Hiya NW & thread,
Here is a report gleaned from Montgomery Securities.
I have highlighted some of the interesting areas:
eMachines: Revolutionary or the Next Packard Bell?
09:48am EDT 3-May-99 Montgomery Securities (K. King)
Highlights
o The ascendance of eMachines and other new players at sub-$500 price points
is a new source of investor concern.
o The real changes so far are chiefly within the retail consumer channel.
This environment should only get tougher later this year as the big
indirect vendors accelerate plans to hit lower price points. Importantly,
retail is only about 23% of U.S. PC sales. Observers often make the mistake
of viewing retail as a surrogate for the overall market.
o Falling consumer PC prices will increase the importance of alternative
revenue streams from consumers (Internet access, peripherals sales,
consumer financing), leading the indirect vendors to focus even more on
direct sales to consumers in order to capture the add-on business.
o Our product assessment shows the eMachines $399 system to be a good box for
the price. Its price advantage over the big brands appears consistent with
its trade-offs in features, quality and warranty/service -- nothing
revolutionary and nothing that can't be replicated.
o We view eMachines' industry implications as similar to those of Packard
Bell in the early-/mid-1990's -- a bit of a growth catalyst, but, more
importantly, a source of added pricing pressure on retail shelves. As
usual, we expect the bigger names to prevail over new competitors through
scale and brand advantages. First mover advantages are negligible when
they're based on price.
o There's no change to our expectations for the larger, more lucrative
corporate market as a result of the new entrants. Consumer-oriented
business models generally aren't exportable to corporate, and budget-
constrained corporate customers are already well served by low-priced white
box vendors.
o We expect PC industry revenue share to continue consolidating around the
four large PC server vendors -- CPQ ($22, BUY), DELL ($41, BUY), HWP ($79,
BUY), IBM ($209, not rated) -- and those with the best marketing and
execution engines, most notably GTW ($66, BUY) and, again, Dell.
o No change to our company models or our 1999 industry forecast of 14% unit
growth and 7% revenue growth, which has held steady for about a year.
o Inside this report we assess the new low-cost PCs in detail, examine these
new price points in the context of the overall PC market and address stock
implications.
Overview -- It's Not the End of the World As We Know It
New entrants driving cheaper PC price points has re-emerged as an investor
concern. The recent emergence of eMachines and several free PC offerings
have created new concerns about worsening industry fundamentals. The PC market
is clearly dynamic -- we saw similar concerns at the time of HP's aggressive
entry into the consumer market in 1995, the initial touting of network
computers late that same year, and the arrival in the U.S. market of several
price-aggressive Asian PC makers in 1996. The point is that the strongest, most
adaptive companies have continued to succeed despite a tough environment, which
we expect to remain the case. As we've shown previously, company performance
can deviate radically from industry performance in fragmented, consolidating
industries. The best example is Dell, whose revenue growth actually accelerated
between 1996 and 1998, the same period in which industry revenue growth slowed
from 20+% to near-zero.
It's the consumer market where the new vendors matter. eMachines and the
various free PC-type offerings have so far targeted the consumer market,
segments of which are very price sensitive and otherwise haven't seen branded
PCs priced below $700 or so. Consumer retail shelf space is currently dominated
by Compaq (CPQ, $22, BUY) and Hewlett-Packard (HWP, $79, BUY), and to a lesser
extent by Packard Bell, NEC and IBM ($209, not rated). eMachines quickly gained
retail shelf space last November and has since sold out at least its first two
quarters of production by offering a $399 box, without monitor and after a $75
rebate. The initial free PC offerings from FreePC.com, InterSquid and others
have garnered lots of media attention but have involved limited unit
quantities, more akin to beta tests than actual market entries. We are like
many observers in viewing eMachines as a serious market entrant and the free
offerings more as doubtful experiments in the ability to offset hardware costs
with ISP bounties and the sale of advertiser access to end users' display
screens or personal data.
