by identifying
research projects in areas including modems, remote access technologies and
others, for which technological feasibility had 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 included a factor which took into account the uncertainty
surrounding the successful development of the purchased in-process technology.
15
RESTRUCTURING AND ASSET IMPAIRMENT CHARGES
In June 1998, Compaq's management approved restructuring plans which
included initiatives to integrate operations of Compaq and Digital, consolidate
duplicative facilities, improve service delivery and reduce overhead. Total
restructuring costs of approximately $1.7 billion were recorded in the second
quarter related to these initiatives, $1.5 billion of which related to Digital
that was recorded as a component of the preliminary purchase price allocation
and $286 million of which related to Compaq that was charged to operations.
The restructuring costs recorded in the second quarter of 1998 were
comprised of the following:
(In millions) COMPAQ DIGITAL TOTAL
================================== ======= ======== ======
Employee separations . . . . . . . $ 132 $ 999 $1,131
Facility closure costs . . . . . . 142 272 414
Relocation . . . . . . . . . . . . - 99 99
Other exit costs . . . . . . . . . 12 88 100
------- -------- ------
Total accrued restructuring costs. $ 286 $ 1,458 $1,744
======= ======== ======
At June 30, 1998, the Digital restructuring plans were based on
management's best estimate of those costs based on available information. The
restructuring costs accrued in June 1998 included estimates of 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 affect the majority of business functions, job
classes and geographies, with most of the reductions occurring in North America
and Europe. The restructuring plans also include costs associated with the
closure of 13.2 million square feet of office, distribution and manufacturing
space, principally in North America and Europe. Other accrued restructuring
costs relate to the relocation of Digital employees, with the majority of this
amount attributable to relocations in North America and Europe, and the cost of
terminating certain Digital contractual obligations. Compaq expects that most
of the restructuring actions will be completed by June 1999.
In the fourth quarter of 1998, Compaq adjusted the Digital restructuring
plan which resulted in a reduction of $59 million of accrued Digital
restructuring costs. This reduction was recorded as an adjustment to the
preliminary purchase price allocation during the quarter ended December 31,
1998. There was no adjustment to the Compaq restructuring plan. The adjustment
to the Digital restructuring plan included a $47 million net increase in
severance costs. This increase was primarily due to higher than expected costs
associated with workforce reductions in Europe, partially offset by higher than
expected attrition rates. While the total Digital employee separation target of
14,700 is expected to be achieved, Digital involuntary separations are expected
to decrease to approximately 12,400 as a result of the higher than expected rate
of attrition. The higher severance costs were more than offset by lower
facility closure costs of $55 million, primarily due to lower than expected
costs to dispose of facilities. In addition, the estimate of employee
relocation costs was reduced by $54 million due to a lower than expected number
of employees accepting relocation packages.
16
The accrued restructuring costs and amounts charged against the accrual as
of December 31, 1998, were as follows:
BEGINNING CASH REMAINING
(In millions) ACCRUAL EXPENDITURES ADJUSTMENT ACCRUAL
================================== ========== ============== ============ ========
Employee separations . . . . . . . $ 1,131 $ (455) $ 47 $ 723
Facility closure costs . . . . . . 414 (42) (55) 317
Relocation . . . . . . . . . . . . 99 (2) (54) 43
Other exit costs . . . . . . . . . 100 (76) 3 27
---------- -------------- ------------ --------
Total accrued restructuring costs. $ 1,744 $ (575) $ (59) $ 1,110
========== ============== ============ ========
Cash expenditures are not reflective of the actual costs incurred due to
the impact of regulatory guidelines in certain countries relating to the timing
of payment of severance benefits to affected employees. As of December 31,
1998, employee separations due to restructuring actions totaled 10,542. Total
severance costs related to these individuals, including the cash payments of
$455 million already made, are approximately $570 million. The total net
headcount reduction since the acquisition of Digital including attrition and
restructuring, partially offset by selective hiring, was approximately 12,800.
During 1998, 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, of assets taken out of service and held for sale or
disposal. The majority of this charge related 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 abandoned the technologies acquired through this acquisition and
discontinued all related products.
Compaq's selling, general and administrative costs are expected to decrease
in the future through the continued implementation of the Company's
restructuring plans.
OTHER ITEMS
In 1998, Compaq's other income was $69 million as compared to other income
of $23 million in 1997 and other expense of $17 million in 1996. The increase
in 1998 was primarily due to an increase in interest and dividend income related
to greater cash and short-term investment balances prior to the Digital
acquisition and a reduction in other expenses, partially offset by the minority
interest dividend paid to Digital preferred shareholders. The increase in other
income in 1997 was primarily driven by an increase in interest and dividend
income related to greater average cash and short-term investment balances,
partially offset by interest expense.
The translation gains and losses relating to the financial statements of
Compaq's international subsidiaries, net of offsetting gains and losses
associated with hedging activities relating to the net monetary assets of these
subsidiaries, are included in other income and expense and resulted in net
losses of $25 million, $27 million and $11 million in 1998, 1997 and 1996,
respectively.
LIQUIDITY AND CAPITAL RESOURCES
Compaq's cash, cash equivalents and short-term investments decreased to
$4.1 billion at December 31, 1998, from $6.8 billion at December 31, 1997. The
decrease in cash, cash equivalents and short-term investments in 1998 was
primarily due to the cash payment made to acquire Digital of approximately $4.5
billion ($1.4 billion net of cash acquired); the completion of a tender offer
for the Digital notes and debentures of $788 million; the repurchase of 11
million shares of common stock for $384 million; cash spent for restructuring
activities of $575 million; investments made in 1998 of $574 million, as
discussed below; cash dividends paid to Compaq shareholders of $95 million and
cash used for the purchase of property, plant and equipment of $600 million.
17
Operating activities generated $644 million in cash in 1998, compared to
$3.7 billion in 1997 and $3.6 billion in 1996, respectively. The decrease in
cash generated by operating activities in 1998 compared to 1997 was
significantly affected by the net loss in 1998 (offset by the purchased
in-process technology acquired from Digital of approximately $3.2 billion) and
an increase in accounts receivable. Accounts receivable increased to $7.0
billion in 1998 from $2.9 billion in 1997, primarily due to the acquisition of
Digital. From time to time, Compaq may sell accounts receivable when it is
economically beneficial. Accounts receivable sold at December 31, 1998 were
$217 million and $1.1 billion at December 31, 1997. Inventory levels increased
to $2.0 billion at December 31, 1998, compared to $1.6 billion at December 31,
1997, due to the acquisition of Digital and increased unit volumes. These
increases were partially offset by changes in production planning as a result of
Compaq's transition to the optimized distribution model. Inventory turns
improved to 13.4 in 1998 versus 12.6 in 1997.
Cash used for investments included a ten percent preferred equity position
in a business venture with Time Warner, Advance/Newhouse, MediaOne and Microsoft
for approximately $213 million. The venture provides Internet services and
intends to accelerate the delivery of broadband services over cable modems to
consumers and small businesses under the Road Runner brand. Cash used for
investments also included the acquisition of a lease portfolio from G.E. Capital
for approximately $361 million.
Compaq plans to use cash 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 a 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. As of
the date of acquisition, the estimated costs to be incurred to develop the
purchased in-process technology into commercially viable products totaled
approximately $3.1 billion in the aggregate through the year 2005. The
remainder to be spent is estimated to be: $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.
Future uses of cash also include cash expenditures for currently planned
restructuring activities which are estimated to be $1.1 billion; capital
expenditures for land, buildings and equipment in 1999 which are estimated to be
$875 million; and the redemption of the Series A Digital Preferred Stock
expected to occur on April 1, 1999 for approximately $400 million plus accrued
dividends.
Other future sources and uses of cash include:
- - A cash tender offer in January 1999 for all of the outstanding shares
of common stock of Shopping.com, an on-line retailer that offers
Internet shoppers an array of consumer products. In February the offer
was successfully concluded, with 96% of the shares tendered. Compaq is
proceeding with the steps necessary to complete the merger, which is
anticipated in March. The aggregate purchase price for Shopping.com is
anticipated to be approximately $220 million. Completion of the
transaction is subject to certain conditions, including clearance
under the Hart-Scott-Rodino Antitrust Improvements Act.
- - The execution of a definitive merger agreement with Zip2 Corporation, the
leading provider of Internet platform solutions for media companies and
local e-commerce merchants in February 1999. The aggregate purchase
price for Zip2 Corporation is anticipated to be approximately $300 million.
Completion of the transaction is subject to customary conditions,
including clearance under the Hart-Scott-Rodino Antitrust Improvements Act.
18
- - The formation of the AltaVista Company in January 1999, a wholly owned
subsidiary established to become a leading Internet site for search
capabilities, localized information, e-commerce and e-services. Compaq will
contribute to AltaVista the AltaVista search site and the associated
intellectual property, Shopping.com, Zip2 Corporation, and certain
additional cash and assets. Compaq anticipates offering a portion of the
AltaVista Company to the public in 1999.
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. In October 1998,
Compaq entered into a one-year $1 billion unsecured revolving credit facility to
replace a similar facility that expired in September 1998. Compaq also has a $3
billion syndicated credit facility that expires in September 2002. Both of
these facilities were unused at December 31, 1998. Compaq has established a
commercial paper program, supported by the syndicated credit facility, which was
unused at December 31, 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 its needs and
market conditions.
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 developments carried out in the
midst of legal disputes 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 1999 in line with third-party research organizations' forecasts of unit
growth of 15%. 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. This expansion
represents an opportunity for Compaq's services business to help enable
customers to implement and manage these new environments. 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,
Compaq 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 personal computer companies sell
directly to end users and, particularly in the U.S., direct sales have increased
as a percentage of the total personal computer 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 its PC
business. Compaq sells directly to end users in its enterprise and service
businesses. The success of its programs to increase its business efficiencies
depends upon Compaq's ability to continue its successful working relationship
with its resellers, to maintain and increase its enterprise and service
businesses, 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.
19
Risks of Newly Acquired Businesses. As a result of the acquisition of
Digital, Compaq has, and will continue to, expand its service offerings and
enterprise solutions. This expansion 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 maintaining key industry alliances and synchronizing
product roadmaps and business processes and integrating logistics, marketing,
product development, services and manufacturing operations to achieve greater
efficiencies. While Compaq has increased its service revenue through this
acquisition, there are risks associated with the service business, which include
jeopardizing Compaq's long-term relationships with third party resellers while
it provides services directly to end-user customers. 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.
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 Compaq 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 revenues, gross margins, and profitability.
20
Systems Implementation. Compaq 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 complicates this
process. Should the transition to new systems not occur in a smooth and orderly
manner, Compaq could experience disruptions in operations, which could have an
adverse financial impact.
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, Compaq 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. 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
revenues 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 attempts to take
measures to limit risks in these areas.
21
Year 2000 Compliance. The following disclosure is a Year 2000 readiness
disclosure statement pursuant to the Year 2000 Readiness and Disclosure Act.
Compaq's Year 2000 program is designed to minimize the possibility of
serious Year 2000 interruptions. Possible Year 2000 worst case scenarios
include the interruption of significant parts of Compaq's business as a result
of critical information systems failure or the failure of suppliers,
distributors or customers. Any such interruption may have a material adverse
impact on future results. Since their possibility cannot be eliminated, Compaq
is incorporating Year 2000 concerns into its contingency plans for dealing with
catastrophic events. In addition, Compaq is monitoring the need to develop
contingency plans to remediate information systems scheduled to be replaced by
systems renewal efforts in case delays in the installation schedule for the new
systems make remediation of the older systems necessary.
In 1997, Compaq established a task force to address its personal computer
product and customer concerns, and a separate task force to address its internal
information systems, including technology infrastructure and embedded technology
systems, and the compliance of its suppliers and distributors. In 1998, Compaq
integrated the Tandem and Digital task forces with those of its own so that the
task force now addresses the product and information systems and supplier and
distributor concerns for the entire Company.
With respect to product readiness, the compliance definitions of Compaq,
Tandem and Digital remain in effect for most of the respective follow-on
products of each company. The readiness status of Compaq, Tandem and Digital
products is available on the Compaq Year 2000 Web site at
www.compaq.com/year2000. In addition to selling tested products, Compaq also
- -----------------------
offers a range of Year 2000 readiness services. Because there is no uniform
definition of Year 2000 "compliance" and because all customer situations cannot
be anticipated, particularly those involving other vendors' products, Compaq may
see a change in demand or an increase in warranty and other claims as a result
of the Year 2000 transition. Such events, should they occur, could have a
material adverse impact on future results.
