Key Hurdle for HP-Compaq Merger Looms This Week

An estimated 10 percent of HP shares--a block that could determine whether or not the largest-ever computer merger succeeds--will be voted in accordance with the opinion ofInstitutional Shareholder Services, which plans to disclose its position on the deal by Tuesday.

ISS, as it is known, advises some 700 funds how to vote in proxy battles, and many of its clients are obligated because of the structure of their funds or potential conflicts of interest to follow ISS advice.

Although some fund managers expect ISS to side with HP management and endorse the merger, a surprise decision by the Bethesda, Md.-based firm to oppose it could sway enough votes to all but scuttle the deal, which has failed to muster much enthusiasm on Wall Street, analysts say.

Noel Dedora, portfolio manager at San Francisco's Fremont Investment Advisors, says Fremont will vote for the merger, preferring as usual to vote with management. The uncertainty of scuttling the deal would be costly, Dedora says.

Even so, he says he is interested to see the ISS decision.

"If the vote favors the merger then it certainly ups the odds considerably, but if the ISS vote goes against it, it is probably a toss up. I don't think it will destroy it," Dedora says.

Hewlett vs. Fiorina

The battle over the merger has grown nasty in recent days, pitting HP CEO Carly Fiorina, who says the merger would create a technology powerhouse to rival IBM, against dissident director Walter Hewlett, who says the deal would saddle the company his father co-founded with a low-margin PC maker.

Hewlett wants Fiorina fired if the deal is scrapped. Fiorina says Hewlett has been deceptive by leaking details of discussed executive pay deals as well as by floating talk of bringing back former HP CEO Lew Pratt to steer the company in the interim.

Both sides have buttressed their views with studies commissioned by outside analysts.

"We will make our own decision," says Kar Ming Leong, a technology analyst for Dreyfus, an ISS client that held about 2.6 million shares of HP on Dec. 31, 2001. "This time it is slightly different, because it is a high-profile thing. I think the shareholders, other than the index funds, would like to voice their own opinions."

ISS was expected to back management, Leong says.

"When was the last time...that you saw ISS oppose a deal? Not in anybody's recent memory. On the other hand, if ISS said no, it is probably a bigger factor," he says, but declined to say which way Dreyfus was leaning.

Index mutual funds, which build portfolios that match the composition of stock indexes like the Standard and Poor's 500, represent around 9 or 10 percent of HP shares, according to several industry analysts. They will vote with ISS as will Barclay's Global Investors, with 3 percent of HP stock, since its CEO, Pattie Dunn, also sits on HP's board.

As a result, a negative ISS opinion would sway votes that combined with the 18 percent stake of founding family interests opposed to the deal and a few percent held by anti-merger, outside investors could leave a third of HP shares aligned against the deal.

Institutional investors with a few percent of HP shares have openly backed the deal, but neither side has been able to rely on retail investors with around 25 percent of shares, leading one opponent to conclude: "If ISS goes for us, then it is a rout. If ISS goes for them, then it's a horse race."

Opponents Outgunned, Have Head Start

But outsiders have learned to never say never in the five-month-long HP merger battle.

Walter Hewlett's opposition in November had market players sure the deal was dead--for a few days. Similarly, the Packard Foundation's December decision to vote "no" with its 10 percent of shares appeared to kill the deal again.

But that was before an aggressive campaign by management to sway outside investors.

HP shares, at $20.21 at Friday's close on the New York Stock Exchange, were down 13 percent since the deal was announced on Sept. 3, compared to a 3 percent rise for IBM over that period.

A number of analysts see management building a silent majority. Bear Stearns analyst Andrew Neff thinks the deal is a bad move, but said HP management simply has the stronger hand.

"The odds are that management will prevail," Neff says. "It is too hard to call right now, just because Walter has a head start. I think he is outgunned, generally."

Sanford C. Bernstein analyst Toni Sacconaghi, who gives 2-to-1 odds that the deal will be voted down, says he thinks only about 20 percent of institutional shareholders who planned to make their own decisions are still waiting to do so.

"But as in any voting situation, recency and momentum can definitely sway lingering uncertain votes," he says.

Opponents of the deal outside the company have been much more vocal than supporters, arguing that Compaq's PC business, No. 2 after losing the lead to Dell Computer last year, was commodity-oriented and would dilute the value of HP's higher-margin printing franchise.

Many passionate retail investors posting on Internet message boards backed that point of view, but HP management has beaten Wall Street financial expectations for the past two quarters, after a year of profit disappointments.

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