____________________________________________________________ FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 1996 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 (713) 370-0670 (Address, including zip code, and telephone number, including area code, of registrant's principal executive offices) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ x ] No [ ] The number of shares of the registrant's Common Stock, $.01 par value, outstanding as of June 30, 1996, was 269.3 million. ____________________________________________________________
Page 1 P A R T I. FINANCIAL INFORMATION Item 1. Financial Statements COMPAQ COMPUTER CORPORATION CONSOLIDATED BALANCE SHEET (Unaudited) ASSETS June 30, December 31, 1996 1995 --------- ------------ (in millions) Current assets: Cash and cash equivalents $ 1,927 $ 745 Accounts receivable, net 2,687 3,141 Inventories 1,535 2,156 Deferred income taxes 365 365 Prepaid expenses and other current assets 121 120 ------- ------- Total current assets 6,635 6,527 Property, plant, and equipment, less accumulated depreciation 1,163 1,110 Other assets 193 181 ------- ------- $ 7,991 $ 7,818 ======= ======= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,141 $ 1,379 Income taxes payable 83 190 Other current liabilities 1,078 1,111 ------- ------- Total current liabilities 2,302 2,680 ------- ------- Long-term debt 300 300 ------- ------- Deferred income taxes 225 224 ------- ------- Stockholders' equity:- Preferred stock, $.01 par value (authorized: 10 million shares; issued: none) Common stock and capital in excess of $.01 par value (authorized: 1 billion shares; issued and outstanding: 269.3 million shares at June 30, 1996 and 267.1 million shares at December 31, 1995) 922 890 Retained earnings 4,242 3,724 ------- ------- Total stockholders' equity 5,164 4,614 ------- ------- $ 7,991 $ 7,818 ======= ======= See accompanying notes to consolidated financial data
Page 2 COMPAQ COMPUTER CORPORATION CONSOLIDATED STATEMENT OF INCOME (Unaudited) Six months ended Quarter ended June 30, June 30, 1996 1995 1996 1995 ---------------------------------------- (in millions, except per share amounts) Sales $ 8,206 $ 6,460 $ 4,001 $ 3,501 Cost of sales 6,400 4,910 3,080 2,675 ---------------------------------------- 1,806 1,550 921 826 ---------------------------------------- Selling, general, and administrative expense 871 719 440 391 Research and development costs 197 124 94 64 Other income and expense, net 22 66 5 30 ---------------------------------------- 1,090 909 539 485 ---------------------------------------- Income before provision for income taxes 716 641 382 341 Provision for income taxes 215 179 115 95 ---------------------------------------- Net income $ 501 $ 462 $ 267 $ 246 ======================================== Earnings per common and common equivalent share: Primary $ 1.81 $ 1.70 $ 0.97 $ 0.90 ======================================== Assuming full dilution $ 1.81 $ 1.69 $ 0.96 $ 0.90 ======================================== Shares used in computing earnings per common and common equivalent share: Primary 276.4 271.6 276.7 272.2 ======================================== Assuming full dilution 277.0 272.8 277.1 273.1 ======================================== See accompanying notes to consolidated financial data
Page 3 COMPAQ COMPUTER CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited) Six months ended June 30, 1996 1995 ------------------- (in millions) Cash flows from operating activities: Cash received from customers $ 8,615 $ 6,236 Cash paid to suppliers and employees (6,924) (5,367) Interest and dividends received 24 20 Interest paid (42) (49) Income taxes paid (322) (163) ------------------- Net cash provided by operating activities 1,351 677 ------------------- Cash flows from investing activities: Purchases of property, plant, and equipment, net (201) (177) Acquisition of businesses (22) Other, net (5) 13 ------------------- Net cash used in investing activities (228) (164) ------------------- Cash flows from financing activities: Proceeds from sale of equity securities 32 42 ------------------- Net cash provided by financing activities 32 42 ------------------- Effect of exchange rate changes on cash 27 (34) ------------------- Net increase in cash and cash equivalents 1,182 521 Cash and cash equivalents at beginning of period 745 471 ------------------- Cash and cash equivalents at end of period $ 1,927 $ 992 =================== Reconciliation of net income to net cash provided by operating activities: Net income $ 501 $ 462 Depreciation and amortization 131 103 Provision for bad debts 14 9 Deferred income taxes 1 Currency exchange losses 6 33 Decrease (increase) in accounts receivable 409 (249) Decrease (increase) in inventories 621 (30) Increase in prepaid expenses and other current assets (5) (65) Increase (decrease) in accounts payable (236) 281 Increase (decrease) in income taxes payable (106) 17 Increase in other current liabilities 15 116 ------------------- Net cash provided by operating activities $ 1,351 $ 677 =================== See accompanying notes to consolidated financial data