In 1998, substantially all internal information systems and other
infrastructure areas including communication systems, building security systems
and embedded technologies in areas such as manufacturing processes were
identified, assessed, and categorized for Year 2000 readiness as Priority 1, 2
and 3, with 1 being critical, 2 being intermediate and 3 being non-critical.
During the fourth quarter of 1998, the Year 2000 program experienced a
significant increase in work resulting from the Digital/Tandem integrations and
new business directions. Additional resources have been added and the necessary
steps have been taken to maintain the following goals: Priority 1 and Priority 2
items will be Year 2000 compliant by June 30, 1999, and Priority 3 items are to
be ready by December 31, 1999 or replaced or left undetermined. As of the end
of the fourth quarter of 1998, Compaq completed remediation on approximately 40%
of the Priority 1 items, and expects to be approximately 75% complete by the end
of March 1999. Specific contingency plans are being made with respect to any
Priority 1 listings which cannot be tested or determined to be compliant. Also,
key suppliers and distributors have been identified and Compaq is in the process
of communicating with them about their Year 2000 readiness plans and progress.
In each of these areas, various testing and readiness determination
methodologies are being used, based on what is appropriate for each type of
system, supplier or distributor.
Coincident with Year 2000 readiness efforts, Compaq is rapidly integrating
the Digital operations worldwide. This includes rationalization of internal
systems, facilities and other infrastructure. Compaq is also carrying out major
planned enterprise-wide internal system renewal efforts. These planned major
enterprise-wide system renewals have been incorporated into the Year 2000
readiness effort. Installations are scheduled through the end of 1999. Based
on Compaq's ongoing evaluation of internal information and other systems, the
integration of Digital operations, and system renewal roll-out schedules, Compaq
does not anticipate significant business interruption. However, should business
interruption occur, there could be a material adverse impact on future results.
With respect to suppliers and distributors, because Compaq's readiness depends
upon their cooperation in identifying, disclosing and remediating problems,
failures on the part of suppliers and distributors remain a possibility and
could have a material adverse impact on future results.
22
The costs of the readiness program for products are primarily costs of existing
internal resources largely absorbed within existing engineering spending levels.
These costs were incurred primarily in 1997 and earlier years and were not
broken out from other product engineering costs. No future material product
readiness costs are anticipated. The costs of the readiness program for
internal information and other systems and suppliers and distributors are a
combination of incremental external spending and use of existing internal
resources and expertise. Over the life of the internal readiness effort, these
costs are estimated to be $130 million, of which approximately 45% has been
incurred to date. The costs of implementing enterprise-wide system renewal
efforts are not included in this estimate. Milestones and implementation dates
and the costs of Compaq's Year 2000 readiness program are subject to change
based on new circumstances that may arise or new information becoming available
that may change underlying assumptions or requirements.
Euro Conversion. Effective January 1, 1999, 11 of the 15 member countries
of the European Union have adopted the euro as their common legal currency. On
that date, the participating countries established fixed euro conversion rates
between their existing sovereign currencies and the euro. The euro now trades
on currency exchanges and is available for non-cash transactions. The
participating countries now issue sovereign debt exclusively in euros, and have
redenominated outstanding sovereign debt. The authority to direct monetary
policy for the participating countries, including money supply and official
interest rates for the euro, is now exercised by the new European Central Bank.
In 1997, Compaq established a euro task force to address its PC product and
customer concerns, and a separate task force to address Compaq's internal
information systems. Compaq hopes to achieve euro product readiness and enable
internal information systems to conduct electronic transactions in the euro
within the first quarter of 1999. The schedule and details of subsequent phases
of internal systems readiness is under review, but will comply with
implementation schedules set by the European Commission. We do not believe the
costs of the overall effort will have a material adverse impact on future
results. However, since all customer situations cannot be anticipated, Compaq
may see a change in demand or an increase in warranty and other claims as a
result of the euro implementation. Such events, should they occur, could have a
material adverse impact on future results. Based on Compaq's ongoing evaluation
of internal information systems, integration of Digital operations and system
renewal roll-out schedules, Compaq does not anticipate significant business
interruption. However, should a significant business interruption occur, there
could be a material adverse impact on future results. With respect to
compliance by suppliers and distributors, failures remain a possibility and
could have a material adverse impact on future results.
Milestones and implementation dates of Compaq's euro readiness program are
subject to change based on new circumstances that may arise or new information
becoming available, which changes underlying assumptions or requirements.
23
Tax Rate. Compaq currently has a 15% effective tax rate, before the effect
of non-deductible purchased in-process technology and merger-related costs, and
expects this rate will increase to 32% in 1999. 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
maintained. 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 current levels, or should Compaq's ability to reinvest these
earnings be reduced, Compaq's effective tax rate would increase. 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.
At December 31, 1998 Compaq has recorded a net deferred tax asset of $2.9
billion. Compaq has determined it is more likely than not that this asset will
be realized. The future utilization of these deferred tax assets may be
restricted from future use by certain limitations imposed by taxing authorities
or by a lack of sufficient income generated in the taxing jurisdictions in which
the asset arose. If these limitations are significant, or if the circumstances
surrounding the expected deductibility of the items change, the ultimate
realization of these assets may be adversely impacted and could have an adverse
impact on future results.
Currency Fluctuations. Compaq's risks associated with currency
fluctuations are discussed in Item 7A 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 7A. MARKET RISKS
Compaq is exposed to market risks, which include changes in U.S. and
international interest rates as well 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
preliminarily assess market risk of its financial instruments and derivative
portfolios. It uses J.P. Morgan's RiskMetrics to estimate the value-at-risk of
its financial instruments and derivative portfolios based on estimates of
volatility and correlation of market factors drawn from J.P. Morgan's
RiskMetrics data sets for the dates calculated. RiskMetrics defines loss as a
reduction in the value of a portfolio in the event of adverse market conditions,
using a predetermined confidence interval, over a specified period of time.
Compaq included all fixed income investments and foreign exchange contracts in
the value-at-risk calculation. See Note 1 and Note 13 in the Notes to
Consolidated Financial Statements for further information regarding these
instruments. The holding period for these instruments varies from two days to
nine months. The measured value-at-risk from holding derivative and other
financial instruments, using a 95% confidence level and assuming normal market
conditions during the periods ended December 31, 1998 and 1997 was immaterial.
24
The value of the U.S. dollar affects Compaq's financial results. Changes
in exchange rates may positively or negatively affect Compaq's revenues (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 revenue of Compaq's
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 and services or a weakening exchange rate against currencies in which
Compaq incurs costs, Compaq's revenues or costs are adversely affected.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements
Financial Statements: Page
----
Report of Independent Accountants. . . . . . . . . . . . . . . . . . . . . . . . 26
Consolidated Balance Sheet at December 31, 1998 and 1997 . . . . . . . . . . . . 27
Consolidated Statement of Income for the three years ended December 31, 1998 . . 28
Consolidated Statement of Cash Flows for the three years ended December 31, 1998 29
Consolidated Statement of Stockholders' Equity for the three years ended
December 31, 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . 32
Financial Statement Schedule:
For the three years ended December 31, 1998
Schedule II - Valuation and Qualifying Accounts. . . . . . . . . . . . . . . 63
ITEM 9: DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
25
REPORT OF INDEPENDENT ACCOUNTANTS
To the Stockholders and Board of Directors of
Compaq Computer Corporation
In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of Compaq
Computer Corporation and its subsidiaries at December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1998, in conformity with generally accepted
accounting principles. In addition, in our opinion, the financial statement
schedule listed in the accompanying index, presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and the
financial statement schedule are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements and
the financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
PRICEWATERHOUSECOOPERS LLP
Houston, Texas
January 26, 1999,
except as to Note 14, which is as of February 16, 1999
26
COMPAQ COMPUTER CORPORATION
CONSOLIDATED BALANCE SHEET
December 31 (In millions, except par value) 1998 1997
=========================================================================== ======== =======
ASSETS
Current assets:
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . $ 4,091 $ 6,418
Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . - 344
Accounts receivable, less allowance of $318 and $243 . . . . . . . . . . . 6,998 2,891
Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,005 1,570
Deferred income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . 1,602 595
Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 471 199
-------- -------
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . 15,167 12,017
Property, plant and equipment, less accumulated depreciation. . . . . . . . 2,902 1,985
Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,341 -
Intangible and other assets . . . . . . . . . . . . . . . . . . . . . . . . 3,641 629
-------- -------
$23,051 $14,631
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,237 $ 2,837
Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 282 195
Accrued restructuring costs. . . . . . . . . . . . . . . . . . . . . . . . 1,110 -
Other current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . 5,104 2,170
-------- -------
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . 10,733 5,202
-------- -------
Postretirement and other postemployment benefits. . . . . . . . . . . . . . 545 -
-------- -------
Commitments and contingencies (Note 13)
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 and outstanding:
1,698 and 1,687 million shares, respectively, at December 31, 1998; and
1,519 million shares issued and outstanding at December 31, 1997). . . . 7,270 2,096
Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,465 7,333
Treasury stock (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . (384) -
-------- -------
Total stockholders' equity . . . . . . . . . . . . . . . . . . . . . . . 11,351 9,429
-------- -------
$23,051 $14,631
======== =======
The accompanying notes are an integral part of these financial statements.
27
COMPAQ COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF INCOME
Year ended December 31 (In millions, except per share amounts) 1998 1997 1996
=========================================================================== ========== ======== =======
Revenue:
Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 27,372 $24,122 $19,611
Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,797 462 398
---------- -------- -------
Total revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,169 24,584 20,009
---------- -------- -------
Cost of sales:
Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,383 17,500 14,565
Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,597 333 290
---------- -------- -------
Total cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . . 23,980 17,833 14,855
---------- -------- -------
Selling, general and administrative expense . . . . . . . . . . . . . . . . 4,978 2,947 2,507
Research and development costs. . . . . . . . . . . . . . . . . . . . . . . 1,353 817 695
Purchased in-process technology . . . . . . . . . . . . . . . . . . . . . . 3,196 208 -
Restructuring and asset impairment charges. . . . . . . . . . . . . . . . . 393 - 52
Merger-related costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . - 44 -
Other income and expense, net . . . . . . . . . . . . . . . . . . . . . . . (69) (23) 17
---------- -------- -------
9,851 3,993 3,271
---------- -------- -------
Income (loss) before provision for income taxes . . . . . . . . . . . . . . (2,662) 2,758 1,883
Provision for income taxes. . . . . . . . . . . . . . . . . . . . . . . . . 81 903 565
---------- -------- -------
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (2,743) $ 1,855 $ 1,318
========== ======== =======
Earnings (loss) per common share:
Basic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1.71) $ 1.23 $ 0.90
Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1.71) $ 1.19 $ 0.87
Shares used in computing earnings (loss) per common share:
Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,608 1,505 1,472
Diluted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,608 1,564 1,516
The accompanying notes are an integral part of these financial statements.
28
COMPAQ COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS
Year ended December 31 (In millions) 1998 1997 1996
=========================================================================== ========== ========== ==========
Cash flows from operating activities:
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (2,743) $ 1,855 $ 1,318
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization. . . . . . . . . . . . . . . . . . . . . . . 893 545 483
Provision for bad debts. . . . . . . . . . . . . . . . . . . . . . . . . . 61 19 160
Purchased in-process technology. . . . . . . . . . . . . . . . . . . . . . 3,196 208 -
Deferred income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . (130) 202 (405)
Restructuring and asset impairment charges . . . . . . . . . . . . . . . . 393 - 52
Changes in operating assets and liabilities, net of effects of
purchased businesses:
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,736) 614 (228)
Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 857 (335) 1,014
Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 63 34
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 589 756 562
Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . (265) (319) 131
Accrued restructuring costs. . . . . . . . . . . . . . . . . . . . . . . . (575) - -
Other current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . (10) 80 445
---------- ---------- ----------
Net cash provided by operating activities. . . . . . . . . . . . . . . . . 644 3,688 3,566
---------- ---------- ----------
Cash flows from investing activities:
Purchases of property, plant and equipment, net . . . . . . . . . . . . . . (600) (729) (484)
Purchases of short-term investments . . . . . . . . . . . . . . . . . . . . (77) (2,405) (1,401)
Proceeds from sales of short-term investments . . . . . . . . . . . . . . . 421 3,134 328
Acquisition of businesses, net of cash acquired . . . . . . . . . . . . . . (1,413) (268) (22)
Acquisition of lease portfolio. . . . . . . . . . . . . . . . . . . . . . . (361) - -
Other, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (437) (31) (75)
---------- ---------- ----------
Net cash used in investing activities. . . . . . . . . . . . . . . . . . . (2,467) (299) (1,654)
---------- ---------- ----------
Cash flows from financing activities:
Repayment of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . (788) (293) -
Purchase of treasury shares . . . . . . . . . . . . . . . . . . . . . . . . (384) - -
Issuance of common stock pursuant to stock option plans . . . . . . . . . . 407 188 131
Tax benefit associated with stock options . . . . . . . . . . . . . . . . . 234 156 91
Dividends paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (95) - -
Other, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (18) (37) -
---------- ---------- ----------
Net cash provided by (used in) financing activities. . . . . . . . . . . . (644) 14 222
---------- ---------- ----------
Effect of exchange rate changes on cash and cash equivalents. . . . . . . . 140 7 21
---------- ---------- ----------
Net (decrease) increase in cash and cash equivalents . . . . . . . . . . . (2,327) 3,410 2,155
---------- ---------- ----------
Cash and cash equivalents at the beginning of the year. . . . . . . . . . . 6,418 3,008 853
---------- ---------- ----------
Cash and cash equivalents at the end of the year. . . . . . . . . . . . . . $ 4,091 $ 6,418 $ 3,008
========== ========== ==========
The accompanying notes are an integral part of these financial statements.
