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Technology Stocks : Compaq -- Ignore unavailable to you. Want to Upgrade?

To: Night Writer who wrote (62160)	5/27/1999 3:18:00 PM
From: Aitch	Read Replies (2) \| Respond to of 97611

Hi NW, Victor, K, El et al, I notice you guys keeping the thread warm <g> Here's something to stoke the flame: H PC Hardware: Margins Could Be Squeezed As Consumer Prices Fall 07:29am EDT 27-May-99 Merrill Lynch (S. Milunovich / K. Campbell) Investment Highlights: o Our view has been that PC unit growth is good, but pricing will be cutthroat over time. The advent of the "affordable PC" should put pressure on traditional vendors. o We now suspect that consumer unit growth may slow and prices could come down more aggressively. Vendor margins could suffer. o Compaq may get hurt if this trend plays out given that about 30% of its PC sales are to consumers. HP and IBM could suffer but less so. Dell is vulnerable, but we see its superior direct model as an offsetting positive. o Profits in the computer industry are moving above and below the PC. Fundamental Highlights: o Our Hard-line Retail analyst Peter Caruso believes that consumer PC unit growth is peaking based on comments from Circuit City. We expect that unit growth will remain solid but may slow from rates above 30%. o Emachines is being joined by other "affordable PC" sellers in the $400-600 range; these systems are flying off of shelves. o We expect another round of price cuts to come in consumer PCs. Consumer PC gross margins could get squeezed with component prices likely to firm in the second half. Merrill U.S. retail analyst Peter Caruso believes that retail PC unit growth is peaking, with the exception of emachines and the new sub-$500 category. According to IDC, consumer desktop unit growth was over 30% in 1Q though revenue growth was flat to slightly down. We expect that unit growth will remain solid but may slow from rates above 30%, and pricing will be cutthroat over time. The advent of the "affordable PC" should put pressure on traditional vendors' consumer PC margins. Emachines is being joined by other "affordable PC" sellers in the $400-600 range; these systems are flying off of shelves. The question at hand is whether a new application or technology such as broadband access will come soon enough to spark significant high-end sales. If not, the next wave will likely have to be driven by the proliferation of the new sub-$500 market segment. We believe retailers aren't hurt by lower PC prices since they can more easily sell higher-margin software, service or financing offerings for the same total ticket price. Direct vendors such as Dell and Gateway reap the same benefit acting as their own retailers and have focused heavily on sales around the box. Indirect vendors do not have the same ability to capture these incremental revenues since they go through the retailer. Hewlett and to a lesser degree IBM proved this past quarter that they can make money with their current cost structures in the current environment. Compaq, on the other hand, is not in as good shape. While its consumer sales have been strong, Compaq's overall cost structure can't yet handle lower PC prices. We worry that while Compaq is playing catch up to the current environment, that pricing will again move to quickly in front of Compaq's strategy. Compaq and other indirect vendors are able to capture an annuity from the portals and access providers they direct new users to. However, the retailers may soon be competing for these dollars as well. We do expect another round of price cuts to come in consumer PCs. With component costs declines moderating, this raises the issue of where who takes the gross margin hit. Now that microprocessor prices are down to about $100 from $200, the incremental 10-15% decline in ASPs does less for the end-user price cut. Similarly, even if DRAM prices weren't firming (at about $5.00-5.50 for 64 MB), further declines would be immaterial to end user price. LCD panel prices have actual increased due to constrained supply. The retailers make very little money on PC hardware (single-digit gross margins at best) and have essentially no more margin to give up. Instead, vendor consumer PC gross margins could get squeezed. Compaq may get hurt if this trend plays out given that about 30% of its PC sales are to consumers. HP and IBM could suffer but less so, with consumer only about 20% and 10-12% of total PC sales, respectively. Dell is also somewhat vulnerable, with about 15% of sales going to consumers, but we see its superior direct model as an offsetting positive. New low-end offerings from wannabe vendors could alleviate low-end supply problems and increase pricing pressure. Emachines' supply is constrained, with most retailers on allocation. However, new entrants Mitsuba, Future Power (backed by Korean conglomerate Dae Woo), and AST will start making cheap PCs to compete with emachines. Mitsuba has begun shipping to regional chains using the "Xtreme" brand name with prices from $399-999. AST already has a $599 PC and will introduce a $999 notebook soon. CTX will start a new campaign this summer with a $499 PC and a higher-end PIII bundle for $1,199. Future Power will sell low-cost PII and PIII PC lines while counting on the customer service and expertise of small local dealers to drive sales. As of yet, vendors haven't indicated a slowdown. Compaq has said its 1Q consumer business in the Nordic countries and in Japan took off. Gateway also has been very strong consumer demand in Japan. Gateway, with about 58% of total sales going to consumers, is not seeing more than the normal June quarter slowdown and indicated that April and May are right on plan. It also pointed out that its Your:)Ware program is very popular with low-income buyers, typically used to making monthly payments on large purchases. Hewlett indicated that its consumer PC growth was accelerating. However, at this point it is hard to tell whether this is from market share gains or overall market growth. On a positive note, international PC and Internet penetration rates are much lower than in the U.S., leaving more room for continued growth. According to IDC, while the U.S home PC penetration rate hovers over 50%, Japan and most countries in Western Europe are in the 20's. Asia Pacific is a miniscule 1%, and Latin America and Rest of World are about 3%. (We acknowledge the accuracy or even relevance of trying to count the number of households in many third world countries when it comes to PC penetration, but we believe this underscores our point that the total number is low.) Internet will likely drive overseas consumer PC growth, but the cost and ease of getting online will have to be addressed. For example, in the U.K. local phone access charges are metered rather than a flat rate per call or per month, hampering addictive online behavior. (On this note, we believe the Palm VII's metered monthly wireless access fee will be less popular than Research in Motion's all-you-can-eat monthly fee). However, Hewlett does believe there is a large growth opportunity in the U.K. consumer market and has just committed to a new UK direct initiative for Pavilion consumer PCs.