Page 4 COMPAQ COMPUTER CORPORATION NOTES TO CONSOLIDATED FINANCIAL DATA Note 1 - Basis of presentation The accompanying unaudited financial data as of June 30, 1996 and December 31, 1995 and for the six month periods ended June 30, 1996 and 1995 have been prepared on substantially the same basis as the annual consolidated financial statements. In the opinion of the Company, the data reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results for those periods and the financial condition at those dates. Note 2 - Inventories Inventories consisted of the following components: June 30, December 31, 1996 1995 --------- ------------ (in millions) Raw materials and work-in-process 641 1,043 Finished goods 894 1,113 ------- ------- $ 1,535 $ 2,156 ======= ======= Note 3 - Other income and expense Other income and expense consisted of the following components: Six months ended Quarter ended June 30, June 30, 1996 1995 1996 1995 ------------------------------- (in millions) Interest and dividend income $ (24) $ (20) $ (18) $ (10) Interest expense associated with hedging 11 (1) 5 Other interest expense 37 37 22 23 Currency exchange losses, net 6 33 1 9 Other, net 3 5 1 3 -------------------------------- $ 22 $ 66 $ 5 $ 30 ================================
Page 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated interim financial statements. Results of Operations The following table presents, as a percentage of sales, certain selected financial data for the six months and quarters ended June 30, 1995 and 1994. Six months ended Quarter ended June 30, June 30, 1996 1995 1996 1995 --------------------------------- Sales 100.0% 100.0% 100.0% 100.0% Cost of sales 78.0 76.0 77.0 76.4 --------------------------------- Gross margin 22.0 24.0 23.0 23.6 --------------------------------- Selling, general, and administrative expense 10.6 11.1 11.0 11.2 Research and development costs 2.4 1.9 2.4 1.8 Other income and expense, net .3 1.1 .1 .9 --------------------------------- 13.3 14.1 13.5 13.9 --------------------------------- Income before provision for income taxes 8.7% 9.9% 9.5% 9.7% ================================= Sales Sales increased 14% and 27% in the second quarter and first half of 1996, respectively, over the comparable periods of 1995, and declined 5% from the first quarter of 1996. European sales represented 33% and 34% of total sales in the second quarter and first half of 1996, respectively, as compared with 37% and 38% in the corresponding periods of 1995. Other international sales, excluding Canada, represented 16% and 15% of the total sales in the second quarter and first half of 1996 as compared with 16% and 15% in the comparable periods of 1995. The Company's increase in consolidated sales in the second quarter of 1996 in comparison to the same period of 1995 stemmed primarily from an increase in the number of units and options sold. Total computer unit sales increased 10% in the second quarter of 1996 over the comparable period of 1995, driven primarily by sales of the Company's commercial desktop and server products. The personal computer industry is highly competitive and marked by frequent product introductions, continual improvement in product price/performance characteristics, and a large number of competitors. In the second quarter the Company launched Compaq ProLiant 5000 Pentium Pro servers that deliver midrange systems performance and capabilities at about half the price, as well as new models of its LTE 5000 notebook computer family and the new Compaq Armada notebook computer families, including the Armada 4100 family that features a flexible slimline design and the latest Pentium processors for notebook computers. In July 1996, the Company announced Compaq Presario PCs designed for specific consumer needs, including the Compaq Presario 3000 series that is easy to move and includes double-bright flat panel display, a four-disc CD changer, and a cordless radio frequency mouse, the Compaq Presario 1000 series of multimedia notebooks, that include built-in CD-ROMs, modem, and stereo speakers, the Compaq Presario 4000 series for home and family users seeking a multi-purpose computer, the Compaq Presario 6000 series for the home office worker who needs corporate office capabilities, and the Compaq Presario 8000 series for high-tech audiophiles who want additional features for games, creativity, and surfing the internet. The Company also announced a redesigned family of Deskpro commercial desktop PCs, including the Deskpro 2000 value PC, the Deskpro 4000 network-ready PC, and the Deskpro 6000 high performance network-ready PCs. Gross Margin Gross margin as a percentage of sales rose to 23% in the second quarter of 1996 from 21.1% in the first quarter, while it fell from 23.6% in the second quarter of 1995. The increase from the first quarter of 1996 primarily resulted from improvements in logistics, asset management, and major new product cycles, while the decline from the comparable period of 1995 primarily resulted from currency fluctuations. The Company maintains a strategy designed to increase its market share and continues to expand its presence in the price sensitive consumer market segment. This strategy, along with the expectation of a continued aggressive pricing environment, will continue to put pressure on the