29
COMPAQ COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS (CONTINUED)
SUPPLEMENTAL CASH FLOW INFORMATION
Year ended December 31 (In millions) 1998 1997 1996
==================================== ===== ===== =====
Interest paid. . . . . . . . . . . . $ 175 $ 164 $ 106
Income taxes paid. . . . . . . . . . $ 259 $ 804 $ 953
Year ended December 31 (In millions) 1998 1997
======================================================== ========== =======
Acquisitions (Note 2)
Fair value of:
Assets acquired. . . . . . . . . . . . . . . . . . . . $ 16,124 $ 362
Liabilities assumed. . . . . . . . . . . . . . . . . . (7,109) (74)
Stock issued . . . . . . . . . . . . . . . . . . . . . (4,284) -
Options issued . . . . . . . . . . . . . . . . . . . . (249) (10)
---------- -------
Cash paid . . . . . . . . . . . . . . . . . . . . . . . 4,482 278
Less cash acquired. . . . . . . . . . . . .. . . . . . . (3,069) (10)
---------- -------
Net cash paid for acquisitions. . . . . . . . . . . . $ 1,413 $ 268
========== =======
The accompanying notes are an integral part of these financial statements.
30
COMPAQ COMPUTER CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
Year ended December 31 (In millions) 1998 1997 1996
=========================================================================== ========== ======= =======
SHARES OF COMMON STOCK ISSUED:
Beginning balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,519 1,492 1,458
Issuance pursuant to stock option plans. . . . . . . . . . . . . . . . . 36 30 34
Issuance of stock pursuant to acquisition. . . . . . . . . . . . . . . . 141 - -
Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (3) -
---------- ------- -------
Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,698 1,519 1,492
========== ======= =======
COMMON STOCK PAR VALUE AND CAPITAL IN EXCESS OF PAR:
Beginning balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,096 $1,779 $1,543
Issuance pursuant to stock option plans. . . . . . . . . . . . . . . . . 407 188 131
Issuance of stock pursuant to acquisition. . . . . . . . . . . . . . . . 4,284 - -
Issuance of stock options pursuant to acquisition. . . . . . . . . . . . 249 10 -
Tax benefit associated with stock options. . . . . . . . . . . . . . . . 234 156 91
Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - (37) 14
---------- ------- -------
Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,270 2,096 1,779
---------- ------- -------
RETAINED EARNINGS:
Beginning balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,333 5,511 4,214
Comprehensive income (loss)
Net income (loss). . . . . . . . . . . . . . . . . . . . . . . . . . . (2,743) 1,855 1,318
Other comprehensive income (loss). . . . . . . . . . . . . . . . . . . (18) (22) (21)
---------- ------- -------
Total comprehensive income (loss). . . . . . . . . . . . . . . . . . . . (2,761) 1,833 1,297
---------- ------- -------
Change in Tandem fiscal period . . . . . . . . . . . . . . . . . . . . . - 12 -
Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (107) (23) -
---------- ------- -------
Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,465 7,333 5,511
---------- ------- -------
TREASURY STOCK:
Beginning balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . - - -
Repurchase of treasury stock, at cost. . . . . . . . . . . . . . . . . . (384) - -
---------- ------- -------
Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (384) - -
---------- ------- -------
TOTAL STOCKHOLDERS' EQUITY. . . . . . . . . . . . . . . . . . . . . . . . . $ 11,351 $9,429 $7,290
========== ======= =======
ACCUMULATED OTHER COMPREHENSIVE INCOME:
Beginning balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (18) $ 4 $ 25
Other comprehensive income (loss)
Foreign currency translations. . . . . . . . . . . . . . . . . . . . . 20 (22) (21)
Minimum pension liability adjustment . . . . . . . . . . . . . . . . . (38) - -
---------- ------- -------
Total other comprehensive income (loss). . . . . . . . . . . . . . . . . (18) (22) (21)
---------- ------- -------
Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (36) $ (18) $ 4
========== ======= =======
The accompanying notes are an integral part of these financial statements.
31
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS. Founded in 1982, Compaq Computer Corporation ("Compaq"
or the "Company") is a global information technology company. Compaq develops
and markets hardware, software, solutions and services, including enterprise
computing solutions, fault-tolerant business-critical solutions, networking and
communication products, commercial desktop and portable products and consumer
PCs. Compaq products and services are sold in more than 100 countries through
subsidiaries and a network of authorized Compaq marketing partners. Compaq
markets its products and services primarily to customers from the business,
home, government, and education sectors.
Compaq completed the acquisition of Digital Equipment Corporation
("Digital") in June 1998. This acquisition was accounted for under the purchase
method of accounting. Compaq completed the acquisition of Tandem Computers
Incorporated ("Tandem") in August 1997. This acquisition was accounted for as a
pooling of interests, consequently, the financial information for 1997 and 1996
has been restated to reflect the merger with Tandem.
PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the
accounts of Compaq and its subsidiaries. All significant intercompany
transactions and balances have been eliminated.
USE OF ESTIMATES. The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and judgments that affect the reported amounts of assets, liabilities, revenues
and expenses, and related disclosure of contingent assets and liabilities.
Actual results could differ from those estimates.
CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS. Cash equivalents include highly
liquid temporary cash investments having maturities of three months or less at
date of acquisition. Short-term investments include certificate of deposits,
commercial paper and other investments having maturities longer than three
months at date of acquisition. For reporting purposes, such cash equivalents and
short-term investments are stated at cost plus accrued interest which
approximates fair value.
INVENTORIES. Inventories are stated at the lower of cost or market, cost being
determined on a first-in, first-out basis.
PROPERTY, PLANT AND EQUIPMENT. Property, plant and equipment are stated at cost
less accumulated depreciation. Major renewals and improvements are capitalized;
minor replacements, maintenance and repairs are charged to current operations.
Depreciation is computed by applying the straight-line method over the estimated
useful lives of the buildings (10-30 years) and by applying the straight-line or
accelerated methods over the estimated useful lives of machinery and equipment
(two to ten years). Leasehold improvements are amortized over the shorter of the
useful life of the improvement or the life of the related lease.
LONG-LIVED ASSETS. Compaq reviews for the impairment of long-lived assets
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. An impairment loss would be recognized when
estimated future cash flows expected to result from the use of the asset and its
eventual disposition is less than its carrying amount.
32
INTANGIBLE ASSETS. Intangible assets primarily relate to the value of the
installed customer base, proven research and development, and trademarks of
companies acquired. The cost of the installed customer base, proven research
and development and trademarks is amortized on a straight-line basis over the
estimated lives of 15 years, 5 years and 5 years, respectively.
REVENUE RECOGNITION. Compaq recognizes products revenue at the time products
are shipped to its customers. Provision is made at the time the related revenue
is recognized for estimated product returns and price protection which may occur
under programs Compaq has with its customers. Compaq provides for the estimated
cost of post-sales support and product warranties upon shipment. When other
significant obligations remain after products are delivered, revenue is
recognized only after such obligations are fulfilled. Services revenue is
recognized ratably over the contractual period or as the services are performed.
FINANCING TRANSACTIONS. Compaq offers customer financing to assist customers in
their acquisition of the Company's products through its leasing subsidiary,
Compaq Capital. At the time a financing transaction is consummated, which
qualifies as either a sales-type or direct financing lease, the Company records
the total receivable, unearned income and the estimated residual value of the
equipment. Unearned income is recognized as finance income using the interest
method over the term of the lease. Lease receivables of $271 million, net of
unearned income, due within the next twelve months are included in accounts
receivable. The non-current portion of $274 million of lease receivables and
the residual value, net of unearned income, are included in long-term other
assets. Leases not qualifying as either sales-type or direct financing leases
are accounted for as operating leases. The underlying equipment is depreciated
on a straight-line basis over the initial term of the lease to its estimated
residual value. Rental equipment of $166 million, net of accumulated
depreciation, is included in property, plant and equipment.
ADVERTISING COSTS. Advertising costs are charged to operations when incurred.
The cost of direct-response advertising is not significant. Advertising expenses
for 1998, 1997 and 1996 were $336 million, $223 million and $175 million,
respectively.
FOREIGN CURRENCY. Compaq's foreign subsidiaries (other than those acquired in
the merger with Tandem) have the U.S. dollar designated as their functional
currency. Financial statements of these foreign subsidiaries are translated to
U.S. dollars for consolidation purposes using current rates of exchange for
monetary assets and liabilities and historical rates of exchange for nonmonetary
assets and related elements of expense. Revenue and other expense elements are
translated at rates that approximate the rates in effect on the transaction
dates. Translation gains and losses are included in Compaq's Consolidated
Statement of Income. The foreign subsidiaries acquired in the merger with
Tandem designated the local currency as their functional currency and related
cumulative translation adjustments have not been significant.
INCOME TAXES. The provision for income taxes is computed based on the pretax
income (loss) included in the Consolidated Statement of Income. The asset and
liability approach is used to recognize deferred tax assets and liabilities for
the expected future tax consequences of temporary differences between the
carrying amounts and the tax bases of assets and liabilities.
EARNINGS PER COMMON SHARE. Basic earnings (loss) per common share is computed
using the weighted average number of common shares outstanding during the
period. Diluted earnings per common share is computed using the combination of
dilutive common share equivalents and the weighted average number of common
shares outstanding during the period. Incremental shares of 59 million and 44
million in 1997 and 1996, respectively, were used in the calculation of diluted
earnings per common share. Diluted loss per common share for 1998 is based only
on the weighted average number of common shares outstanding during the period,
as the inclusion of 60 million common share equivalents would have been
antidilutive.
33
Stock options to purchase 13 million, 9 million and 28 million shares of
common stock in 1998, 1997 and 1996, respectively, were outstanding but not
included in the computation of diluted earnings (loss) per common share because
the option exercise price was greater than the average market price of the
common shares.
STOCK-BASED COMPENSATION. Compaq measures compensation expense for its
stock-based employee compensation plans using the intrinsic value method and has
provided in Note 8 the pro forma disclosures of the effect on net income (loss)
and earnings (loss) per common share as if the fair value-based method had been
applied in measuring compensation expense.
COMPREHENSIVE INCOME. Other comprehensive income refers to revenues, expenses,
gains and losses that under generally accepted accounting principles are
included in comprehensive income but are excluded from net income as these
amounts are recorded directly as an adjustment to stockholders' equity.
Compaq's other comprehensive income is primarily comprised of foreign currency
translation adjustments and adjustments made to recognize additional minimum
liabilities associated with the Company's defined benefit pension plans. The
tax benefit or expense, as well as any reclassifications related to the
components of other comprehensive income were not significant.
SEGMENT DATA. During 1998, Compaq adopted Statement of Financial Accounting
Standards No. 131 ("FAS 131"), Disclosures about Segments of an Enterprise and
Related Information. FAS 131 supersedes FAS 14, Financial Reporting for
Segments of a Business Enterprise, replacing the "industry segment" approach
with the "management" approach. The management approach designates the internal
reporting that is used by management for making operating decisions and
assessing performance as the source of the Company's reportable segments. FAS
131 also requires disclosures about products and services, geographic areas and
major customers. The adoption of FAS 131 did not affect results of operations
or the financial position of Compaq but did affect the disclosure of segment
information (Note 12).
