Apropos answering many times - this must be my upteenth post on the sub-zero PC - there must still be non-believers out there, fully gullible about the garbage Michael Dell's mouth is spewing out. I like your comparison to the pre New Era CPQ!!!
Enjoy the read - this is really one worth it!!!
Take care
K.
PC Hardware & Peripherals: Wolf Bytes 19: The Sub-Zero PC Is Hot!
12:22pm EST 24-Nov-97 Credit Suisse First Boston (Wolf, Charles)
Wolf Bytes 19
The Sub-Zero PC Is Hot!
The success of the sub-zero PC-priced at less than $1,000-has
led to doom-and-gloom predictions that it will cut into the
profitability of PC companies.
The economics of the home PC market suggest otherwise. The
sub-zero has contributed importantly to the profitability of
Compaq, the leader in this market.
It should continue to be a money maker, even after competition
heats up and the demand of first-time buyers is satisfied.
Summary
The sub-zero PC-priced at less than $1,000-has become a hot
item this year. It appears to have represented as much as 40%
of all home PC sales in recent months. Because of the low
price point, the widely perceived wisdom is that it will
cannibalize a significant fraction of the sales of higher
priced home PCs and drag down gross margin dollars in the
process.
The evidence to date suggests that the sub-zero PC has, in
fact, been a cannibal. Depending on the source, between 30%
and 35% of sub-zero sales have come at the expense of higher
priced PCs. But as we show in Wolf Bytes 19, this percentage
is substantially below the cannibalization rate which would
reduce PC companies' profitability. In particular, the
emergence of the sub-zero has contributed importantly to the
profitability of Compaq, the leader in this market. And it
should continue to do so even after competition in this market
heats up and the pent-up demand of first-time buyers is
largely satisfied.
The sub-zero PC's success has stemmed from its ability to
offer up-to-date technology to price-sensitive buyers-both
first time buyers and current PC owners. Responding to the
new low price point, the latter group has acquired an
additional computer, typically for off-to-school children, or
to replace an older model. We believe the sub-zero market
will begin to decline once the demand among first-time, price-
sensitive buyers is satisfied. After that, it will consist
mostly of additions and replacements. With its limited
feature set, the sub-zero PC will not threaten sales of PCs
offering the latest and greatest in multimedia technologies.
That market-in the $2,000-$2,500 price range-is driven more by
new technologies than by price.
In Wolf Bytes 19, we quantify the value-creating potential of
the sub-zero market. We also attempt to size the price-
sensitive first-time buyers market, because the profitability
of the sub-zero market depends on the continued presence of
this group. Unfortunately, this proved to be an exercise in
futility.
The Break-even Cannibalization Rate.
The sub-zero PC arrived on the scene early this year when
Compaq and Packard Bell introduced PCs targeted at home buyers
at price points below $1,000. What distinguished these
machines from earlier sub-zero models was that they were
configured with relatively fast microprocessors. In the past,
sub-$1,000 PCs featured end-of-life processors with obvious
performance limitations. With the current crop, buyers could
be assured that the technology would not be hopelessly out of
date even before the PC was plugged in.
The success of the sub-zero PC has been nothing short of
sensational. Its share of the home market has shot up to 39%
by August of 1997, the last month for which data is available.
These dramatic market share gains have raised the specter of
cannibalization.
The cannibalization issue arises because of the inability of
PC vendors to exclude buyers from the sub-zero market who
might have purchased a higher priced machine. In addressing
cannibalization, it is helpful to diagram where it occurs.
Table 2 shows that two customer groups-first time buyers and
current PC owners who purchased an additional machine-have
expanded the PC market, subject to the caveats discussed
below. The third group, who have bought sub-zero PCs to
replace higher priced, older machines, represent
cannibalization potential.
How high can the cannibalization rate be before it reduces the
overall profitability of the home PC market?
As derived in Appendix A, the break-even cannibalization rate,
that is, the rate which would be gross margin dollar neutral,
is provided by equation (1).
z = (GM(y) x P(y))/(GM(x) x P(x))
(1)
where z = the break-even cannibalization rate,
GM(y)= the gross margin percentage on subzero PCs,
GM(x) = the gross margin percentage on higher priced home PCs,
P(y) = the average price of subzero PCs, and
P(x) = the average price of higher priced home PCs.