Company's gross margins. Despite this pressure, the Company expects the combination of changes in product mix, reductions in the cost of materials, and higher margins on new products to maintain its current gross margin levels in the remainder of 1996. The Company attempts to mitigate the effect of pricing actions through implementation of effective design to cost goals, the aggressive pursuit of reduced component costs, manufacturing efficiencies, and control of operating expenses. Operating Expenses The Company strives to manage total operating expenses in line with sales growth and gross margin levels. The Company's selling, general, and administrative expense increased in amount while declining as a percentage of sales in the second quarter of 1996 as compared with the same period of 1995. The increase in expenses resulted from domestic and international selling expense associated with higher unit volumes as well as expense incurred in connection with the entry into new markets and the expansion of distribution channels. The Company anticipates that in the remainder of 1996 selling, general, and administrative expense will increase in absolute dollars as it supports significant new product introductions, steps up its advertising and promotion programs, expands into new markets, and increases its investment in the area of service and support, especially in support of its systems business. Research and development costs increased to 2.4% in the second quarter of 1996 compared to 1.8% in the corresponding period of 1995. The Company is committed to continuing a significant research and development program and research and development costs in absolute dollars are likely to remain at current levels or increase slightly for the remainder of the year. Other Items Other income and expense in the second quarter of 1996 was an expense of $5 million. Interest income and interest expense in the second quarter was a net expense of $3 million compared to $18 million in the corresponding period of 1995. The lower net interest expense is attributable to higher interest income due to higher cash balances, lower hedging interest expense, and lower interest expense associated with lower international borrowing. The translation gains and losses relating to the financial statements of the Company's international subsidiaries, net of offsetting gains and losses associated with hedging activities related to the net monetary assets of these subsidiaries, are included in other income and expense and were a net loss of $1 million in the second quarter of 1996, compared to a net loss of $9 million in the second quarter of 1995. Provision for Income Taxes The Company estimates the effective tax rate for 1996 will be 30%, a decline from 34% in 1995. The Company's tax rate in 1995 increased from 26% in 1994 due to a non-tax deductible charge associated with the Company's acquisitions and a decline in the ratio of earnings derived from the Company's Singaporean manufacturing subsidiary to total earnings. The Company anticipates that the proportion of its Singaporean earnings will continue to decline in 1996, bringing the rate to 30%. The Company's tax rate is heavily dependent upon the mix of earnings of its Singaporean manufacturing subsidiary due to this subsidiary's earnings not being subject to taxes in Singapore until August 2001 (with potential extension to August 2004 if certain cumulative investment levels and other conditions are met) and the Company's decision to invest a portion of the undistributed earnings of this subsidiary indefinitely in operations outside the United States. These earnings would become subject to U.S. tax if they were actually or deemed to be remitted to the Company as dividends or if the Company should sell its stock in this subsidiary. As a result, the Company does not provide tax on these earnings, which lowers its effective tax rate. Should the Company choose to discontinue its permanent reinvestment policy, the Company's effective tax rate will increase at that time. Liquidity and Capital Resources The Company's working capital increased to $4.3 billion at June 30, 1996, compared to $3.8 billion at December 31, 1995. The Company's cash and cash equivalents increased to $1.9 billion at June 30, 1996, from $745 million at December 31, 1995, primarily because of positive cash flow from operating activities and better management of costs, inventory, and accounts receivable. Accounts receivable decreased to $2.7 billion at June 30, 1996, from $3.1 billion at December 31, 1995, primarily as a result of a decline in sales from the fourth quarter of 1995. Accounts payable decreased to $1.1 billion at June 30, 1996, from $1.4 billion at December 31, 1995, primarily as a result of lower volumes. Inventory levels decreased to $1.5 billion at June 30, 1996, from $2.2 billion at December 31, 1995, as a result of better overall management of inventories. Cash used in the second quarter of 1996 for the purchase of property, plant and equipment totaled $89 million. The Company estimates that capital expenditures for land, buildings, and equipment during the remainder of 1996 will be approximately $200 million. The Company has commitments for only