Wednesday, June 4, 2008

HP/EDS Combination: The Conclusion

This entry is the last in our series of four entries on the HP/ED deal.

The Setting

Hewlett Packard has proposed a take-over of EDS, in order to improve its services, revenues and profits. EDS is #2 to IBM in the computer services industry. Hewlett Packard is #5. The combined company, at $38 billion on revenues, would have only a 5% share of the market. IBM has $54 billion in services revenues and 7% market share. The reaction in the stock market has been mixed. Hewlett Packard stockholders don’t like it. Its share price fell. The EDS shareholders like it a lot better, as their shares increased in value.

A company undertakes an acquisition to achieve one or more of these three objectives: first, acquire a product that it does not have; second, acquire customers that it otherwise could not service; and third, establish a new lower unit cost through the combination of the two companies. We will look at each of these, in turn, in the current HP and EDS deal and then summarize our conclusions in the last entry.

Our Conclusion

As we explained in the previous three blog entries, the combination is likely to succeed in all three of the major objectives of an acquisition. It improves the product offering. It opens up the combined company to new customers. And it is virtually certain to reduce the unit costs the company incurs. A successful acquisition almost always requires success in two of the three objectives in order to make economic sense. This combination meets all three objectives.

This combination is essential to shift market share.

There is a hidden force behind the business logic for the merger between HP and EDS in the computer services industry. The hidden force is the dominance of “failure” in normal market share movement.

Failure moves more market share than does success in most mature markets (see the Perspective, “Failure Shifts More Share Than Success” in In most fast-growing markets, there are many opportunities to “win” market share. You “win” market share by offering customers something that other competitors can not, or will not, offer them. But as markets become more mature and growth slows, “winning” market share becomes much more difficult. The reason? Competitors copy the most obvious innovations. These obvious innovations tend to be product Functions or unique Pricing schemes.

Once an industry reaches a slower growth level of maturity, “failure” tends to drive far more market share than does success. By “failure”, we mean that an incumbent supplier does not meet the customers’ expectations. These customer expectations are the result of the customer’s beliefs about the product offerings of other competitors. The “failing” incumbent can not offer the Functions, Reliability, Convenience or Price that the customer expects and “fails” the customer. This “failure” causes the customer to open his relationship to other suppliers.

Once a market becomes “failure” driven, it takes many years to move significant market share from one competitor to another. Then, acquisitions become important to growth and profitability. Of course, these acquisitions have value only to the extent that the acquiring company is able to retain the purchased customers (see “Acquiring Share, Not Sand” in

Despite the fact that the #2 and #5 competitors in the marketplace are combining to compete more effectively with the #1 competitor, you should expect little or no price pressure to emerge in the market as a result. This market is highly fragmented with the top competitors holding only 20% of it. That leaves another 80% of the market served by smaller firms. The larger, more sophisticated competitors should grow at the expense of smaller companies, a typical evolution in fragmented markets. Furthermore, the growth in the marketplace, at 8-10% per annum, means that the infrastructure of the industry has to double every eight to ten years. This takes capital and profits and, therefore, reasonable prices.

This combination is a very good bet for success. Not a sure bet, but certainly a good one. However, it is unlikely to be successful very quickly. IBM stumbled for several years as it created a strong services business. IBM bought a consulting firm to help it improve its service offerings. The integration of its acquired consulting firm proved difficult and costly. IBM got over that hurdle and now has a profitable and fast-growing business. I expect that this HP/EDS combination will become far more profitable and fast growing than either current company, even if there are some bumps in the road.

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