Shakeout Could Be on the Way for the PC Industry

The annals of auto manufacturing are filled with legendary but long-departed names: Studebaker, Duesenberg, Packard and Rambler. As the personal computer industry endures one of its toughest periods, experts are beginning to wonder whether the PC graveyard might soon include such names as Gateway, Compaq or even IBM.

If PC sales to consumers and businesses continue to deteriorate as sharply as they have over the last several months, the industry might ship fewer desktop computers in 2001 than it did last year. That would mark the first time the industry has experienced negative growth year-to-year since PCs hit the marketplace two decades ago.

Such a slump would leave it with so much oversupply, analysts say, that a Detroit-like shakeout of laggard companies might be inevitable. “The music’s stopped and it’s time for someone to leave,” said Andrew J. Neff, technology analyst for Bear, Stearns & Co.

It is unclear how a wave of PC mergers or withdrawals might unfold. “Everyone thinks it’s the other ones that should go,” Neff said.

Facing the greatest risk, in Neff’s estimation, is Gateway Inc., which ranks fourth in the nation for PC sales with about 9% of the market, according to International Data Corp. The San Diego-based firm, which lost $502.9 million in the first quarter of 2001, is the most vulnerable of the leading PC makers to the downturn in consumer spending in general and to the U.S. economic slowdown. (“Our recommendation: Look for potential acquirers now,” Neff wrote in January.)

“If the company’s for sale, I’m not aware of it,” responded Bart Brown, senior vice president for consumer sales at Gateway.

Neff also believes that IBM Corp. should exit the PC business, in which its 6% market share trails the other major manufacturers, and that at least one other merger in the industry should take place.

Though PC executives disagree with some points of Neff’s analysis, many observers expect an old-fashioned shakeout in the industry.

The reason is the sharp slowdown in sales of personal computers that began in 2000 and is expected to continue through this year. Although analysts expect as many as 165 million desktop PCs, notebooks and workstations to be sold this year, that’s a scant 3% more than the 160 million sold in 2000.

PC makers, accustomed to double-digit annual growth, are responding with a wave of retrenchments that include layoffs of thousands of workers. Since Jan. 1, Compaq Computer Corp., Dell Computer Corp. and Gateway, which have a combined 46% of the domestic PC market, have announced they will shed 9,700 workers here and abroad. Such once-familiar second- and third-tier brands as Packard Bell, EMachines and Micron either have abandoned the U.S. market or are fading fast.

“The PC industry is already shrinking,” said Michael Dell, chairman and chief executive of Dell Computer, in a recent interview. “It’s just not happening by merger and acquisition.”

And the process may be just starting. Analysts believe that the PC industry is about to enter a period of ferocious price-cutting that will slash profits to the bone as the largest companies strive to expand their market share at the expense of their rivals. The goal is to be stronger, or at least still be standing, when consumer and corporate PC purchases pick up again.

“We’re planning on taking share by pricing very aggressively and sacrificing our gross margins,” said Gateway’s Brown. “Dell has said they’re going to fight the share game too. The bottom line is, it’s a great time to buy a PC.”

PC Market Resembles Detroit of Old

If Brown sounds like a car salesman anxious to seal a deal, that is not surprising. The state of the PC industry resembles the Detroit of more than half a century ago, before a wave of consolidations and bankruptcies pared it down to three major domestic manufacturers (one of which, Chrysler, is controlled from abroad) and a handful of foreign companies.

The PC market is highly fragmented, with five large companies--Compaq, Dell, Gateway, Hewlett-Packard Co. and IBM--accounting for roughly 65% of the U.S. market. Most of the rest of the market belongs to so-called white-box computers, which are unbranded, generic units made by small-scale manufacturers or assembled at home.

Just as the auto makers have had to struggle through times of overcapacity, the potential supply of PCs today exceeds demand. And the price-cutting certainly is a familiar phenomenon to the auto industry: In the 1970s, Japanese auto makers became famous for cutting profit margins to secure market share in the U.S.