a small portion of such amounts and the actual level of spending will depend on a variety of factors, including general economic conditions and the Company's business. The Company currently expects to fund expenditures for capital requirements as well as liquidity needs created by changes in working capital from a combination of available cash balances, internally generated funds, and financing arrangements. The Company from time to time may borrow funds for actual or anticipated funding needs or because it is economically beneficial to borrow funds for the Company's needs instead of repatriating funds in the form of dividends from its foreign subsidiaries. The Company has a $250 million syndicated credit facility, which will expire in October 1996, and a $1 billion syndicated credit facility, which will expire in October 2000, both of which were unused at June 30, 1996. The Company has established a commercial paper program, which is supported by the syndicated credit facility, which was unused at June 30, 1996. In the U.S. and various international locations the Company has uncommitted bank lines of credit, of which $10 million was outstanding at June 30, 1996. The Company believes that these sources of credit provide sufficient financial flexibility to meet future funding requirements. The Company continually evaluates the need to establish other sources of working capital and will pursue those it considers appropriate based upon Company needs and market conditions. Factors That May Affect Future Results The Company participates in a highly volatile industry that is characterized by fierce industry-wide competition for market share resulting in aggressive pricing practices, continually changing customer demand patterns, growing competition from well-capitalized high technology and consumer electronics companies, and rapid technological development carried out in the midst of legal battles over intellectual property rights. In developing strategies to achieve continued increases in sales and operating profits, the Company anticipates the continued expansion of the computer market and spending on information technology. In this environment the Company seeks profitable PC market share growth while expanding its product offerings. The Company's operating results could be adversely affected should the Company be unable to anticipate customer demand accurately, to maintain short design cycles while meeting evolving industry performance standards, to manage its product transitions, inventory levels, and manufacturing processes efficiently, to distribute its products quickly in response to customer demand, to differentiate its products from those of its competitors, or to compete successfully in the markets for its new products. In accordance with the provisions of the Private Securities Litigation Reform Act of 1995, the cautionary statements set forth below identify important factors that could cause actual results to differ materially from the projected results contained in the forward-looking statements in this report. Competitive Environment. The Company expects the PC market in 1996 to expand in line with third party research organizations' forecasts of unit growth in the range of 17% to 20%. The Company is putting in place programs and products focused on meeting market demand and gaining market share profitably. Competition for PC market share remains fierce and a number of the Company's competitors have announced plans to increase their PC market shares. Several of the Company's suppliers also manufacture and market PCs or motherboards, which contain the microprocessor and other internal operating components of the PC. In addition, a number of consumer electronics companies are entering the PC market as it expands into the consumer sector and consumer models expand multimedia features. Each of these companies may be willing to accept lower profit margins to win market share. In addition, when the Company lowers prices on existing products or announces new products at lower price points, the Company must increase the volume of unit sales to achieve sales targets. Third Quarter Outlook. For the third quarter 1996, the Company is targeting sales above second quarter levels. This level of sales is dependent on continued strong customer demand and the availability of new products. The Company also expects the combination of changes in product mix, reductions in the cost of materials, higher margins on new products, and ongoing expense controls to enable it to achieve third quarter earnings that exceed the same period of 1995 and second quarter 1996. The Company's ability to achieve targeted sales and earnings levels depends upon a number of competitive and market factors and is subject to the risks set forth in this report. Gross Margin Pressures and Operating Expenses. In order to maintain or increase its market share, the Company must continue to price its products competitively, to design products at lower price points with attractive price/performance characteristics, and, from time to time, to use various incentive programs to increase sales. Some of these strategies lower the average sales price per unit and may cause declines in gross