In English, the break-even cannibalization rate is the product
of two ratios-(1) the ratio of the gross margins on subzero
and higher priced PCs and (2) the ratio of the average price
of subzero and higher priced PCs.
The application of Equation (1) is illustrated for Compaq's
Presario family of home computers. We use Compaq because it
is the only independent PC company currently selling sub-
zeros. And it is the leader in this market by a large
percentage.
In the way of background, we have listed the current suggested
prices of base configurations of Compaq Presario home
computers found on the company's Web pages. Monitors-which
virtually every customer adds-are not included.
Compaq Presario 2200 $ 799
Compaq Presario 4505 $ 999
Compaq Presario 4528 $1,499
Compaq Presario 4814 $1,699
Compaq Presario 4808 $1,799
Compaq Presario 4824 $1,799
Compaq Presario 4840 $2,199
Our Compaq sales/earnings model (Compaq report dated October
21, 1997) suggests that the wholesale price of the sub-zero
Presarios bundled with monitors and perhaps other accessories
averages about $1,100. The average wholesale bundled price of
higher priced Presarios is around $1,750. This translates
into a price ratio, Py/Px, in Equation (1) of 0.63
($1,100/$1,750).
In contrast to the relative prices, the gross margins on the
sub-zero and higher-priced Presarios are surprisingly close
because of the ingenious design and engineering of the sub-
zeros. This is consistent with our sale/earnings model which
shows that the gross margin on Compaq's home PCs held
relatively steady at about 15% even after the introduction of
subzero PCs. This would imply gross margin around 14% on sub-
zero Presarios and 15% on higher-price models. This produces
a gross margin ratio, gmy/gmx, in Equation (1) of 0.93
(14%/15%).
The value of z, the break-even cannibalization rate, then, is
0.59 (0.63 x 0.93). This indicates that as much as 59% of the
unit sales of sub-zero models could cannibalize sales of
higher priced models before Compaq would realize a
deterioration in the gross margin dollars earned on the
Presario line.
The Value Creating Potential of the Sub-zero Home PC Market.
A number of surveys, most prominently those of the Computer
Electronics Manufacturers Association, have been conducted to
quantify the three segments of the sub-zero PC market,
identified in Table 2. All of these arrive at roughly similar
percentages. The sub-zero PC is about equally divided between
first-time buyers, buyers of an additional PC and replacement
buyers.
Table 3
Buyer Composition of Sub-zero PC Market
First-time buyers 35%
Additional PC buyers 32%
Replacement buyer 33%
What the raw numbers do not reveal is the exact percentage of
cannibalization. We don't know, for example, how many first-
time buyers would have purchased a higher price machine if a
sub-zero PC was not available. But we can infer that this
percentage must necessarily be small if only because the first-
time buyers of sub-zeros, by definition, represent the price
sensitive segment of the market. After all, they rejected the
choice of a higher price PC. We suspect a higher percentage
of current owners who bought an additional PC might have
chosen a higher-price model, absent a sub-zero PC.
By the same token, the percentage of replacement purchases is
no doubt overstated. This is because replacements include PCs
currently in use as well as those stuffed in closets. The
latter should obviously be excluded from the replacement
numbers. Likewise, replacements of older sub-zero PCs should
also be excluded. They don't represent true cannibalization,
which we define as the replacement of higher priced machines.
Indeed, in its own survey of buyers, Compaq discovered that
around half of its new sub-zeros replaced old ones. This
would imply a true cannibalization rate of about one-sixth
rather than one-third of the sub-zero market. In the absence
of a more refined survey which quantifies these nuances, we
assume the actual cannibalization rate is accurately
represented solely by replacement buyers.
This 33% rate is substantially below Compaq's break-even
cannibalization rate of 59%. Given the disparity between the
two percentages, we believe it is safe to assume that the
cannibalization rate would remain below the break-even
percentage even after refinements.
