1/2 to answer some of your questions - CPQ doing VERY well with sub-zero PC!!!
K.
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Another Look at $1K PC; Profitability Concerns Misplaced; BUY CPQ
04:12pm EST 10-Nov-97 Montgomery Securities (K. King)
NATIONSBANC MONTGOMERY***NATIONSBANC MONTGOMERY***NATIONSBANC MONTGOMERY
Another Look at the $1K PC; Profitability Concerns Appear Misplaced;
Reiterate BUY on CPQ
This furthers our discussion of the $1K PC, which we began with our note of
10/21. Our first note concluded that worries about Compaq's pursuit of this
market were misplaced as: (1) sales appear to be primarily incremental; (2) the
bottom-line impact is positive; and (3) playing in low-end markets will allow
Compaq to consolidate the PC market, with Compaq likely achieving 20% market
share by the end of the decade. This note takes a look at some broader issues,
including profitability.
Concerns about profitability on the new low end boxes appear
misplaced. Our analysis of the bill-of-materials on Compaq's $799 and $999
consumer boxes indicate gross margins in the 15-20% range, which we've
confirmed with the company. We would expect the profitability to be similar for
HWP. We think concerns that profitability is being achieved only through a
misallocation of overhead to be particularly misplaced. We believe Compaq's
consumer business shifted about a year and a half ago to a fairly rigorous
system of allocating costs to specific product lines. Allocations are based on
an estimate of 'real' overhead costs, reflecting the use of contract
manufacturing versus direct labor, required inventory levels, shipping costs,
etc. This contrasts with the standard industry practice of using arbitrary
mark-ups of the bill of materials or a fixed dollar amount per unit. Both of
Compaq's sub-$1000 consumer Presarios are built by contract manufacturers (FIC
builds the $799, Cyrix-based system, and a Mitac subidiary builds the $999,
Intel-based system.) The large majority are direct shipped to retailers, such
that Compaq never touches the boxes. Compaq has stated that its $1K consumer
systems generate ROICs in excess of 100%. Such a story would have been
inconceivable at the Compaq of two or three years ago, when inventory turns
were in the 5 range, channel inventories ran as high as three months and
desktop manufacturing was all internal.
Our analysis indicates that gross margins on the new low-end boxes are
higher than many would expect. While our cost estimates below include some
ballpark numbers on smaller items, we think the margin for error is small
enough that our gross margin conclusions are very likely correct within 200
basis points.
The industry's shift to lower-ASP products is being driven mainly by
the vendors themselves. The most basic reason for the surge in sales of the
$1K PC is that the leading vendors now offer and promote $1K PCs. Compaq
entered the market with a new $999 consumer system in February and announced
its first new $999 corporate systems a few months later. HWP's launch schedule
was similar to Compaq's, and IBM just last week entered the fray with a new
sub-$1000 consumer offering. Prior to these announcements, each vendor's price
floor tended to be in the $1200 range, most often for older systems originally
sold at higher price points. When we did see big-brand systems listing below
$1000, they tended to be fire sale offerings, such as the Compaq 486 desktops
that worked their way through the channel in early to mid-1996. Prices below
$1000 have otherwise been the province of third-tier and no-name vendors.
Despite the recent shift to lower-end systems, we think end-user demand
fundamentals remain healthy. We think fears that end users don't need
performance any more, or that the hardware has gotten too far ahead of the
software, are likely overdone. These fears have surrounded the PC business for
at least the last 10 years, but have yet to be born out on any sustained basis.
It is true that Intel's price cuts in recent months have been more aggressive
than usual, which could be contributing marginally to ASP pressure at the
systems level. We saw a similar, although more pronounced, version of the same
story in 1996 in the DRAM market, where the rapid drop in DRAM prices was not
entirely offset by increased end-user DRAM consumption, resulting in lower PC
ASPs because of lower DRAM content in dollar terms. However, we emphasize that
rapidly falling component prices have nothing but positive implications for
overall PC demand and for individual PC manufacturers who avoid accumulations
of old, higher-priced inventory.
Why is this shift to the low end happening now? Two reasons: New, lower-
cost components and more efficient vendor business models. Seeking refuge from
Intel, vendors such as Cyrix have in the last year introduced low-end, multi-
function chipsets that offer Pentium-class processor performance as well as
graphics and other capabilities. We've also seen new, low-end offerings in the
storage and power supply areas, as well as the all-important collapse of DRAM
prices. As a result, a full-function PC using current processor technology can
for the first time be built, sold and supported without quality sacrifices at
sub-$1000 price points. Also critical have been the business model improvements
at Compaq and elsewhere, which include faster inventory turns, lower channel
inventories and widespread use of outsourced manufacturing. These new, low-
margin products are still financially attractive as they require very little
asset commitment.
The most important implication of new, sub-$1000 PCs is not ASP pressure
but industry consolidation benefiting the biggest players. As we've noted
previously, we expect to see a significantly more consolidated PC industry as
we head toward the new decade. We see Compaq, as the #1 player, holding 20% of
the market within the next three years. We see the top five vendors eventually
holding 50% share. This contrasts with today's fragmented market, where
Compaq's roughly 10% market share held steady for the last three years, the top
five vendors hold about a 33% share and tens of thousands of marginally
profitable, little-known vendors continue to hold about half the industry's
share. Perhaps the strongest driver of consolidation will be share gains by the
big names at the low end of the market, driven by new, sub-$1000 products.
We'll go so far as to say we're entering a new phase in the PC industry, in
which the no-name half of the market will no longer be insulated from
competition with the industry's lowest-cost producers (e.g., CPQ and HWP). This
is a critical change from the traditional PC industry environment, where the
biggest players have for the most part focused on the higher end of the market
and traded share with one another based on execution, while leaving the low
price points to smaller vendors.
Earnings announcements from HWP and DELL in the next two weeks should
help restore the market's confidence in the PC group. We think the current
negative psychology surrounding the PC group should be helped by upcoming
earnings announcements by two of the PC industry leaders.
o Hewlett-Packard, 11/17 after the close: While HWP's overall business
remains a mixed bag, its PC business has clearly re-gained momentum
following some slowing in the first half. We think Europe in particular has
been strong, with sales in the October quarter likely up 50% or more from a
year ago. We expect HWP management to single out the PC business as a bright
spot in its conference call.
o Dell, 11/24 after the close: We expect DELL to beat numbers and see
estimates increased following its 3Q announcement, consistent with the
pattern of the last six quarters. We would expect management to maintain
that it's seen no loss of business to sub-$1000 PCs, and to emphasize the
incremental, first-time-buyer nature of $1K PC sales by CPQ and HWP, its two
largest competitors. |