margin and profitability. Other sales incentives increase operating expenses and may lower profitability. To compensate for the impact of lower prices and sales incentives on its sales, gross margins, and profitability, the Company must increase unit shipments, aggressively reduce costs, maintain tight control over operating expenses, and continue to pursue gross-margin enhancing opportunities. Despite quarterly fluctuations, the Company remains focused on achieving gross margin levels at or above current levels. The Company's ability to achieve higher gross margin levels and lower operating expenses as a percentage of sales in the remaining quarters of the year depends upon a variety of competitive and market factors and is subject to the other risks set forth in this report. Inventory. The Company anticipates that its inventory turns, which increased to 5.5 in 1995 from 5.2 in 1994, will continue to increase in 1996. In the second quarter of 1996, the Company achieved inventory turns of 7.1 in comparison to 6.5 in the first quarter of 1996 as a result of improved product cycle management and other efficiencies accompanying the reengineering of certain internal processes. In the event of a drop in worldwide demand for PC products, lower than anticipated demand for one or more of the Company's products, difficulties in managing product transitions, or component pricing movements that affect the value of raw material inventory, there could be an adverse impact on inventory, cash, and related profitability. Product Transitions. This summer the Company has announced and will be announcing additional major new products in each of its products groups. In each product transition cycle the Company confronts the risk of delays in new product production that would impact sales of its newer PCs while it manages the inventory of its older products and facilitates the sale of older Compaq inventory held by resellers. The Company provides currently for estimated product returns and price protection that may occur under programs the Company has with its customers and under floor planning arrangements with third-party finance companies. From time to time the Company and its resellers may hold substantial amounts of inventory of selected older products. To facilitate smooth product transitions, the Company carries out pricing actions and marketing programs to raise dealer sales. The success of the Company's product transition strategy depends upon a variety of competitive and market factors. Should the Company be unable to sell its inventory of older products at anticipated prices or if dealers hold higher than expected amounts of inventory subject to price protection at the time of planned price reductions, there could be a resulting adverse impact on sales, gross margins, and profitability. Reengineering Implementation. The Company continues to expand its manufacturing capacity as well as reengineer its internal processes to support continued growth. During 1996 the Company continues to focus on making its business processes more efficient in order to increase customer satisfaction, improve productivity, and lower costs. In the event of a delay in reengineering implementation, there could be an adverse impact on inventory, cash, and related profitability. As the Company has grown it has outstripped the ability of certain of its systems to support continued expansion. In connection with its reengineering efforts the Company is moving many of its systems from a legacy environment of proprietary systems to client-server architectures. Should the Company's transition to new systems not occur in a smooth and orderly manner, the Company could experience disruptions in the operations of its business, which could have an adverse financial impact. Alliance and Acquisition Strategy. Because of the rapid pace of technological advances in information technology, the Company must introduce on a timely basis new products offering competitive features that appeal to a wide variety of customers. The Company's product development efforts are centered on aggressively developing new areas in which the Company can differentiate its products and add value, focusing on innovative platform features, the integration of hardware and software, and new related products and services, such as storage devices. Because the Company's business now intersects with a number of areas in which other companies have significantly greater technological, marketing, and service expertise, the Company has focused on alliances with third parties that have complementary products and skills as well as acquisitions that target incremental business opportunities. The Company believes that its alliance and acquisition strategies enable it to provide best-in-class solutions integrated in its platforms while expanding its offerings of complementary products. Each of these approaches, however, carries significant risks. In its acquisition activities the Company confronts significant challenges in retaining key employees and reconciling diverse corporate cultures, synchronizing product roadmaps and business processes, and integrating logistics, marketing, product development, and manufacturing operations