We think the threat to the traditionally well-positioned vendors is less
than generally perceived. The downward consumer price trend reinforces the
importance of success in the enterprise business and outside the U.S. for the
PC industry's winners. It's been clear for the last several years that the high
growth, high margin enterprise business (PC servers, server add-ons and
services) can provide insulation from the relatively poor fundamentals of the
desktop PC business, particularly consumer. Server-related areas have been and
will likely remain the domain of Compaq, IBM, Hewlett-Packard and Dell (DELL,
$41, BUY) who today account for roughly 75% of the PC-based enterprise segment
and continue to consolidate share. The NT upgrades due this year and next
should help sustain the strong historic trends in enterprise. More broadly, we
believe the most attractive segments for vendors will be international markets,
the higher-growth, higher-margin server, workstation and notebook segments,
and, within the desktop arena, sub-$1000 PCs, add-on sales and recurring
revenue streams.
Industry Implications of New Low Cost PCs -- It's Mainly a Consumer Thing
Opening up lower-income consumer segments is the most important implication
of the new entrants. More first-time buyers and multiple PC households will
help sustain high industry unit growth rates as well as industry ASP pressure.
A state-of-the-art PC has effectively been a luxury item to the lower half of
the income distribution, where a $1,000 box could account for over 20% of the
disposable income for a family earning $30,000. This has constrained the level
of PC penetration to about 43% of U.S. households, hindered purchases of second
and third PCs in families where web-cruising could displace TV viewing and
precluded PC purchases by a large segment of the student population. These
issues are even more pronounced in most international markets, where disposable
income levels and PC penetration rates are significantly lower than in the U.S.
The $400 price point arrived last holiday season, roughly 53% below 1996's low
point and 43% below 1997's.
It's safe to assume the new entrants have accelerated price erosion in the
consumer segment, at least for the near term. It's hard to quantify, but we
have to believe the recent dip in entry-level consumer price points has had the
effect of ratcheting down higher-end customers to some extent. However, entry-
level prices have been falling steadily for about the last three years.
Therefore, lacking data, we assume the incremental effects of the new entrants
on the overall pricing trend to be minor rather than profound. We believe the
effect on the largest retail vendors, most notably CPQ and HWP, has been to
pull in their low-end product road maps by a quarter or two.
We don't expect changes to the previous trends in the corporate market.
Consumer-oriented models generally aren't exportable to corporate. The most
obvious differences are the corporate market's distinct, technically-
sophisticated distribution channels and the ability of customers to negotiate
large price discounts, which means even the biggest brands are already cheap --
note than no one views the business market as significantly under-penetrated.
More subtle is the tendency of corporate buyers to value total cost of
ownership, which benefits from big brands' service/support infrastructures
and is hindered by cheap boxes' lack of network certification and tendency to
interchange components. Otherwise, to the extent there's room to under-price
the big brands, the corporate market already appears well-served by the
thousands of white box makers. History shows that new corporate entrants moving
over from the consumer market, even with sizable consumer market share, are
more or less starting from scratch. This is evidenced by the difficulties of
Packard Bell and even Gateway (GTW, $66, BUY) in building corporate market
share.
Assessing the Products -- You Get What You Pay For
Adjusting for features and service, Hewlett Packard's and Compaq's low-end
consumer boxes are more competitive than generally perceived. We expect even
lower price points from these companies in the second half. Hewlett Packard and
Compaq today offer entry-level boxes priced at $599 and $719, respectively.
While nominally priced 50% to 80% above eMachines' $399 offering (post-rebate),
we find the deltas to be easily explainable by differences in features,
component quality and warranty/service. Most notably, the Hewlett Packard PC is
based on a more powerful and much more expensive Intel processor and features
twice as much memory; it compares quite favorably with an eMachine based on the
same processor, at only a 9% price premium (post-rebate and with a 15
monitor). The Hewlett Packard and Compaq PCs also both offer on-site service
and larger hard drives and monitors than the eMachine. We expect Hewlett
Packard to offer a new Pavilion PC at a $499 price point during this year's
back-to-school season and expect Compaq to follow with something similar during
its fourth quarter.