The impact of the difference between the actual and the break-
even cannibalization rates on Compaq's profitability is
estimated in Table 4. The addition of sub-zero models
increased Presario unit shipments by 36%, Presario revenues by
15% and Presario gross margin dollars by 14%. In view of the
fact that Compaq sub-contracts manufacturing of its sub-
zeroes, the return on invested capital for this product is
significantly higher than the corporate average.
Sizing the First-time Buyers Market
The potential size and durability of the first-time buyers
market plays an important role in the overall profitability of
the sub-zero PC market. Table 3 points out that without first
time buyers, the sub-zero market is about equally divided
between buyers acquiring an additional PC and replacement
buyers. If the pent-up demand among first-time buyers is
quickly satisfied, the profitability of sub-zero market could
be threatened. At least in Compaq's case, the disappearance
of first-timers poses only a modest threat because of the
proximity of the company's gross margins on sub-zero and
higher priced Presarios. However, it could jeopardize the
profitability of competitors if, as likely, the economics of
their sub-zero manufacturing operations are less favorable
than Compaq's.
Unfortunately, there is no obvious way to estimate the size of
the first-time buyers market. In view of the fact that around
60% of the 100 million households in the U.S. do not own
personal computers, it is potentially huge. But it's not
clear that price is the major hurdle
What we know is that the PC penetration rate into the home
market climbed steadily to almost 40% by 1995 but has stalled
since then. The most widely cited reason for the slow down is
that the difficulties in mastering the use of a PC have
outweighed its perceived benefits in consumer minds. At the
prestigious Agenda '97 conference, for example, there was an
entire session devoted to this topic. The conclusion was that
the major barrier to increased home penetration was the
difficulty in using PCs. Obviously, at such a gathering, the
perceived benefits of PCs were taken for granted.
Dataquest-an industry consulting firm-estimated that the
penetration rate in the home market would approach 48% by
1998. The eight percentage point increase over two years,
equivalent to eight million first-time buyer units, appears
improbable. It implies first-time home buyers alone would
account for over 10% of total U.S. PC shipments in both 1997
and 1998.
In theory, it would not be difficult to come up with an
estimate of the potential size of the first-time home buyers
market. An industry research firm, such as Intelliquest,
could easily design a conjoint study which measured the price
elasticity of demand among non-PC owners as well as their
likelihood of buying a PC at different price points. But to
our knowledge, no such study has been undertaken.
We do have data on Apple's Macintosh sales when the company
introduced the Mac Classic in October 1990. Targeted at price-
sensitive first-time buyers, the Classic was priced around
$1,250, about a third below any other Mac model. The response
was sensational. Mac Classics accounted for 40% of Apple's
total unit sales over the next two quarters. Driven chiefly
by the Classic, total Macintosh sales increased 53% in the
December quarter, up from 17% in September. In the March 1991
quarter, sales registered an 88% increase But the Classic was
a short-lived phenomenon: sales faded over the remainder of
fiscal 1991.
Our price elasticity of demand research suggests that the sub-
zero market could increase unit sales in the U.S. home market
by two million units over each of the next couple of years.
We arrive at this estimate as follows. The home market
represents about 20% of the total U.S. market, equivalent to
six million units in 1997 and the introduction of the sub-zero
PC should reduce the average selling prices of home PCs by
about a third. Given an estimated price elasticity of demand
of one, which we derived in Personal Computer Industry
Overview (September 12, 1996), the 33% decline in price could
produce about a 33%, or two million unit increase in
shipments.
Until the ease-of-use issue is addressed, we estimate that
half of the home market is probably off-limits. This would
size the potential market of price-sensitive home buyers at
ten million. Apple's Mac Classic experience suggests this
group is likely to enter the market quickly, causing a sharp
spike in sales for a few years followed by a gradual slowdown.
Needless to say, all of the above is quite subjective. At
least from Compaq's perspective, however, the good news is: it
doesn't much matter. The difference in the gross margins the
company earns on sub-zero and higher priced Presarios is so
small that the sub-zero market should remain a value creating
proposition for it even if the first-time buyers market were
to completely disappear. |