to achieve greater efficiencies. In developing business plans based on an alliance model, the Company must rely on the performance of third parties, many of whom may compete with the Company in other parts of their businesses. In addition, particularly in attempting to expand into enterprise computing through an alliance model, the Company competes against businesses that are vertically integrated and offer customers the convenience of dealing with only one vendor for their enterprise-wide systems. Customers' willingness to adopt the Company's more cost-effective solution will depend upon the reputation for reliability and support that it and its business allies earn in this area. Technology Standards. Participants in the PC industry generally rely on the creation and implementation of technology standards to win the broadest market acceptance for their products. The Company must successfully manage and participate in the development of standards while continuing to differentiate its products in a manner valued by customers. While industry participants generally accept, and may encourage, the use of their intellectual property by third parties under license, when intellectual property owned by competitors or suppliers becomes accepted as an industry standard, the Company must obtain a license, purchase components utilizing such technology from the owners of such technology or their licensees, or otherwise acquire rights to use such technology, which could result in increased Company costs. In addition, delays in access to technology developed by competitors and suppliers could slow the Company's design and manufacture of components and subsystems that distinguish its products. Supplier Issues. In managing production levels, product transitions, and developments in microprocessor and other component technology, the Company must develop and implement effective strategies that anticipate availability and pricing by suppliers as well as forecast customer demand for its products. The Company attempts to select suppliers that can provide sufficient and timely supplies of high quality material. There can be no assurance, however, that the Company will acquire sufficient supplies of components, including microprocessors, to deliver its products in volume in response to shifts in customer demand. Order lead times and cancellation requirements vary by supplier and component. Should the Company underestimate the component supplies needed to meet demand, the Company could be unable to meet customer demand. Should the Company overestimate the component supplies needed to meet customer demand, the Company's cash and profitability could be adversely affected. Many of the components used in the Company's products, particularly microprocessors and memory, experience steep price declines over their product lives. If the Company is unable to manage its purchases and utilization of such components efficiently to maintain low inventory levels immediately prior to major price declines, the Company could be unable to take immediate advantage of such declines to lower its product costs, which could adversely affect the Company's sales and gross margins. In planning product transitions the Company evaluates the speed at which customers are likely to switch to newer products. The contrast between the 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. Technology transitions may occur more quickly or more slowly than anticipated based on pricing decisions by industry component suppliers, particularly microprocessor prices set by Intel Corporation. Because of the lead times associated with the Company's volume production, should the Company be unable to predict the rate of a product transition accurately, the Company's inventory levels, cash and profitability could be negatively affected. In addition, certain of the Company's products are manufactured by third-party original equipment manufacturers, which could fail to respond in a timely manner to the Company's purchase orders or could fail to meet the Company's quality standards. The Company attempts to maintain tight control over production by third-party original equipment manufacturers to ensure that these products comply with its standards and schedule. Intellectual Property Infringement. Because of rapid technological changes in the computer industry, extensive patent and copyright coverage, and the rapid establishment of new copyright and patent rights, certain components of the Company's products designed by the Company or purchased from third parties may unknowingly infringe intellectual property rights of others. The Company believes, based in part on industry practices, that if any infringements do exist, the Company will be able to modify its products to avoid infringement, obtain components that do not infringe, or obtain licenses or rights to such intellectual property on terms not having a material adverse effect on the Company. There can be no assurance, however, that the Company will be able to ensure that component supplies and the cost of components are not adversely affected by legal proceedings in which an adverse determination is made with respect to intellectual property rights of the Company