RECENT PRONOUNCEMENTS. In June 1998, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards No. 133 ("FAS 133"),
Accounting for Derivative Instruments and Hedging Activities. FAS 133 is
effective for transactions entered into after January 1, 2000. 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 the type of hedge transaction.
The ineffective portion of all hedges will be recognized in earnings. Compaq is
in the process of determining the impact that the adoption of FAS 133 will have
on its results of operations and financial position.
RECLASSIFICATIONS. Certain prior year amounts have been reclassified to conform
to the 1998 presentation.
34
NOTE 2. ACQUISITIONS
On June 11, 1998, Compaq consummated its acquisition of Digital. Digital
was an industry leader in implementing and supporting networked business
solutions in multi-vendor environments based on high performance platforms and
had 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 at the acquisition
date. In the fourth quarter of 1998, Compaq adjusted the fair values of certain
assets acquired and liabilities assumed based on the receipt of additional
information which was outstanding as of the date of the acquisition. These
adjustments did not have a material impact on the initial purchase price
allocation. The fair value assigned to intangible assets acquired was based on
a valuation prepared by an independent third-party appraisal company of the
purchased in-process technology, proven research and development, installed
customer base and trademarks of Digital. 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 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.
The following table shows the fair value of the long-term assets acquired,
the allocation of the excess value over the purchase price and the resulting
assigned value for the long-term assets acquired through the acquisition of
Digital:
EXCESS VALUE VALUE ASSIGNED
OVER PURCHASE TO NET ASSETS
BALANCE SHEET CATEGORY (In millions) VALUATION PRICE ACQUIRED
==================================== =========== =============== ================
Property, plant and equipment. . . . $ 1,470 $ (592) $ 878
Purchased in-process technology. . . 5,722 (2,526) 3,196
Intangible assets:
Proven research and development . . 990 (437) 553
Installed customer base . . . . . . 2,150 (949) 1,201
Trademarks. . . . . . . . . . . . . 291 (129) 162
Other assets . . . . . . . . . . . . 953 (262) 691
Deferred tax liability . . . . . . . (1,121) 829 (292)
Approximately $3.2 billion of the purchase price represents purchased
in-process technology that had not yet reached technological feasibility and had
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 had not been
established, including UNIX/OpenVMS ($1.6 billion), NT Systems ($800 million),
storage ($2.7 billion) 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 included 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.
35
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 is presented for illustrative purposes only and
is not necessarily indicative of the combined results of operations of future
periods or the results that actually would have occurred had Compaq and Digital
been a combined company during the specified periods. The pro forma combined
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.
Year ended December 31 (In millions, except per share amounts) 1998 1997
============================================================== ========= =========
PRO FORMA UNAUDITED
Revenue:
Products. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 29,955 $ 31,350
Services. . . . . . . . . . . . . . . . . . . . . . . . . . . 6,447 6,295
--------- ---------
Total revenue . . . . . . . . . . . . . . . . . . . . . . . $ 36,402 $ 37,645
--------- ---------
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 275 $ 1,798
--------- ---------
Earnings per common share:
Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.16 $ 1.09
Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.16 $ 1.05
Shares used in computing earnings per common share:
Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,672 1,646
Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,736 1,706
During 1998, Compaq Capital purchased from G.E. Capital Corporation a lease
portfolio for $361 million. The underlying equipment consists primarily of
Digital manufactured equipment. Also during 1998, Compaq Capital purchased
certain assets and assumed certain liabilities of Dana Commercial Credit
Corporation's computer equipment leasing business. The purchase price was $50
million. The assets acquired consist primarily of direct financing leases
related to Compaq manufactured equipment.
On August 29, 1997, Compaq merged with Tandem Computers Incorporated
("Tandem") in a stock-for-stock transaction accounted for as a pooling of
interests. Tandem provided its customers with reliable, scaleable,
fault-tolerant enterprise computer systems and client/server solutions. In
connection with the merger, Compaq issued 126 million shares of common stock,
based upon an exchange ratio of 1.05 shares of Compaq common stock for each
share of Tandem common stock. Merger-related costs of $44 million are comprised
primarily of transaction costs for fees of investment bankers, attorneys,
accountants and printing, and are reflected in the Consolidated Statement of
Income for the year ended December 31, 1997. The financial data included in
these financial statements have been restated to reflect the merger with Tandem.
There were no material transactions between Compaq and Tandem during the periods
prior to the merger. The consolidated financial data for the year ended December
31, 1996 includes the results of Tandem for the year ended September 30, 1996.
For 1997, Tandem's fiscal year end was changed from September 30 to December 31.
As permitted by Securities and Exchange Commission regulations, Tandem's
three-month period ended December 31, 1996 has been omitted from the
Consolidated Statement of Income and recorded as an adjustment to retained
earnings in 1997. Tandem's revenues, expenses and net income were $436 million,
$424 million and $12 million, respectively, for that period. Tandem also
generated a $40 million increase in cash and cash equivalents during the quarter
ended December 31, 1996.
36
In May 1997, Compaq completed a tender offer for Microcom, Inc., a
manufacturer of remote access technologies and solutions. The aggregate
purchase price of $288 million consisted of $278 million in cash and the
assumption of certain employee stock options. The transaction was accounted for
under the purchase method of accounting. Accordingly, the results of operations
of the acquired business and the fair market values of the acquired assets and
liabilities were included in Compaq's financial statements from the date of
acquisition. The aggregate purchase price has been allocated to the assets and
liabilities acquired. The aggregate purchase price included $208 million,
representing the value of purchased in-process technology that had not yet
reached technological feasibility and had no alternative future use.
Accordingly, this amount was expensed in Compaq's Consolidated Statement of
Income during 1997.
NOTE 3. RESTRUCTURING AND ASSET IMPAIRMENT CHARGES
In June 1998, Compaq's management approved restructuring plans which
included initiatives to integrate operations of Compaq and Digital, consolidate
duplicative facilities, improve service delivery and reduce overhead. Total
restructuring costs of approximately $1.7 billion were recorded in the second
quarter related to these initiatives, $1.5 billion of which related to Digital
that was recorded as a component of the preliminary purchase price allocation
and $286 million of which related to Compaq that was charged to operations.
The restructuring costs recorded in the second quarter of 1998 were comprised of
the following:
(In millions) COMPAQ DIGITAL TOTAL
================================== ======= ======== ======
Employee separations . . . . . . . $ 132 $ 999 $1,131
Facility closure costs . . . . . . 142 272 414
Relocation . . . . . . . . . . . . - 99 99
Other exit costs . . . . . . . . . 12 88 100
------- -------- ------
Total accrued restructuring costs. $ 286 $ 1,458 $1,744
======= ======== ======
At June 30, 1998, the Digital restructuring plans were based on
management's best estimate of those costs based on available information. The
restructuring costs accrued in June 1998 included estimates of 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 affect the majority of business functions, job
classes and geographies, with most of the reductions occurring in North America
and Europe. The restructuring plans also included costs associated with the
closure of 13.2 million square feet of office, distribution and manufacturing
space, principally in North America and Europe. Other accrued restructuring
costs relate to the relocation of Digital employees, with the majority of this
amount attributable to relocations in North America and Europe, and the cost of
terminating certain Digital contractual obligations. Compaq expects that most
of the restructuring actions will be completed by June 1999.
37
In the fourth quarter of 1998, Compaq adjusted the Digital restructuring
plan which resulted in a reduction of $59 million of accrued Digital
restructuring costs. This reduction was recorded as an adjustment to the
preliminary purchase price allocation during the quarter ended December 31,
1998. There was no adjustment to the Compaq restructuring plan. The adjustment
to the Digital restructuring plan included a $47 million net increase in
severance costs. This increase was primarily due to higher than expected costs
associated with workforce reductions in Europe, partially offset by higher than
expected attrition rates. While the total Digital employee separation target of
14,700 is expected to be achieved, Digital involuntary separations are expected
to decrease to approximately 12,400 as a result of the higher than expected rate
of attrition. The higher severance costs were more than offset by lower
facility closure costs of $55 million, primarily due to lower than expected
costs to dispose of facilities. In addition, the estimate of employee
relocation costs was reduced by $54 million due to a lower than expected number
of employees accepting relocation packages.
The accrued restructuring costs and amounts charged against the accrual as
of December 31, 1998, were as follows:
BEGINNING CASH REMAINING
(In millions) ACCRUAL EXPENDITURES ADJUSTMENT ACCRUAL
================================== ========== ============== ============ ========
Employee separations . . . . . . . $ 1,131 $ (455) $ 47 $ 723
Facility closure costs . . . . . . 414 (42) (55) 317
Relocation . . . . . . . . . . . . 99 (2) (54) 43
Other exit costs . . . . . . . . . 100 (76) 3 27
---------- -------------- ------------ --------
Total accrued restructuring costs. $ 1,744 $ (575) $ (59) $ 1,110
========== ============== ============ ========
Cash expenditures are not reflective of the actual costs incurred as of
December 31, 1998 due to the impact of regulatory guidelines in certain
countries relating to the timing of payment of severance benefits to affected
employees. As of December 31, 1998, employee separations due to restructuring
actions totaled 10,542. Total severance costs related to these individuals,
including the cash payments of $455 million already made, are approximately $570
million. The total net headcount reduction since the acquisition of Digital
including attrition and restructuring, partially offset by selective hiring, was
approximately 12,800.
During 1998, 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 related 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 abandoned the technologies acquired through this acquisition and
discontinued all related products.
38
NOTE 4. BALANCE SHEET COMPONENTS
Inventories consisted of the following:
December 31 (In millions) 1998 1997
========================= ====== ======
Raw material. . . . . . . $ 404 $ 439
Work-in progress. . . . . 403 328
Finished goods. . . . . . 1,198 803
------ ------
$2,005 $1,570
====== ======
Property, plant and equipment consisted of the following:
December 31 (In millions) 1998 1997
===================================== ====== ======
Land. . . . . . . . . . . . . . . . . $ 249 $ 185
Buildings and leasehold improvements. 1,653 1,076
Machinery and equipment . . . . . . . 2,927 2,392
Construction-in-process and other . . 394 373
------ ------
5,223 4,026
Less accumulated depreciation . . . . 2,321 2,041
------ ------
$2,902 $1,985
====== ======
Depreciation expense totaled $606 million, $447 million and $387 million in
1998, 1997 and 1996, respectively.
Intangibles and other assets consisted of the following:
December 31 (In millions) 1998 1997
================================ ====== =====
Installed customer base. . . . . $1,201 $ -
Proven research and development. 612 178
Trademarks . . . . . . . . . . . 164 5
Other assets . . . . . . . . . . 2,119 751
------ -----
4,096 934
Less accumulated amortization. . 455 305
------ -----
$3,641 $ 629
====== =====
Amortization expense totaled $287 million, $98 million and $96 million in
1998, 1997 and 1996, respectively.
39
Other current liabilities consisted of the following:
December 31 (In millions) 1998 1997
================================== ====== ======
Salaries, wages and related items. $ 749 $ 195
Deferred revenue . . . . . . . . . 845 136
Accrued warranty . . . . . . . . . 752 431
Other accrued liabilities. . . . . 2,758 1,408
------ ------
$5,104 $2,170
====== ======
NOTE 5. CREDIT AGREEMENTS AND FINANCING ARRANGEMENTS
In October 1998, Compaq entered into a one-year $1 billion unsecured
revolving credit facility to replace a similar facility that expired in
September 1998. In addition, Compaq has a five-year, $3 billion revolving
credit facility that expires in September 2002. There were no borrowings under
these facilities during 1998 or 1997.