EMachine Compaq Hewlett
Packard
Price (post rebate) $399 $599 $719
Price (with 15" $549 $704 $819
monitor, post rebate)
Processor 333MHz Cyrix 333MHz Cyrix 366MHz Intel
MII GX MII GX Celeron
Memory 32 MB 32 MB 64 MB
Hard Drive 2.1 GB 4.0 GB 6.4 GB
CD-ROM 24X 24X 32X
Speakers Low end Premium Premium
Warranty Service Mail-in / 90 day on-site1 year on-site
Replacement 1 year carry-
for 1 year in
Technical Support by 7x16 for 15 7x24 for 1 7x24 for 1
Phone days year year
from first
call
Software MS Works MS Works MS Works
MS Money MS Money
Quicken Basic Quicken Basic
MS Encarta MS Encarta
MS Word MS Word
misc. other misc. other
Evaluating the eMachines product -- not a bad deal if the dollars really
matter. We enlisted the expertise of our desktop engineering department to
disassemble and evaluate a $399 (after $75 rebate) eMachine PC and $100 eView
monitor. As expected, we found the eMachine to be quite satisfactory given its
price; the only truly critical thing missing from the system we purchased was
the $75 rebate coupon! Note that eMachines takes $50 out of the price of a
total system by offering a 14 monitor, versus Tier One vendors' minimum
offering of 15 monitors. Price notwithstanding, we found the eMachines system
to be something of a mixed bag, with such positives as cables color-coded to
ports and some high quality, name-brand components installed alongside somewhat
low quality CD-ROM and floppy drives and low-end external speakers. Overall, we
would gladly recommend an eMachine to the truly budget constrained buyer. The
trade-offs are straightforward, namely lower performance and quality and more
limited features, service and phone support than is currently available at the
higher Tier One price points.
Outlook -- Think Revenue, Not Units
Going forward we should measure PC companies by revenue growth, not unit
growth. The arrival of lower consumer price points reinforces this notion. The
onset of heavier industry ASP pressure in 1996/1997 has led vendors to tout
unit growth and downplay revenue growth in their public communications. This
can lead to some overly optimistic conclusions when vendors achieve unit growth
and corresponding market share gains primarily through penetration of
progressively lower consumer price points. The sale of, say, a $50,000 server
at 40% gross margin should obviously be valued by investors differently from a
$400 PC sold at 10% gross margin, even though unit growth numbers reported by
vendors miss this distinction. Note the difference below between Dell, whose
growth has been strongest in its enterprise segment, and Apple, whose recent
share gains have come mainly from the consumer market.
(most recently reported
quarter) Apple Dell Compaq Gateway
Revenue Growth (y/y) 9% 38% 66% 22%
Unit Growth (y/y) 27% 55% 26% 31%
ASP Change (y/y) -13% -10% 11% -7%
% of Revenue from 36% 15% 15% 35%
Consumer
The arrival of 'fat pipes' into the home is the best hope for ASP
stabilization, although we're probably a year or more away from the benefits
becoming material on an industry level. Broadband links allowing, among other
things, real-time video and easy access to large data files generally aren't
yet available to consumers lacking thick wallets and/or the correct home
location. The accelerated adoption of DSL and cable modems we're likely to see
in the U.S. over the next two years will lead to increased data flows, feeding
demand for more robust PCs than those currently purchased to cruise the web
through snail-like 56.6k modems. Bigger pipes will almost certainly accelerate
upgrades within today's consumer installed base, particularly those 486 and
Pentium-based boxes bought at $2000+ price points in the mid-90's.