or one of its suppliers. To minimize the impact of intellectual property claims by third parties, the Company pursues an active patent portfolio development plan. Product Distribution. During the first half of 1996 the Company continued to broaden its product distribution. Offering its products in an increasing number of geographic locations and through a variety of distribution channels, including dealers, distributors, value-added resellers, mass merchandise stores, consumer electronic outlets, computer superstores, and mail order, requires the Company to increase its geographic presence and to provide increased levels of sales and support interface with customers. There can be no assurance, however, that the requisite service and support to ensure the success of the Company's operations in new locations or through new channels can be achieved in a cost effective manner, particularly with respect to the levels of service and support desired by customers to support systems products in enterprise-wide computing solutions. While the Company anticipates that its geographic expansion will continue and the number of outlets for its products will continue to increase in the remainder of 1996, a reduction in the pace of this growth could affect sales and profitability. Geographic expansion, particularly the expansion of manufacturing operations in developing countries, such as Brazil and China, and the expansion of sales into economically and politically volatile areas such as China, Hong Kong, Latin America, and Eastern Europe, subject the Company to a number of economic and other risks, such as currency devaluation, expropriation, and financial instability among resellers in these regions. The Company continues to evaluate its business operations in these regions and attempts to take measures to limit its risks in these areas. Credit Risks. The Company's primary means of distribution remains third-party resellers. The Company continuously monitors and manages the credit it extends to resellers and attempts to limit credit risks by broadening its distribution channels, utilizing certain risk transfer instruments, and obtaining security interests in property owned by its debtors. The Company's business could be adversely affected in the event that the financial condition of third-party computer resellers worsens. Upon the financial failure of a major reseller, the Company could experience disruptions in its distribution as well as the loss of the unsecured portion of any outstanding accounts receivable. The Company generally has experienced longer accounts receivable cycles in its emerging markets, in particular China 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 the Company's larger resellers in these regions fail, the Company could be adversely affected. Forecasting Issues. Because of the pace of technological advances in the computer industry, the Company must introduce on a timely basis new products that offer customers competitive technologies while managing the production and marketing cycles of its existing products. 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 the configuration requirements, such as language localization, in certain markets. As a result, while overall demand may be in line with the Company's projections and manufacturing implementation, local market variations can lead to differences between expected and actual demand and resulting delays in shipment, which can affect the Company's financial results. Currency and Hedging Risks. The value of the U.S. dollar continues to affect the Company's financial results. The functional currency for the Company's international subsidiaries is the U.S. dollar. When the U.S. dollar strengthens against other currencies, sales made in those currencies translate into lower sales in U.S. dollars; and when the U.S. dollar weakens, sales made in local currencies translate into higher sales in U.S. dollars. Correspondingly, costs and expenses incurred in non-U.S. dollar currencies increase when the U.S. dollar weakens and decline when the U.S. dollar strengthens. Accordingly, changes in exchange rates may positively or negatively affect the Company's sales (as expressed in U.S. dollars), gross margins, and operating expenses, and the Company's results of operations can be significantly affected in the short term by fluctuations in foreign currency exchange rates. The Company engages in hedging programs aimed at limiting in part the impact of currency fluctuations. Through these programs the Company hedges its non-U.S. dollar net monetary assets and its Japanese yen denominated purchase commitments primarily through the use of forward exchange and option contracts. For certain of its markets, particularly Latin America, the Company has determined that ongoing hedging of its 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 the Company purchases foreign currency option contracts as well as short-term forward exchange contracts to protect against currency exchange risks associated with the anticipated sales of its international marketing subsidiaries, principally in Europe and Japan. These instruments provide only limited protection against currency exchange risks. The Company