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. OTHER INCOME AND EXPENSE
Other income and expense consisted of the following:
Year ended December 31 (In millions) 1998 1997 1996
================================================== ======== ======== ========
Interest and dividend income . . . . . . . . . . . $ (287) $ (266) $ (126)
Interest (income) expense associated with hedging. 9 (4) (3)
Other interest expense . . . . . . . . . . . . . . 166 168 106
Currency losses, net . . . . . . . . . . . . . . . 16 31 14
Minority interest dividend . . . . . . . . . . . . 19 - -
Other, net . . . . . . . . . . . . . . . . . . . . 8 48 26
-------- -------- --------
$ (69) $ (23) $ 17
======== ======== ========
NOTE 7. PROVISION FOR INCOME TAXES
The components of income (loss) before provision for income taxes were as
follows:
Year ended December 31 (In millions) 1998 1997 1996
==================================== ========== ====== ======
Domestic . . . . . . . . . . . . . . $ (4,782) $1,789 $ 929
Foreign. . . . . . . . . . . . . . . 2,120 969 954
---------- ------ ------
$ (2,662) $2,758 $1,883
========== ====== ======
40
The provision for income taxes charged to operations was as follows:
Year ended December 31 (In millions) 1998 1997 1996
==================================== ======== ===== ========
Current tax expense (benefit)
U.S. federal. . . . . . . . . . . . $ (92) $430 $ 672
State and local . . . . . . . . . . (9) 30 34
Foreign . . . . . . . . . . . . . . 312 241 238
-------- ----- --------
Total current . . . . . . . . . . . 211 701 944
-------- ----- --------
Deferred tax expense (benefit)
U.S. federal. . . . . . . . . . . . (429) 194 (332)
State and local . . . . . . . . . . (11) 2 (19)
Foreign . . . . . . . . . . . . . . 310 6 (28)
-------- ----- --------
Total deferred. . . . . . . . . . . (130) 202 (379)
-------- ----- --------
Total provision . . . . . . . . . . $ 81 $903 $ 565
======== ===== ========
The reasons for the differences between income tax expense and amounts
calculated using the U.S. statutory rate of 35% were as follows:
Year ended December 31 (In millions) 1998 1997 1996
=============================================== ======== ======= ========
Tax expense (benefit) at U.S. statutory rate. . $ (932) $ 965 $ 659
Foreign tax effect, net . . . . . . . . . . . . (40) (88) (105)
Non-deductible purchased in-process technology. 1,119 73 -
Release of valuation allowance. . . . . . . . . (77) (30) (7)
Other, net. . . . . . . . . . . . . . . . . . . 11 (17) 18
-------- ------- --------
$ 81 $ 903 $ 565
======== ======= ========
In connection with the 1998 and 1997 acquisitions, Compaq recorded
non-recurring, non-tax-deductible charges for purchased in-process technology of
approximately $3.2 billion and $208 million, respectively. In connection with
the 1997 Tandem merger, Compaq incurred $44 million of non-recurring,
non-tax-deductible merger expenses. The exclusion of these non-taxable charges
would result in effective tax rates of 15% and 30% in 1998 and 1997,
respectively.
Compaq benefits from a tax holiday in Singapore which expires in 2001, with
a potential extension to August 2004 if certain cumulative investment levels and
other conditions are maintained. Compaq has determined that the undistributed
earnings of its Singaporean manufacturing subsidiary will be reinvested
indefinitely. In addition, Compaq has determined that the preacquisition
undistributed earnings of the acquired Digital foreign subsidiaries will be
reinvested indefinitely. Undistributed post-acquisition earnings of the Digital
subsidiaries are not reinvested indefinitely. As a result of these
determinations, no incremental tax is reflected for the earnings of Compaq's
Singaporean manufacturing subsidiary or for the pre-acquisition earnings of the
Digital subsidiaries. These earnings would become subject to incremental
foreign withholding, federal and state income tax if they were actually or
deemed to be remitted to the U.S. Compaq estimates an additional tax provision
of approximately $2.1 billion would be required if the full amount of
approximately $6.0 billion in accumulated earnings were actually or deemed
distributed to the U.S.
41
Compaq recorded a gross deferred tax asset of approximately $2.8 billion
upon the acquisition of Digital. This gross deferred tax asset was reduced by a
valuation allowance of $562 million, resulting in a net increase in the deferred
tax asset of approximately $2.2 billion. The valuation allowance is principally
composed of pre-acquisition tax loss carryforwards and credit carryforwards
incurred by Digital which management has determined are more likely than not to
expire unused. If it is subsequently determined that a portion of the Digital
deferred tax asset to which the valuation allowance relates should be
recognized, the tax benefit of such recognition will be allocated to noncurrent
intangible assets acquired in the acquisition.
During 1998 the Company recorded $65 million of other tax loss and credit
carryforwards for which a full valuation allowance was provided due to
uncertainty surrounding their realizability.
The valuation allowance was reduced by $77 million to reflect Tandem credit
carryforwards which, as a result of the fourth quarter 1998 liquidation of the
U.S. Tandem parent company, are now believed more likely than not to be
realized. This reduction in the valuation allowance resulted in a tax benefit
as a component of the deferred income tax provision.
Deferred tax assets (liabilities) are comprised of the following:
December 31 (In millions) 1998 1997
======================================================================== ======== ========
Property, plant and equipment. . . . . . . . . . . . . . . . . . . . . . $ 144 $ -
Compensation accruals. . . . . . . . . . . . . . . . . . . . . . . . . . 227 -
Restructuring accrual. . . . . . . . . . . . . . . . . . . . . . . . . . 431 -
Post sales support and warranty accruals . . . . . . . . . . . . . . . . 255 154
Receivable allowances. . . . . . . . . . . . . . . . . . . . . . . . . . 349 353
Inventory adjustments. . . . . . . . . . . . . . . . . . . . . . . . . . 182 99
Capitalized research and development costs . . . . . . . . . . . . . . . 679 95
Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300 50
Credit carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . 411 119
Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441 186
-------- --------
Gross deferred tax assets. . . . . . . . . . . . . . . . . . . . . . 4,419 1,056
-------- --------
Difference arising from different tax and financial reporting year ends. - (254)
Intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . (715) (64)
Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (104) (73)
-------- --------
Gross deferred tax liabilities . . . . . . . . . . . . . . . . . . . (819) (391)
-------- --------
Deferred tax asset valuation allowance . . . . . . . . . . . . . . . . . (684) (134)
-------- --------
$ 2,916 $ 531
======== ========
Tax loss carryforwards will generally expire between 1999 and 2019. Credit
carryforwards will generally expire between 1999 and 2013. U.S. tax laws limit
the annual utilization of tax loss and credit carryforwards of acquired
entities. These limitations should not materially impact the utilization of the
tax carryforwards.
NOTE 8. STOCK OPTION PLANS
Compaq maintains various stock option plans for its employees. Options to
employees are generally granted at the fair market value of the common stock at
the date of grant and generally vest over four to five years. Options granted to
employees under Compaq's stock option plans must be exercised not later than ten
years from the date of grant.
42
In 1998, Compaq adopted the 1998 Stock Option Plan. Pursuant to the terms
of this plan, employees and non-employee directors are eligible to receive
options to purchase Compaq common stock. Up to 150 million shares may be issued
under this plan and will be drawn from either authorized but previously unissued
shares or from treasury shares. Options granted under this plan, except those
granted in connection with acquisitions (Note 2), are granted at the fair market
value of the common stock at the date of grant. The vesting period and option
life for grants to employees are at the discretion of the Board of Directors.
The terms for initial grants and annual grants to non-employee directors are
described below.
Compaq also maintains plans under which it offers stock options to
non-employee directors. Pursuant to the terms of the plans under which
directors are eligible to receive options, each non-employee director is
entitled to receive options to purchase common stock upon initial appointment to
the Board (initial grants) and upon subsequent reelection to the Board (annual
grants). Initial grants are exercisable during the period beginning one year
after initial appointment to the Board and ending ten years after the date of
grant. Annual grants vest over two years and are exercisable thereafter until
the tenth anniversary of the date of grant. Both initial grants and annual
grants have an exercise price equal to the fair market value of Compaq's common
stock on the date of grant. Additionally, directors may elect to receive stock
options in lieu of all or a portion of the annual retainer to be earned. Such
options are granted at 50% of the price of Compaq's common stock at the date of
grant and are exercisable during the period beginning one year after the grant
date and ending ten years after the grant date. The expense resulting from
options granted at 50% of the price of Compaq's common stock at the grant date
is charged to operations over the vesting period.
At December 31, 1998, there were 374 million shares of common stock reserved by
the Board of Directors for issuance under all of Compaq's stock option plans.
For all plans, options of 88 million, 71 million and 73 million shares were
exercisable at December 31, 1998, 1997 and 1996 with a weighted average exercise
price of $11.76, $6.52 and $5.53, respectively. There were 217 million, 64
million and 101 million shares available for grant under the plans at December
31, 1998, 1997 and 1996, respectively.
43
The following table summarizes activity under the stock option plans for each of
the three years ended December 31, 1998:
Shares Weighted Average
In Millions Price Per Share Price Per Share
============================================== ============= ================= ================
OPTIONS OUTSTANDING, DECEMBER 31, 1995 . . . . 164 $ 5.94
Options granted . . . . . . . . . . . . . . . 47 $ 4.71 - $22.39 14.11
Options lapsed or canceled. . . . . . . . . . (15) 8.61
Options exercised . . . . . . . . . . . . . . (33) 0.38 - 13.46 3.50
-------------
OPTIONS OUTSTANDING, DECEMBER 31, 1996 . . . . 163 8.53
Options granted . . . . . . . . . . . . . . . 46 2.55 - 37.38 27.17
Options lapsed or canceled. . . . . . . . . . (9) 11.57
Options exercised . . . . . . . . . . . . . . (29) 0.79 - 25.96 6.26
-------------
OPTIONS OUTSTANDING, DECEMBER 31, 1997 . . . . 171 13.63
Options granted in the acquisition of Digital 25 5.94 - 39.23 22.23
Options granted . . . . . . . . . . . . . . . 13 14.44 - 42.00 33.35
Options lapsed or canceled. . . . . . . . . . (16) 21.84
Options exercised . . . . . . . . . . . . . . (36) 1.30 - 39.23 11.39
-------------
OPTIONS OUTSTANDING, DECEMBER 31, 1998 . . . . 157 16.37
============= ================
The following table summarizes significant ranges of outstanding and
exercisable options at December 31, 1998:
Options Outstanding Options Exercisable
------------------------------------- ----------------------
Weighted Weighted Weighted
Average Average Average
Ranges of Shares Remaining Exercise Shares Exercise
Exercise Prices In Millions Life in Years Price In Millions Price
================= =========== ============= ========= =========== =========
under $5.00. . 31 3.3 $ 3.16 31 $ 3.16
5.01 to 10.00. 32 6.2 8.81 21 8.66
10.01 to 15.00 16 6.6 12.26 9 12.26
15.01 to 20.00 26 7.7 16.26 11 16.57
20.01 to 25.00 7 7.5 22.82 7 22.85
25.01 to 30.00 26 8.8 27.97 5 27.98
over $30.00 . 19 8.5 35.35 4 37.23
44
The fair value of the stock options granted in the Digital acquisition was
included in the purchase price of Digital. Excluding options issued in the
Digital acquisition, the weighted average fair value per share of stock based
compensation issued during 1998, 1997 and 1996 was $12.95, $9.74 and $6.55,
respectively. The fair value for these options was estimated using the
Black-Scholes model with the following weighted average assumptions:
Year ended December 31 1998 1997 1996
=============================== ===== ===== =====
Expected option life (in years) 5 4 5
Risk-free interest rate . . . . 4.6% 6.0% 6.1%
Volatility. . . . . . . . . . . 33.5% 33.3% 44.0%
Dividend yield. . . . . . . . . 0.2% 0.2% -
The table that follows summarizes the pro forma effect on net income (loss)
if the fair values of stock based compensation had been recognized in the year
presented as compensation expense on a straight-line basis over the vesting
period of the grant. The following pro forma effect on net income (loss) for
the years presented is not representative of the pro forma effect on net income
(loss) in future years because it does not take into consideration pro forma
compensation expense related to grants made prior to 1995.
Year ended December 31 (In millions, except per share amounts) 1998 1997 1996
============================================================== ========== ====== ======
Income (loss) before provision for income taxes:
As reported . . . . . . . . . . . . . . . . . . . . . . . . . $(2,662) $2,758 $1,883
Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . (2,832) 2,667 1,835
Net income (loss):
As reported . . . . . . . . . . . . . . . . . . . . . . . . . (2,743) 1,855 1,318
Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . (2,854) 1,796 1,287
Diluted earnings (loss) per share:
As reported . . . . . . . . . . . . . . . . . . . . . . . . . (1.71) 1.19 0.87
Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . (1.77) 1.15 0.85
NOTE 9. STOCKHOLDERS' EQUITY
Dividends - On December 10, 1998, Compaq announced that the Board of
Directors approved a cash dividend of $0.02 per share of common stock, or
approximately $34 million, to shareholders of record as of December 31, 1998 to
be paid in 1999.
