Blue, blue, my world is blue... can't get DELL bluer than Big Blue... >g<
Loss-Leader PC Sales Work Well for IBM
By SAUL HANSELL
IBM was once as closely linked to personal computers as Kleenex is to tissue. But no more.
The company's market share has fallen behind those of Compaq and Dell, and it has not made a profit on PC's in at least four years. Indeed, IBM's PC unit lost nearly $1 billion last year and $311 million so far this year.
IBM Chairman Louis Gerstner Jr. even declared in the company's annual report that "the PC era is over" because computing power was moving onto the Internet.
So last week, IBM announced a tactical retreat on the PC front, saying it would pull its desktop computers off store shelves and let customers buy them only over the Internet.
All this raises a bigger question: Should it get out of the PC business altogether? IBM certainly does have other business lines that are profitable and growing, like software, semiconductors and computer services. And it is pursuing these even at the risk of humiliating its own PC unit.
In recent months, IBM agreed to sell its rival Dell access to its most advanced technology and its 130,000 service technicians. With those deals calling for $22 billion in revenue, analysts have asked whether IBM would be better off ceding the PC business and focusing on areas where it has been more successful.
"I have argued that they should withdraw from both consumer and commercial desktop PC's," said Steven Milunovich of Merrill Lynch. "It's a business they haven't figured out."
But David Thomas, the executive in charge of IBM's personal systems group, says the company now does have the business figured out. In fact, it has been figuring quite hard over the last year.
"Any time you lose close to a billion dollars, you have to ask a lot of hard questions," Thomas acknowledged in a recent interview at corporate headquarters in Armonk, N.Y.
After an elaborate study, the company concluded that personal computers would likely remain a tough market with thin margins at best. Yet the study concluded that the customers who used IBM's most profitable products also bought lots of personal computers, and that abandoning PC's would thus create an opportunity for another company to establish a relationship to steal the good business.
So Thomas has developed a new strategy that essentially treats personal computers the way a convenience store has sold milk: a high-volume, low-margin item meant to bring customers in the door in the hope that they will grab a candy bar and a bag of chips on the way out.
To make this approach work, IBM has decided to emphasize selling directly to customers, rather than relying on dealers. Selling directly, as Dell does, is cheaper, and more important, it creates the opportunity to add on other products.
For example, if a consumer bought an IBM Aptiva desktop in a retail store, it was the retailer who decided which monitor and printer to offer. On IBM's Web site, by contrast, the company can push its own products. For businesses, the plan is much the same: to offer PC's with other IBM services like leasing from the IBM Credit Corp.
In addition, the PC unit, with the backing of Gerstner, is trying to get the other IBM units to return the favor and push its products to their customers. Most notably, David Thomas and Samuel Palmisano, then the head of IBM Global Services, concocted a plan called Blue on Blue that was meant to get more services customers to also buy IBM PC's. This was hardly an easy change for the services unit, which for nearly a decade has competed against independent companies like Electronic Data Systems by asserting it was agnostic about what brand of hardware a client chose to use.
For IBM, the motive for the change is clear. Thomas figures that at best, IBM can make 3 cents in profit for every $1 in revenue on the sale of a desktop PC. But by adding services, software, financing and other extras, the company can tack on a further 50 cents in revenue and 9 cents in profit.
"Until now, the profit has been on the system unit itself," Thomas said. "The next big battle is all things beyond the box."
IBM's strategy echoes the moves by other PC makers to deal with the competitive price pressures by finding other, more profitable products to sell along with the computers. Gateway has long offered lease financing and Internet service bundled with its computers for one monthly payment. Compaq put buttons on its keyboards to channel users to Web sites that pay for the traffic. And Hewlett-Packard bundles its computers with its printers, making the most money on the ink-refill cartridges.