varies the percentage of anticipated sales that it attempts to protect against currency exchange risks based upon its judgment of currency markets and the costs of these instruments, and in some markets, particularly in developing areas, the Company's ability to utilize such instruments is limited. If the Company overestimates the hedging amount needed to protect anticipated sales during a period in which the dollar weakens or yen-denominated purchase commitments during a period when the dollar strengthens, the Company could incur expense that would not be balanced by the impact of exchange rate movements on its sales and purchase commitments. All currency contracts that are entered into by the Company are components of its hedging programs and are entered into for the sole purpose of hedging an existing or anticipated currency exposure, not for speculation. Although the Company 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 the Company sells its products or a weakening exchange rate against currencies in which the Company incurs costs, particularly the Japanese yen, the Company's sales or its costs are adversely affected. Tax Rate. The Company's tax rate is heavily dependent upon the proportion of earnings that are 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 the Company's total earnings were to decline significantly from anticipated levels, or should the Company's ability to reinvest these earnings be reduced, the Company's tax rate would increase above the estimated 30%. In addition, should the Company's intercompany transfer pricing with respect to its Singaporean manufacturing subsidiary require significant adjustment due to audits or regulatory changes, the Company's overall tax rate could increase. Seasonality. General economic conditions have an impact on the Company's business and financial results. From time to time the markets in which the Company sells its products experience weak economic conditions that may negatively affect sales of the Company's products. Although the Company does not consider its business to be highly seasonal, it has experienced seasonally higher sales and earnings in the fourth quarter of the year. The continued expansion of its retail business is likely to result in the increased seasonality of the Company's business, particularly in the fourth quarter of the year, and its financial results being more dependent on retail business fluctuations. Facilities. Certain of the Company's facilities, including its European distribution center in Gorinchem, The Netherlands, and critical suppliers are located in areas that are at risk for natural disasters such as floods, tornadoes, hurricanes and earthquakes. While the Company attempts to minimize the potential for loss through preventative planning and insurance risk transfer products, such natural disasters could negatively affect the Company's sales, profitability, and cash flow. Because of the foregoing factors, as well as other variables affecting the Company'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. In addition, the Company's participation in a highly dynamic industry often results in significant volatility of the Company's common stock price. P A R T II. OTHER INFORMATION Item 1. Legal Proceedings The Company has been named as a defendant in a number of repetitive stress injury lawsuits, primarily in New York state courts or federal district courts for the New York City area. In each of these lawsuits the plaintiff alleges that he or she suffers from symptoms generally known as repetitive stress injury, which allegedly were caused by the design of the keyboard supplied with the computer the plaintiff used. The suits naming the Company are similar to those filed against other major suppliers of personal computers. Ultimate resolution of the litigation against the Company may depend on progress in resolving this type of litigation overall. The Company is unable to determine at this time the outcome of these suits or the likelihood of the Company's being named in additional suits by plaintiffs' alleging similar injuries. The Company has denied these claims and intends to defend vigorously the suits. The Company believes that the claims will not have a material adverse effect on the Company's financial results of operations or its financial position. Item 4. Submission of Matters to a Vote of Security Holders At the annual meeting of stockholders of the Company on April 25, 1996, the shareholders voted on the election of directors. The votes in this election were set forth in Item 4 of the Company's Quarterly Report on Form-Q for the quarter ended March 31, 1996, which is incorporated herein by reference. Item 6. Exhibits and Reports on Form 8-K (a) Exhibit No. Description 11 Statement regarding computation of per share earnings 27 EDGAR financial data schedule All other items specified by Part II of this report are inapplicable and accordingly have been omitted. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. August 5, 1996 Compaq Computer Corporation /s/ EARL MASON ------------------------------ Earl Mason, Senior Vice President, Finance, and Chief Financial Officer (as authorized officer and as principal financial officer)