Treasury Stock - On April 23, 1998, the Board of Directors authorized a
systematic common stock repurchase program. Compaq implemented this program in
May 1998. Compaq has repurchased approximately 11 million shares through
December 31, 1998, for a cost of approximately $384 million under this program.
The program was implemented to reduce the dilutive impact of common shares
issued under Compaq's equity incentive plans.
NOTE 10. PENSION AND OTHER BENEFIT PROGRAMS
Defined Benefit Pension Plans and Other Postretirement Employee Benefit
Plans ("OPEB" plans) - Upon consummation of the Digital acquisition, Compaq
assumed certain of Digital's defined benefit pension and OPEB plans. Digital
employees who were eligible to participate in the Digital plans at the time of
the acquisition continue to be eligible to participate in these plans. Compaq
also assumed the OPEB plans that provide medical and dental benefits to
Digital's retirees and their eligible dependents in the U.S. and certain other
locations.
Benefits under the defined benefit pension plans are generally based on pay
and service. In the U.S., the main plan (which covers only certain ex-Digital
employees) is a cash balance plan, under which the benefit is usually paid as a
lump sum amount.
45
The Company's OPEB plans are funded as costs are incurred. The majority of
these plans are contributory, with contributions in many cases adjusted for
general inflation or inflation in costs under the plan.
The Company recorded an additional minimum liability as of December 31,
1998 totaling $55 million ($38 million net of tax) for plans where the
accumulated benefit obligation exceeded the fair market value of assets. The
projected benefit obligation, accumulated benefit obligation and fair value of
plan assets for which the accumulated benefit obligations exceed plan assets
approximated $1.1 billion, $994 million and $840 million, respectively. The
minimum liability recorded for plans with an overfunded and underfunded status
is as follows:
Underfunded Overfunded
December 31, 1998 (In millions) Plans Plans Total
==================================================== ============= ============ =======
Plan status:
Accrued pension liability . . . . . . . . . . . . . $ (50) $ - $ (50)
Prepaid pension asset . . . . . . . . . . . . . . . - 16 16
Minimum liability required . . . . . . . . . . . . . (76) (13) (89)
------------- ------------ -------
Minimum pension liability adjustment reflected
in comprehensive income . . . . . . . . . . . . . (26) (29) (55)
Tax benefit. . . . . . . . . . . . . . . . . . . . . 8 9 17
------------- ------------ -------
Minimum liability reflected in comprehensive income
(loss), net of tax. . . . . . . . . . . . . . . . . $ (18) $ (20) $ (38)
============= ============ =======
46
Information regarding Compaq's defined benefit and OPEB plans is as
follows:
DEFINED BENEFIT
PENSION PLANS OPEB PLANS
Year ended December 31, 1998 (In millions) US FOREIGN US FOREIGN
================================================= ======== ======== ======== =======
Change in benefit obligation
Benefit obligation at beginning
of year . . . . . . . . . . . . . . . . . . . $ - $ - $ - $ -
Digital acquisition. . . . . . . . . . . . . . . 2,181 1,557 329 15
Service cost . . . . . . . . . . . . . . . . . . 37 35 4 1
Interest cost. . . . . . . . . . . . . . . . . . 87 57 13 -
Plan participants' contributions . . . . . . . . - 6 2 -
Actuarial (gain) loss. . . . . . . . . . . . . . 17 122 (14) (1)
Benefits paid. . . . . . . . . . . . . . . . . . (119) (37) (14) -
Currency loss. . . . . . . . . . . . . . . . . . - 91 - -
-------- -------- -------- -------
Projected benefit obligation at end of year. . 2,203 1,831 320 15
-------- -------- -------- -------
Change in plan assets
Fair value of plan assets at beginning of year. - - - -
Plan assets acquired through acquisition
of Digital . . . . . . . . . . . . . . . . . . 2,346 1,833 - -
Actual return on plan assets . . . . . . . . . . (29) (99) - -
Employer contribution. . . . . . . . . . . . . . - 8 12 -
Plan participants' contributions . . . . . . . . - 6 2 -
Benefits paid. . . . . . . . . . . . . . . . . . (119) (37) (14) -
Currency gain. . . . . . . . . . . . . . . . . . - 102 - -
-------- -------- -------- -------
Fair value of plan assets at end of year . . . . 2,198 1,813 - -
-------- -------- -------- -------
Funded status . . . . . . . . . . . . . . . . . . (5) (18) (320) (15)
Unrecognized net actuarial (gain) loss. . . . . . 173 307 (18) (1)
-------- -------- -------- -------
Prepaid (accrued) benefit cost
(measurement date October 31, 1998). . . . . . 168 289 (338) (16)
Contributions after measurement date . . . . . . - 6 3 -
-------- -------- -------- -------
Prepaid (accrued) benefit cost . . . . . . . . . $ 168 $ 295 $ (335) $ (16)
======== ======== ======== =======
Amounts included in the Consolidated Balance
Sheet are comprised of:
Prepaid benefit cost . . . . . . . . . . . . . . $ 168 $ 420 $ - $ -
Accrued benefit liability. . . . . . . . . . . . - (180) (335) (16)
Accumulated other comprehensive income . . . . . - 55 - -
-------- -------- -------- -------
Net amount recognized. . . . . . . . . . . . . $ 168 $ 295 $ (335) $ (16)
======== ======== ======== =======
47
DEFINED BENEFIT OPEB
PENSION PLANS PLANS
--------------- --------------
Year ended December 31, 1998 US FOREIGN US FOREIGN
====================================== ======== ======== ====== =============
Weighted-average assumptions as of
October 31
Discount rate . . . . . . . . . . . . 7.00% 5.75 % 7.00% 5.25%
Expected return on plan assets. . . . 9.00% 7.00 % N/A N/A
Rate of compensation increase . . . . 4.50% 3.25 % N/A N/A
Health care cost trend rate,
current year. . . . . . . . . . . . N/A N/A 5.25% 5.5% to 8.5%
Health care cost trend rate,
ultimate year . . . . . . . . . . . N/A N/A 4.50% 3.5% to 5.5%
Trend rate decreases to the ultimate
rate in the year. . . . . . . . . . N/A N/A 2001 2001 to 2003
Components of net periodic benefit
cost (in millions)
Service cost. . . . . . . . . . . . . $ 37 $ 35 $ 4 $ 1
Interest cost . . . . . . . . . . . . 87 57 13 -
Expected return on plan assets. . . . (126) (79) - -
Curtailment (gain). . . . . . . . . . - (1) - -
-------- -------- ------ -------------
Net periodic pension cost . . . . . . $ (2) $ 12 $ 17 $ 1
======== ======== ====== =============
Assumed health care cost trend rates could have an effect on the amounts
reported for the health care plans. A one-percentage point change in the
assumed health care cost trend rates would have the following effects:
(In millions) 1% POINT INCREASE 1% POINT DECREASE
- ------------------------------------- ------------------ -------------------
Effect on total service and interest
cost components . . . . . . . . . . $ 4 $ (3)
Effect on postretirement benefit
obligation. . . . . . . . . . . . . $ 37 $ (32)
Defined Contribution Plans - Compaq has defined contribution plans under
which Compaq makes matching contributions based on employee contributions.
These plans are intended to qualify as deferred compensation plans under Section
401(k) of the Internal Revenue Code of 1986. Contributions are invested at the
direction of the employee in one or more funds, including a fund that consists
of common stock of Compaq. Amounts charged to expense were $98 million, $48
million and $36 million in 1998, 1997 and 1996, respectively.
Incentive Compensation Plan - Compaq has an incentive compensation plan for
the majority of its employees. Starting in 1998, payments under the plan are
based on a uniform percentage of employees' base pay as determined by a matrix
using return on invested capital and customer satisfaction results. Prior to
1998, payments were based on 6% of net income from operations, as defined under
the previous plan. Payments are made semiannually. Amounts charged to expense
were $68 million, $109 million and $76 million in 1998, 1997 and 1996,
respectively.
48
NOTE 11. DIGITAL SUMMARIZED FINANCIAL INFORMATION (DIGITAL STAND-ALONE)
In 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 $36 million per year.
The Series A Preferred Stock is not convertible into, or exchangeable for,
shares of any other class or classes of Compaq 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 depositary share), plus
accrued and unpaid dividends. The redemption is expected to occur on April 1,
1999. Compaq has guaranteed the dividend payments, redemption price and
liquidation preference of the Digital Series A Preferred Stock. At December 31,
1998, there were declared and unpaid dividends of $9 million. The minority
interest of $422 million on Compaq's Consolidated Balance Sheet represents the
fair value of the Series A Preferred Stock as of the date of the Digital
acquisition.
The summarized financial information for Digital and its consolidated
subsidiaries on a stand-alone basis is presented below. The financial
information for the period subsequent to the acquisition is based on the new
basis of accounting reflecting the amounts included in the purchase price
allocation resulting from Compaq's acquisition of Digital (see Notes 2 and 3),
and is presented in accordance with generally accepted accounting principles.
The new basis of accounting adjustments include (i) fair value adjustments to
the historical basis of assets and liabilities acquired, (ii) the fair value
assigned to intangible assets, including purchased in-process technology and
(iii) accrued restructuring charges. Additionally, the Digital stand-alone
financial information includes an allocation of certain costs incurred by Compaq
including an allocation of $66 million of (i) costs for administrative functions
and services performed on behalf of Digital by centralized staff groups within
Compaq, and (ii) Compaq's general corporate expenses. The costs of these
functions and services have been allocated to Digital using methods that Compaq
management believes are reasonable. Such allocations are not necessarily
indicative of the costs that would have been incurred if Digital had been a
separate entity.
Although Digital financial information is presented on a stand-alone basis,
the companies are being managed on a consolidated basis. The stand-alone
Digital information does not necessarily reflect the results that Digital would
have realized had the acquisition not occurred and is not necessarily indicative
of the future results of Digital. Separate financial information and other
disclosures concerning Digital are deemed by management to not be meaningful to
holders of the Series A Preferred Stock.
49
(In millions) NEW BASIS OLD BASIS
======================== ================== ==================
DECEMBER 26, 1998 DECEMBER 27, 1997
Current assets . . . . . $ 4,781 $ 6,428
Non-current assets . . . 6,704 2,365
Current liabilities. . . 4,432 3,487
Non-current liabilities. 545 1,910
Stockholders' equity . . 6,508 3,396
(In millions) NEW BASIS OLD BASIS
====================== ===================== ==============================================================
FOR THE PERIOD FROM FOR THE PERIOD FROM
JUNE 12, 1998 DECEMBER 28, 1997 YEAR ENDED
THROUGH THROUGH ---------------------------------------
DECEMBER 26, 1998 JUNE 11, 1998 DECEMBER 27, 1997 DECEMBER 28, 1996
--------------------- --------------------- ------------------ -------------------
Revenue:
Products. . . . . . . $ 2,898 $ 2,650 $ 7,228 $ 7,562
Services. . . . . . . 3,294 2,731 5,833 6,046
--------------------- --------------------- ------------------ -------------------
Total revenue . . . $ 6,192 $ 5,381 $ 13,061 $ 13,608
Gross margin:
Products. . . . . . . $ 1,027 $ 779 $ 2,636 $ 2,603
Services. . . . . . . 981 834 1,821 1,876
--------------------- --------------------- ------------------ -------------------
Total gross margin. $ 2,008 $ 1,613 $ 4,457 $ 4,479
Net income (loss). . . $ (2,966)(1) $ (13) $ 275 $ (378)
===================== ===================== ================== ===================
<FN>
(1) Net loss includes $3.2 billion for the write-off of purchased in-process technology resulting from
Compaq's acquisition of Digital.
NOTE 12. SEGMENT DATA
Compaq manages its business segments primarily on a geographic basis. The
Company's reportable segments are comprised of North America and Europe, Middle
East and Africa ("EMEA"). Other operating segments include Japan, Greater
China, Asia Pacific and Latin America. Each operating segment provides products
and services as further described in Note 1.
The accounting policies of the various segments are the same as those
described in the "Summary of Significant Accounting Policies" in Note 1. The
Company evaluates the performance of its segments based on segment profit.
Segment profit for each segment includes sales and marketing expenses and other
overhead charges directly attributable to the segment and excludes certain
expenses which are managed outside the reportable segments. Costs excluded from
segment profit primarily consist of corporate expenses, including income taxes,
as well as other non-recurring charges for purchased in-process technology,
restructuring and asset impairment charges and merger-related costs. Corporate
expenses are comprised primarily of research and development costs, certain
costs related to the Digital integration, corporate marketing costs and other
general and administrative expenses which are separately managed. Compaq does
not include intercompany transfers between segments for management reporting
purposes. Segment assets exclude corporate assets. Corporate assets include
cash and cash equivalents, short-term investments, manufacturing facilities and
intangible assets. Capital expenditures for long-lived assets are not reported
to management by segment and are excluded as presenting such information is not
practical.