It is too soon to tell whether IBM's strategy will restore its PC unit to its onetime glory. But there are some early signs that things are getting better. Over all, the unit's sales, flat for three years, jumped by 34 percent so far this year to $11.2 billion. In the third quarter, the PC unit's loss was down to $69 million from $122 million a year earlier. Nearly all of that loss, IBM says, was due to the home PC area it is pulling back from. (And mainframe computers, not PC's, are the villain in the decline in profit that IBM warned of last week, as the windfall from corporate investments in Year 2000 readiness comes to an end.)
Aside from desktop computer sales in the United States, IBM's financial results from PC's have been better. Thomas says the company has consistently made good money on PC's in Asia, even selling through retail stores. And profit margins are much higher for its Thinkpad notebook computers and Netfinity servers for Windows NT, two areas where customers are willing to pay higher prices for IBM's technology.
Yet desktops still make up two-thirds of the company's PC volume, and Thomas has sharply cut prices in order to win business, especially from big companies that buy lots of other things from IBM.
"Last year, we decided to put our desktop PC's up for bid every month because we were trying to squeeze the last drop of blood from the suppliers," said George D. Kunkel, the head of PC operations for PNC Bank in Pittsburgh. "IBM won most of the time, and I think that's part of the reason they lost more than $900 million last year." More recently, PNC signed a one-year deal with IBM, but only because it promised to maintain the low pricing.
PNC still buys its IBM personal computers through a reseller, but as with its consumer business, IBM is trying to shift its corporate customers to buying direct. Already, 10 percent of IBM's sales are direct to customers. By next year, Thomas hopes that 20 to 30 percent of IBM's sales will be direct, and ultimately as much as 50 percent.
Compaq, which faces many of the same problems as IBM, alienated dealers by announcing it would start selling directly last year. So IBM has been quieter as it set about to do the same thing, in part because the plan had some growing pains.
"I tried to buy my father an IBM system because I like their displays," said Kevin McCarthy, an analyst who follows IBM for Donaldson, Lufkin & Jenrette. "I finally got them on the telephone, and I knew more than the salesman did. It was so frustrating that I hung up and called Dell."
In addition to its traditional sales prowess, Dell has some new arrows in its quiver, thanks to its technology and services deals with IBM.
Those deals have challenged IBM's PC group to find new ways to compete. "Skip the middleman -- 'Be Direct' with IBM," was one pitch suggested in a letter the company sent to its sales force, playing on Dell's advertising slogan.
IBM points out that Dell has agreed to buy only three of the 60 services related to personal computers that it offers. And it does seem to have gotten some early success with the Blue on Blue program of selling PC's to services clients. But that is largely because the company is offering customers even more discounts when they buy a total package.
For example, last Thursday, IBM Global Services presented two bids to a national retailer that wanted someone to maintain a network of servers at each of its 2,700 stores. IBM's basic price was $1,500 per server per year for any brand of hardware. But if the customer bought IBM Netfinity servers, the price for the server would fall to $1,200. Global Services can absorb the discount because its own costs are lower when customers use IBM hardware, said Tom Conway, head of IBM's PC services unit. Support costs are lower because the company knows its own machines better, and maintenance is faster because it has supplies of spare parts all around the country.
And just to make sure that it gets the word out on these deals, IBM changed the compensation for its sales force, so someone in the services unit will get a bonus for selling hardware, and vice versa.
"The strings of the pocketbook affect behavior," said Conway.
It seems to be working. Last year, before the Blue on Blue program, IBM services customers bought $500 million in IBM personal computers. So far this year, PC sales to services customers have doubled to $1 billion, 10 percent of the PC group's total revenue.
Despite these gains, Roger Kay, an analyst with the International Data Corp., argues that customers and investors should be skeptical about how long Thomas' plan will last.
"IBM has come out repeatedly with very strong strategy statements, championed by a strong executive, only to have it all change when the next executive comes in," he said. "Compare them to Dell, which has been making the same strategy statement for 18 quarters."
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