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Torture! The PC and the Pendulum
The sub-$1,000 personal computer is tormenting component makers even as it (barely) helps the likes of Compaq. By Aaron Task
The flood of personal computers priced for sale this Christmas season at under $1,000 has brought smiles to consumers' faces, but a grimace to most of the PC industry. It appears that the explosive sale of cheap boxes with less-than-state-of-the-art components may ultimately prove to be a Pyrrhic victory for the industry, with only the biggest manufacturers like Compaq Computer (CPQ) able to reap gains, and component makers suffering heavy losses.
The PC makers, putting their best spin forward, say lower-priced machines allow them to sell both to current computer users seeking a second unit and new users with slim wallets. But some top industry analysts are now saying that sanguine view is nonsense, declaring that the sub-$1,000 computer has slammed profit margins so severely it signals the beginning of the end of the industry.
Those with an apocalyptic view believe the recent sub-par performance of the shares in component makers -- from disk-drive manufacturers like Seagate Technology (SEG) to distributors like Vanstar (VST) -- provides a glimpse of the dark future for the manufacturers.
"This is what always happens when things in technology get past their prime," said Roxane Googin, an independent technology analyst. "What happened to the minicomputer market is going to happen to the PC makers. You get inexorable margin erosion. It's death by 1,000 cuts. The only debate is how well you deal with it."
Noting that now-sluggish Wang Laboratories (WANG), Data General (DGN) and Digital Equipment (DEC) "were high flying companies" when minicomputers ruled the Earth, Googin said she believes the PC and component makers will have to evolve extra-fast if they want to survive in a new, network-dominated era.
"Unless you get a radical new set of features people are clamoring for on the desktop, the upgrade market will disappear," she said. "After a while, there will be no pent-up demand waiting for cheaper PCs, then you get slow unit growth plus collapsing prices. To me, it's an obvious warning sign -- the PC is shriveling up."
Certainly, it will be years before we know whether low-priced PCs were really harbingers of doom, or just another marketing ploy. What is clear so far:
In October, 35.8% of desktop units sold at retail were priced under $1,000, vs. just 7.2% at that price point in January, according to research firm Computer Intelligence. At the same time, boxes priced over $2,000 fell to 8.5% of all units sold, from 18.9% at the beginning of the year.
Nearly all of the major original-equipment manufacturers are now offering low-priced boxes. Most are rather nicely configured with a gigabyte or two of hard-drive space, a Pentium 166 microprocessor, a modem, and a megabyte of video RAM. Retail users are embracing the cheap boxes because they're plenty powerful for nearly all but the most sophisticated user.
In addition to their attractive price tag, demand for low-end PCs is being driven by a lack of "must have" applications at the high end. Industry observers say the lack of sufficient Internet bandwidth is blocking the development of applications such as video conferencing that could take full advantage of Intel's relatively expensive Pentium II MMX chip. Without such applications, demand for higher-priced machines is expected to wane further.
Compaq dominates the low-end market, garnering 51% of the sub-$1,000 sales in the retail channel in October, according to Computer Intelligence. Privately held Packard Bell's 35% put it in the second slot, followed by Hewlett-Packard (HWP) with 6.3%.
Compaq's success in the low-end market has, according to analysts, two sources: First, it is able to leverage its outstanding server business, which contributes 40% of the company's revenues. Analysts believe the company is succeeding at offering corporate clients a package deal of cut-rate PCs to go along with those high-priced servers.
Second, the company is able to use its marketing clout and sleek distribution system to wring every last cent of profit from its suppliers and distributors. Here's the drill: The box building is out-sourced to contract-assembly companies like SCI Systems (SCIC), Solectron (SLR) and Jabil Circuits (JBIL). When the machines come off the assembly line, Compaq buys them, glues on the nameplates with its brand name , then turns around and sells them to distribution partners like Merisel (MSEL), which then complete the final sale to PC retailers or directly to corporate clients.
"It's an awesome business," said Mark Specker, PC analyst at Soundview Financial, noting the capital employed by Compaq in the low-end market is minimal. "All you've got to do is have brand equity like Compaq."
The catch for the component suppliers is that Compaq is demanding -- and getting -- low prices for those computer parts that are hidden under the hood. Who brags to their buddies that they have a Western Digital disk drive? No one. The lack of pricing power has pounded these companies' profits, and electrocuted their stocks.
Patrick Tenney, who follows the storage industry at BancAmerica Robertson Stephens, says the disk drives used in sub-$1,000 PCs are priced at about $100 -- a point at which it has been historically difficult for drive makers to turn a profit. Tenney doesn't believe the sub-$1000 PC market is cannibalizing sales of more expensive boxes yet, but admits the trend isn't helping matters. "Clearly, the mix is not beneficial for the disk-drive companies," he said.
Chip and equipment makers, too, have been slammed by the worries about Asian demand. But some industry watchers see the pressures overseas as exacerbating existing problems -- not as the prominent issue facing the group.
"We have a situation where the industry is on a down slope. We have sort of a chronic oversupply, a lot of price weakness, and the primary end market, for the time being, is no longer evolving as fast as it was before," said Merrill Lynch's prominent semiconductor analyst, Tom Kurlak, during a Dec. 2 conference call in which he downgraded several chip makers. "Now you add to that the concern about worldwide economic growth (and) it's quite likely that 1998 is going to be a difficult year." Furthermore, Kurlak added that "it is unlikely the stocks have seen their lows for this down cycle," estimating "we might have another 25% risk at this point."
Among the nine distribution partners employed by Compaq, most are down for the year and even the group's champions lag the 33% gain registered by the Standard & Poor's 500 Index. InaCom (ICO) is down 15% for the year; MicroAge (MICA), off 5%; CompuCom (CMPC), down 13%; and Vanstar (VST) has ebbed 40%.
So, are the PC makers destined for the same fate? The first sign would be erosion of gross margins, but no one knows for sure if it's happening yet because fabulous margins in the high-end server market may be masking the problem at Dell and Compaq. Neither company breaks down gross margin by product line.
Dell is up 210% for the year; Compaq has climbed 91% and IBM (IBM) has gained 42%. But Hewlett - Packard (HWP) has risen just 20%, Micron Electronics (MUEI) is off 42% and Apple Computer (AAPL) has lost 38%. Gateway 2000 (GTW) and AST Research (ASTA) are essentially unchanged.
Going forward, indeed, Googin believes Compaq will compete more with high-end workstation maker Sun Microsystems (SUNW) than, say, Dell or Gateway. "Earlier this year, they bought Tandem when they could have bought Gateway," she said. That was a signal, she thinks, that chief executive Eckhard Pfeiffer and his crew see the future -- and that it's not in making home PCs for less than a thousand bucks a pop.
In addition to its own push to sell servers, Dell is somewhat insulated from the sub-$1,000 market because it still retains about 90% of its revenue from corporations, a client base that has not embraced lower-priced models thus far.
Still, Googin is dubious about the PC makers, and is downright aghast at the prospects for component providers. But that's not to say she sees only gloom.
The analyst is gung-ho about the potential for giants of the telecommunications industry, like WorldCom (WCOM) and AT & T (T), who will control the sprawling networks of the future that will connect all those cheap PCs worldwide. Rather than focusing on hardware kingpins Michael Dell, Pfeiffer and IBM chief Louis Gerstner, she opines, WorldCom chairman Bernie Ebbers "is the man to watch." |