50
Summary information by segment as of and for the years ended December 31,
1998, 1997 and 1996 is as follows:
(In millions) 1998 1997 1996
=============================== ======= ======= =======
NORTH AMERICA:
Revenue:
Products . . . . . . . . . . $13,411 $13,101 $10,448
Services . . . . . . . . . . 1,341 168 164
Gross margin:
Products . . . . . . . . . . 2,884 3,584 2,783
Services . . . . . . . . . . 545 36 45
Segment profit . . . . . . . . 1,666 2,587 2,015
Interest expense . . . . . . . 124 108 65
Depreciation and amortization. 100 61 61
Segment assets . . . . . . . . 3,126 1,924 2,507
- ------------------------------- ------- ------- -------
EMEA:
Revenue:
Products . . . . . . . . . . $10,135 $ 7,783 $ 6,398
Services . . . . . . . . . . 1,794 150 107
Gross margin:
Products . . . . . . . . . . 2,667 2,157 1,669
Services . . . . . . . . . . 530 52 32
Segment profit . . . . . . . . 1,845 1,484 1,078
Interest expense . . . . . . . 5 6 2
Depreciation and amortization. 37 24 44
Segment assets . . . . . . . . 4,028 1,814 1,950
- ------------------------------- ------- ------- -------
OTHER SEGMENTS:
Revenue:
Products . . . . . . . . . . $ 3,720 $ 3,238 $ 2,765
Services . . . . . . . . . . 768 144 127
Gross margin:
Products . . . . . . . . . . 833 820 587
Services . . . . . . . . . . 231 41 31
Segment profit . . . . . . . . 339 349 137
Interest expense . . . . . . . 15 10 8
Depreciation and amortization. 33 29 27
Segment assets . . . . . . . . 3,020 1,217 1,173
- ------------------------------- ------- ------- -------
51
A reconciliation of the Company's segment gross margin, segment profit and
segment assets to the corresponding consolidated amounts as of and for the years
ended December 31, 1998, 1997 and 1996 is as follows:
(In millions) 1998 1997 1996
================================================= =========== ========== ==========
Segment gross margin. . . . . . . . . . . . . . . $ 7,690 $ 6,690 $ 5,147
Non-segment gross margin. . . . . . . . . . . . . (501)(1) 61 7
----------- ---------- ----------
Total gross margin . . . . . . . . . . . . . . . $ 7,189 $ 6,751 $ 5,154
=========== ========== ==========
Segment profit. . . . . . . . . . . . . . . . . . $ 3,850 $ 4,420 $ 3,230
Corporate expenses, net . . . . . . . . . . . . . (2,923) (1,410) (1,295)
Purchased in-process technology . . . . . . . . . (3,196) (208) -
Restructuring and asset impairment charges. . . . (393) - (52)
Merger-related costs. . . . . . . . . . . . . . . - (44) -
----------- ---------- ----------
Income (loss) before provision for income taxes. $ (2,662) $ 2,758 $ 1,883
=========== ========== ==========
Segment assets. . . . . . . . . . . . . . . . . . $ 10,174 $ 4,955 $ 5,630
Corporate assets. . . . . . . . . . . . . . . . . 12,877 9,676 6,701
----------- ---------- ----------
Total assets . . . . . . . . . . . . . . . . . . $ 23,051 $ 14,631 $ 12,331
=========== ========== ==========
<FN>
(1) Non-segment gross margin in 1998 primarily related to certain costs incurred by
Digital manufacturing operations which were not allocated to the geographic segments
for management reporting purposes.
Revenue and long-lived assets related to operations in the United States
and other foreign countries as of and for the years ended December 31, 1998,
1997 and 1996 are as follows:
(In millions) 1998 1997 1996
=========================== ======= ======= =======
Revenue:
United States. . . . . . . $13,981 $12,593 $10,014
Other foreign countries. . 17,188 11,991 9,995
------- ------- -------
Total revenue. . . . . . $31,169 $24,584 $20,009
======= ======= =======
Long-lived assets:
United States. . . . . . . $ 5,490 $ 1,693 $ 1,376
Other foreign countries. . 1,053 921 866
------- ------- -------
Total long-lived assets. $ 6,543 $ 2,614 $ 2,242
======= ======= =======
52
Additional information regarding revenue by products and services groups is
as follows:
Year ended December 31 (In millions) 1998 1997 1996
==================================== =========== ======= =======
REVENUE:
Enterprise. . . . . . . . . . . . . $ 10,700 $ 8,660 $ 6,228
Commercial PC . . . . . . . . . . . 11,621 11,558 10,533
Consumer PC . . . . . . . . . . . . 4,945 3,904 2,850
Services. . . . . . . . . . . . . . 3,903(1) 462 398
---------- ------- -------
Total . . . . . . . . . . . . . . $ 31,169 $24,584 $20,009
========== ======= =======
<FN>
(1) 1998 services revenue is presented on a management reporting basis and
includes $106 million of products revenue.
NOTE 13. COMMITMENTS, CONTINGENCIES, FINANCIAL INSTRUMENTS AND FACTORS THAT MAY
AFFECT FUTURE OPERATIONS
Derivative financial instruments and fair value of financial instruments
Compaq primarily utilizes forward contracts and purchased foreign currency
options to reduce its exposure to potentially adverse changes in foreign
currency exchange rates. Compaq does not hold or issue financial instruments for
trading purposes nor does it hold or issue interest rate or leveraged derivative
financial instruments.
Compaq's program to reduce currency exposure associated with the net
monetary assets of Compaq's international subsidiaries includes agreements to
exchange various foreign currencies for U.S. dollars. At December 31, 1998 and
1997, such agreements to sell foreign currencies included forward contracts
aggregating $2.7 billion and $1.5 billion, respectively. Generally, gains and
losses associated with currency rate changes on these forward contracts are
recorded currently to income and are reflected in accounts receivable or other
current liabilities in Compaq's balance sheet, while the interest element is
recognized over the life of each contract. The amount recorded in the balance
sheet approximates the fair value of such contracts at December 31, 1998 and
1997. The maturity dates of the forward contracts which were outstanding at
December 31, 1998 ranged from two days to nine months.
From time to time, Compaq hedges a portion of its anticipated but not
firmly committed sales of its international marketing subsidiaries using
purchased foreign currency options. Realized and unrealized gains and the net
premiums on these options are deferred and recognized as a component of revenue
in the same period that the related sales occur. Option contracts aggregating
$394 million and $311 million were outstanding at December 31, 1998 and 1997,
respectively, related to the hedge of such sales for a nine-month period. The
unrealized gains deferred on these contracts were not material. In addition,
Compaq frequently utilizes forward contracts to protect Compaq from the effects
of currency fluctuations on anticipated but not firmly committed sales which are
expected to occur within a three-month period. These forward contracts
generally do not extend beyond the end of any quarter or year. Any gains or
losses and the interest element on these forward contracts are recognized as a
component of sales during each quarter.
Compaq may, from time to time, hedge commitments for inventory purchases
and capital expenditures and other items constituting firm commitments. Any gain
or loss, if realized, or cost related to these contracts are recorded as part of
inventory or capital items upon acquisition. At December 31, 1998 and 1997,
there were no contracts outstanding to hedge commitments for inventory purchases
and capital expenditures.
53
In the event of a failure to honor one of these forward contracts by one of
the banks with which Compaq has contracted, management believes any loss would
be limited to the exchange rate differential from the time the contract was made
until the time it was compensated. To the extent Compaq has option contracts
outstanding, the amount of any loss resulting from a breach of contract would be
limited to the amount of premiums paid for the options and the unrealized gain,
if any, related to such contracts.
Compaq enters into various other types of financial instruments in the
normal course of business. Fair values for certain financial instruments are
based on quoted market prices. For other financial instruments, fair values are
based on the appropriate pricing models using current market information. The
amounts ultimately realized upon settlement of these financial instruments will
depend on actual market conditions during the remaining life of the instruments.
Fair values of cash and cash equivalents, short-term investments, accounts
receivable, accounts payable and other current liabilities reflected in the
December 31, 1998 and 1997 consolidated balance sheet approximate carrying value
at these dates.
Concentration of credit risk
Compaq's cash, cash equivalents, short-term investments and accounts
receivable are subject to potential credit risk. Compaq's cash management and
investment policies restrict investments to low risk, highly-liquid securities
and Compaq performs periodic evaluations of the relative credit standing of the
financial institutions with which it deals.
Compaq distributes products primarily through third-party resellers and as
a result, maintains individually significant accounts receivable balances from
various major resellers. If the financial condition and operations of these
resellers deteriorate, Compaq's operating results could be adversely affected.
One customer accounted for 8% of sales for 1998 and 9% of accounts receivable at
December 31, 1998. During this period, no other customer of Compaq accounted
for 3% or more of sales. In 1998, Compaq's five largest resellers represented
approximately 19% of Compaq's 1998 sales. The receivable balances from Compaq's
five largest resellers represented approximately 16% of accounts receivable at
December 31, 1998. Compaq generally has experienced longer accounts receivable
cycles in its emerging markets, in particular Asia Pacific and Latin America,
when compared to its U.S. and European markets. In the event that accounts
receivable cycles in these developing markets lengthen further or one or more of
Compaq's larger resellers in these regions fails, Compaq's operating results
could be adversely affected.
Contingencies
Certain of Compaq's resellers finance a portion of their inventories
through third-party finance companies. Under the terms of the financing
arrangements, Compaq may be required, in limited circumstances, to repurchase
certain products from the finance companies. Additionally, Compaq has on
occasion guaranteed a portion of certain resellers' outstanding balances with
third-party finance companies and financial institutions. Guarantees under
these and other arrangements were not significant at December 31, 1998 or 1997.
Compaq offers lease financing of selected products to its customers.
Certain sales-type leases are originated by Compaq and either sold on a
nonrecourse basis or used as collateral for borrowings from certain third-party
financial institutions. Generally, Compaq receives all proceeds at the inception
of the lease. The third-party financial institution assumes the credit risk and
the administrative responsibility for the collection of the lease receivables.
In the event of a default by a lessee, the financial institution's only recourse
is generally limited to the collateralized computer equipment. Compaq may be
required to use its "best efforts" to remarket the computer equipment.
54
Factors that may affect future operations
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 developments carried out in the
midst of legal disputes over intellectual property rights. Compaq's operating
results could be adversely affected should Compaq be unable to successfully
integrate acquired entities, anticipate customer demand accurately, maintain
short design cycles while meeting evolving industry performance standards,
manage its product transitions, inventory levels and manufacturing processes
efficiently, distribute its products quickly in response to customer demand,
differentiate its products from those of its competitors or compete successfully
in the markets for its new products.
Significant numbers of components are purchased from single sources due to
technology, availability, price, quality or other considerations. Key components
and processes currently obtained from single sources include certain of Compaq's
displays, microprocessors, application specific integrated circuits and other
custom chips, and certain processes relating to construction of the plastic
housing for Compaq's computers. In addition, new products introduced by Compaq
often initially utilize custom components obtained from only one source until
Compaq has evaluated whether there is a need for additional suppliers. In the
event that a supply of a key single-sourced material process or component were
delayed or curtailed, Compaq's ability to ship the related product in desired
quantities and in a timely manner could be adversely affected. Compaq attempts
to mitigate these risks by working closely with key suppliers on product plans,
strategic inventories and coordinated product introductions.
Litigation
Compaq is subject to legal proceedings and claims which arise in the
ordinary course of business. Management does not believe that the outcome of
any of those matters will have a material adverse effect on Compaq's
consolidated financial position, operating results or cash flows.
Five class action lawsuits have been consolidated 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. Lead
counsel for the plaintiff has been appointed. The plaintiffs seek monetary
damages, interest, costs and expenses. Compaq 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 two of
the cases, and remanded for further proceedings. The parties are proceeding
with discovery.
55
Lease commitments
Compaq leases certain manufacturing and office facilities and equipment
under noncancelable operating leases with terms from one to 30 years. Rent
expense for 1998, 1997 and 1996 was $205 million, $135 million and $128 million,
respectively.