Generating alternative revenue streams is the key to success within
consumer. Most attractive is attaching Internet access to the PC sale.
Depending on a vendor's hardware margin levels, gross profits from attaching a
year of Internet access are the equivalent to an extra $200 to $600 in PC
selling price. In addition, attaching add-on sales (peripherals, software,
financing contracts) can add hundreds dollars to a sales ticket, although
vendors will generally miss this opportunity if they're not selling direct.
Dell and Gateway each recently announced programs intended to drive add-on
sales to multiples of their previous portions of revenue mixes.
Despite a delayed pursuit of the lowest price points, the big brands will
win at the end of the day. There's little 'first mover advantage' to new
entrants differentiated by price. Given the biggest vendors' huge scale
advantages and ability to commandeer retail shelf space, we're confident we'll
see the same consolidation at the lowest consumer price points we've already
seen in every other price band. We recall Packard Bell just five years ago
holding about a 40% share of the retail market, prior to an onslaught by HWP
and CPQ. Although Packard Bell has never been consistently profitable, for the
last three years it has struggled to keep its doors open with the help of
funding from NEC, its corporate parent.
Implications for Vendors and Their Stocks
Implications vary by vendor. As usual, the direct model appears best
positioned. Packard Bell appears most vulnerable. More important than overall
market trends is the business model and target market of the individual vendor.
Our take:
o Packard Bell NEC (private) -- Most vulnerable, in the cross-hairs of the
new entrants. Packard Bell's traditional franchise is the first-time,
price-sensitive buyer, the top candidate for a new eMachine or anything
else with a low price tag. Packard Bell has been on shaky ground since
Compaq's and HP's consumer groups began pushing down-market in 1996.
o Dell -- Least vulnerable, most in control of its destiny. Consumer is
only about 15% of Dell's business. Within consumer, Dell has mastered the
art of using direct customer relationships to segment out the most
sophisticated, high-budgeted buyers and therefore has the most
profitable, highest ASP consumer business in the industry. Dell recently
disclosed plans to begin pursuing sub-$1,000 consumer sales, but
initially only at high triple-digit price points, and only at attractive
profitability levels. We think Dell's consistent 60%-80% unit growth rate
in consumer over the last two years is sufficient evidence there's little
defensive about Dell's current strategy. To the contrary, we view Dell as
methodical in moving gradually to lower price points as improved
efficiencies and product mixes allow stable operating margins.
o Gateway -- The savviest consumer marketer; absent from retail channels.
Gateway's position is not bulletproof given its heavy reliance on the
consumer market broadly defined. But the company still benefits from the
ability to segment customers and up-sell low-end customers to higher
price points. The company says only about 10% of its unit sales are below
$1000 currently, reflecting the fact that the most budget-constrained
consumers tend to shop other channels. The direct model allows Gateway to
aggressively pursue add-on sales (as evidenced by its YourWare program)
which should cushion ASP pressure going forward.
o Compaq, HP and IBM -- Forced to react to lower retail price points; this
is negative but exposure can be offset by other businesses. We believe
each vendor has accelerated its plans to hit lower consumer price points,
which should couple continued high unit growth with sustained ASP
pressure going forward. It's clear these vendors, particularly Compaq and
HP, will accept cannibalization of their higher price points over losing
share to new entrants. Consumer PCs are about 15% of CPQ's revenue and
closer to noise level for HWP's and IBM's overall businesses, meaning
more competition at the margin within consumer PCs is probably not
material to these companies' earnings outlooks.
o Apple -- Directly exposed to downward retail price trends, making
sustainable revenue growth even tougher; proprietary platform provides
some insulation. The Mac clearly doesn't exist in a vacuum, especially
given the importance of new consumers to Apple's long-term growth
strategy. Accordingly, it's not clear to us how Apple can escape the kind
of ASP pressure that last quarter led to 27% unit growth but only 9%
revenue growth against an easy comparison.
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