Compaq's minimum rental commitments under noncancelable operating leases at
December 31, 1998 were approximately $249 million in 1999, $177 million in 2000,
$123 million in 2001, $100 million in 2002, $67 million in 2003 and $133 million
thereafter.
NOTE 14. SUBSEQUENT EVENTS
In February 1999, Compaq announced the execution of a definitive merger
agreement with Zip2 Corporation, the leading provider of Internet platform
solutions for media companies and local e-commerce merchants. The aggregate
purchase price is anticipated to be approximately $300 million. Completion of
the transaction is subject to customary conditions, including clearance under
the Hart-Scott-Rodino Antitrust Improvements Act.
In January 1999, Compaq announced a cash tender offer for all of the
outstanding shares of common stock of Shopping.com, an on-line retailer that
offers Internet shoppers an array of consumer products. In February the offer
was successfully concluded, with 96% of the shares tendered. Compaq is
proceeding with the steps necessary to complete the merger, which is anticipated
in March. The aggregate purchase price for Shopping.com is anticipated to be
approximately $220 million. Completion of the transaction is subject to certain
conditions, including clearance under the Hart-Scott-Rodino Antitrust
Improvements Act.
56
SELECTED QUARTERLY UNAUDITED FINANCIAL DATA (NOT COVERED BY REPORT OF
INDEPENDENT ACCOUNTANTS)
The table below sets forth selected unaudited financial information for
each quarter of the last two years.
1ST 2ND 3RD 4TH
(In millions, except per share amounts) QUARTER QUARTER QUARTER QUARTER
======================================= ======== ========== ======== ========
1998
Revenue . . . . . . . . . . . . . . . . $ 5,687 $ 5,832 $ 8,791 $ 10,859
Gross margin. . . . . . . . . . . . . . 1,023 1,110 2,185 2,871
Net income (loss)(1). . . . . . . . . . 16 (3,632) 115 758
Earnings (loss) per common share(3)
Basic. . . . . . . . . . . . . . . . . $ 0.01 $ (2.33) $ 0.07 $ 0.45
Diluted. . . . . . . . . . . . . . . . $ 0.01 $ (2.33) $ 0.07 $ 0.43
1997
Revenue . . . . . . . . . . . . . . . . $ 5,272 $ 5,515 $ 6,474 $ 7,323
Gross margin. . . . . . . . . . . . . . 1,417 1,537 1,777 2,020
Net income(2) . . . . . . . . . . . . . 414 257 517 667
Earnings per common share(3)
Basic. . . . . . . . . . . . . . . . . $ 0.28 $ 0.17 $ 0.34 $ 0.44
Diluted. . . . . . . . . . . . . . . . $ 0.27 $ 0.17 $ 0.33 $ 0.42
<FN>
(1) Includes a $3.2 billion non-recurring, non-tax-deductible charge in the
second quarter of 1998 and a $38 million non-recurring, non-taxable credit in the
fourth quarter of 1998 for purchased in-process technology in connection with the
Digital acquisition, and a $393 million charge for restructuring and asset
impairments in the second quarter of 1998 in connection with the Digital
acquisition and the closing of certain Compaq facilities.
(2) Includes a $208 million non-recurring, non-tax-deductible charge for
purchased in-process technology in connection with the Microcom acquisition in
the second quarter of 1997, and $44 million of expenses related to the Tandem
merger in the third quarter of 1997.
(3) Earnings per common share are computed independently for each of the
quarters presented and therefore may not sum to the total for the year.
PART III
ITEMS 10 TO 13 INCLUSIVE.
These items have been omitted in accordance with the general instructions
to Form 10-K Annual Report. The Registrant will file with the Commission in
March 1999, pursuant to Regulation 14A, a definitive proxy statement that will
involve the election of directors. The information required by these items will
be included in such proxy statement and are incorporated herein by reference.
57
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as a part of this report:
1. Financial Statements:
Report of Independent Accountants
Consolidated Balance Sheet at December 31, 1998 and 1997
Consolidated Statement of Income for the three years ended
December 31, 1998
Consolidated Statement of Cash Flows for the three years ended
December 31, 1998
Consolidated Statement of Stockholders' Equity for the three
years ended December 31, 1998
Notes to Consolidated Financial Statements
Financial Statement Schedule:
For the three years ended December 31, 1998
Schedule II: Valuation and Qualifying Accounts
2. Exhibits.
Exhibits identified in parentheses below, on file with the Securities and
Exchange Commission are incorporated by reference as exhibits.
EXHIBIT
NO. DESCRIPTION OF EXHIBITS
- ----- -------------------------
3.1 Restated Certificate of Amendment (Exhibit 3.1 to Form 10-K for the year ended
December 31, 1997 ("1997 Form 10-K").
3.2 Bylaws (Exhibit No. 3.2 to Form 10-Q for the quarter ended September 30, 1997).
10.1 1982 Stock Option Plan, as amended (Exhibit 10.1 to Form 10-Q for the quarter
ended June 30, 1989 ("1989 Second Quarter Form 10-Q")).
10.2 1985 Stock Option Plan (Exhibit 10.3 to Form 10-K for the year ended December
31, 1991 ("1991 Form 10-K")). *
10.3 1985 Executive and Key Employees Stock Option Plan, as amended (Exhibit 10.3 to
1989 Second Quarter Form 10-Q). *
10.4 1985 Nonqualified Stock Option Plan, as amended (Exhibit 10.4 to 1989 Second
Quarter Form 10-Q). *
10.5 Forms of Stock Option Agreements relating to Exhibits 10.1 through 10.5 (Exhibit
10.6 to Form 10-K for the year ended December 31, 1987). *
10.6 1989 Equity Incentive Plan, as amended (Exhibit 10.6 to 1997 Form 10-K). *
10.7 Form of Stock Option Notice relating to Exhibit 10.6, as amended (Exhibit 10.7 to
1996 Form 10-K). *
10.8 1995 Equity Incentive Plan, as amended (Exhibit 10.8 to 1997 Form 10-K). *
10.9 Form of Stock Option Notice relating to Exhibit 10.8, as amended (Exhibit 10.9 to
1996 Form 10-K). *
10.10 Bonus Incentive Plan (Exhibit 10.11 to Form 10-K for the year ended December 31, 1995). *
10.11 Stock Option Plan for Non-Employee Directors, as amended (Exhibit 10.11 to 1997 Form 10-K).*
10.12 Forms of Stock Option Notice relating to Exhibit 10.11 (Exhibit 10.9 to 1996 Form 10-K). *
58
10.13 Employment Agreement dated as of January 1, 1992 between Compaq and Eckhard
Pfeiffer (Exhibit 10.15 to 1991 Form 10-K). *
10.14 Form of letter agreement between Compaq and its executive officers (Exhibit 10.16
to 1991 Form 10-K). *
10.15 Deferred Compensation and Supplemental Savings Plan (Exhibit 4.1 to Registration
Statement No. 333-42375 on Form S-8). *
10.16 First Amendment to Deferred Compensation and Supplemental Savings Plan
(Exhibit 4.2 to Registration Statement No. 333-42375 on Form S-8). *
10.17 1998 Stock Option Plan (Exhibit 10.20 to Form 10-Q for the quarter ended
March 31, 1998)*
10.18 1,000,000,000 Credit Agreement dated as of October 2, 1998, among Compaq
Computer Corporation, the banks signatory thereto and Bank of America National
Trust and Savings Association, as Administrative Agent (Exhibit 10.21 to Form 10-
Q for the quarter ended September 30, 1998 ("1998 Third Quarter Form 10-Q")).
10.19 3,000,000,000 Credit Agreement dated as of September 22, 1997, among Compaq
Computer Corporation, the banks signatory thereto and Bank of America National
Trust and Savings Association, as Administrative Agent (Exhibit 10.19 to 1997
Form 10-K).
10.20 Amendment No. 1 to $3,000,000,000 Credit Agreement dated as of October 2, 1998,
among Compaq Computer Corporation, the banks signatory thereto and Bank of
America National Trust and Savings Association, as Administrative Agent (Exhibit
10.22 to 1998 Third Quarter Form 10-Q).
21 Subsidiaries.
23 Consent of PricewaterhouseCoopers LLP, independent accountants.
27 Financial Data Schedule (EDGAR version only).
<FN>
* Indicates management contract or compensatory plan or arrangement.
(b) Reports on Form 8-K.
(i) Report on Form 8-K dated October 14, 1998, containing Compaq's news release
dated October 14, 1998, with respect to its earnings release for the third quarter
of 1998.
(ii) Report on Form 8-K dated January 11, 1999, containing Compaq's news release
dated January 11, 1999, announcing Compaq's agreement to acquire
Shopping.com, an on-line retailer.
(iii) Report on Form 8-K dated January 21, 1999, containing Compaq's news release
dated January 21, 1999, announcing an amendment of Compaq's offer price for
shares of Shopping.com.
(iv) Report on Form 8-K dated January 26, 1999, containing Compaq's news release
dated January 26, 1999, announcing the creation of AltaVista Company.
(v) Report on Form 8-K dated January 27, 1999, containing Compaq's news release
dated January 27, 1999, with respect to its earnings release for the fourth quarter
of 1998.
59
(vi) Report on Form 8-K dated February 16, 1999, containing Compaq's news release
dated February 16, 1999, announcing Compaq's agreement to acquire Zip2
Corporation, the leading provider of Internet platform solutions for media and
Compaq's news release dated February 16, 1999, announcing Compaq's
successful conclusion of its tender offer for shares of Shopping.com.
COMPAQ, the Compaq logo, and AltaVista, Registered in U.S. Patent and
Trademark Office. MICROSOFT is a registered trademark of Microsoft Corp.
Other product names mentioned herein may be trademarks or registered trademarks
of their respective companies.
60
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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 on this 23rd day of
February, 1999.
Compaq Computer Corporation
By: /s/ ECKHARD PFEIFFER
---------------------------
Eckhard Pfeiffer, President and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
President and Director February 23, 1999
/s/ ECKHARD PFEIFFER (principal executive officer)
- -------------------------
(Eckhard Pfeiffer)
Senior Vice President February 23, 1999
and Chief Financial Officer
/s/ EARL L. MASON (principal financial officer and
- -------------------- principal accounting officer)
(Earl L. Mason)
/s/ Benjamin M. Rosen Chairman of the February 23, 1999
- ---------------------- Board of Directors
(Benjamin M. Rosen)
/s/ Lawrence T. Babbio Director February 23, 1999
- -----------------------
(Lawrence T. Babbio)
/s/ Judith L. Craven Director February 23, 1999
- -------------------------
(Judith L. Craven)
/s/ Frank P. Doyle Director February 23, 1999
- -------------------------
(Frank P. Doyle)
/s/ Robert Ted Enloe III Director February 23, 1999
- -------------------------
(Robert Ted Enloe, III)
61
/s/ George H. Heilmeier Director February 23, 1999
- -------------------------
(George H. Heilmeier)
/s/ Peter N. Larson Director February 23, 1999
- -------------------------
(Peter N. Larson)
/s/ Kenneth L. Lay Director February 23, 1999
- -------------------------
(Kenneth L. Lay)
/s/ Thomas J. Perkins Director February 23, 1999
- -------------------------
(Thomas J. Perkins)
/s/ Kenneth Roman Director February 23, 1999
- -------------------------
(Kenneth Roman)
/s/ Lucille S. Salhany Director February 23, 1999
- -------------------------
(Lucille S. Salhany)
62
SCHEDULE II
COMPAQ COMPUTER CORPORATION
VALUATION AND QUALIFYING ACCOUNTS
Year ended December 31 (In millions) 1998 1997 1996
======================================= ======== ======= =======
ALLOWANCE FOR DOUBTFUL ACCOUNTS
Balance, beginning of period. . . . . . $ 243 $ 247 $ 118
Additions due to acquisition. . . . . . 114 - -
Additions charged to expense. . . . . . 61 19 160
Reductions. . . . . . . . . . . . . . . (100) (23) (31)
-------- ------- -------
Balance, end of period. . . . . . . . . $ 318 $ 243 $ 247
======== ======= =======
DEFERRED TAX ASSET VALUATION ALLOWANCE
Balance, beginning of period. . . . . . $ 134 $ 121 $ 119
Additions due to acquisition. . . . . . 562 - -
Additions charged to expense. . . . . . 65 43 9
Reductions. . . . . . . . . . . . . . . (77) (30) (7)
-------- ------- -------
Balance, end of period. . . . . . . . . $ 684 $ 134 $ 121
======== ======= =======
63