Of course, there are major differences between the two industries. It’s expensive to build an automobile factory, which also requires a skilled labor force. By contrast, PCs can be assembled by unskilled workers overseas, in mom-and-pop storefronts in the U.S. and by reasonably handy hobbyists at home. Automobile brands tend to be structurally and technologically distinct from each other, but most PCs are standardized, with one brand similar to another once the beige case is opened.

“The products are largely undifferentiated and the [profit] margins are slim,” said Dean McCarron, components analyst at Mercury Research. Over the last three years, Dell, Gateway and Compaq combined averaged only 5 cents in profit for every $1 in sales. To keep production costs low, most major PC companies outsource their manufacturing to generic factories in Latin America, Asia or Eastern Europe and use standardized parts.

This may explain why there has been no major merger in the PC industry since 1998, when Compaq bought rival Digital Equipment for $9 billion. As it happens, Compaq found it harder than expected to extract gains from the merger of two disparate corporate cultures, further discouraging similar deals. Its stock has fallen more than 35% since the acquisition, a period in which the benchmark Standard & Poor’s 500 index has risen a cumulative 6%.

“We’ve looked at many possible purchases and combinations,” Dell said, “and concluded they don’t make a lot of sense unless we can buy assets cheaper than we could build them.”

Self-Made Billionaires Take the Lead

Although Apple Computer Inc. and IBM created the PC industry, they have been leapfrogged by aggressive self-made billionaires such as Dell. A college dropout, Dell, 35, started his firm with $1,000 in 1984. And even with his company’s stock selling at less than half its record high, he is worth $12 billion.

Another PC billionaire is pony-tailed Ted Waitt, 38, who started Gateway in an Iowa farmhouse. His cows-on-boxes ad campaign caught on and Gateway hit $9 billion in sales last year. Unlike Dell, Gateway spent heavily to set up a retail store chain. But facing slowing sales and growing losses, Waitt in January replaced several executives and took over as chief executive.

Analysts say fragmentation of the PC market places a limit on the industry’s ability to raise prices and fatten profits. One problem is that the natural three- to four-year cycle of corporate computer replacement was reset by panic over the Y2K bug. Because companies spent heavily to ensure that their systems were Y2K-compliant, “Surprise, surprise: In 2001 no one’s buying,” said Martin Reynolds, PC industry analyst at Gartner Group/Dataquest.

For consumers, meanwhile, the power of the newest computers finally exceeds what is needed for the most popular applications. PC owners who used to grouse that their new computers were made obsolete by the latest Intel Pentium chip almost before they got them unpacked are now finding that last year’s chip will do just fine for years.

“For e-mail, Web browsing and homework, you don’t need a Pentium 4,” said Anne Bui, analyst at International Data Corp.

To handle popular Web applications such as downloading music or video from the Internet, the important factor is the speed of an Internet connection, not the speed of the computer, Bui noted.

In any event, the most profitable segment of the consumer market is largely saturated, with at least one PC in 53% of all American homes. Bringing the remaining households to PC ownership will be a much harder sell, analysts say.

“Our advice to clients is to get out the ladders, because the low-hanging fruit is gone,” said Roger Kay, PC analyst at IDC.

Consumers who don’t own PCs tend to be those who are waiting for prices to fall further or who are resistant to the lure of the digital world. Kay said he has abandoned his original expectations that PCs would eventually reach more than 95% of all homes, like televisions and telephones. “Now we think some people will never get a PC.”

Because of these factors, U.S. sales of desktop and notebook PCs and low-end servers--the computers used by businesses--are expected at best to rise by a meager 2.2% this year compared with 2000. That’s in contrast to market growth last year of 23.8% from 1999, according to IDC.

The year-to-year statistics may mask a darker trend. One survey of consumer electronics sales during the last holiday season showed desktop PC sales dropping 6.4% from the same period in 1999. Instead, consumers spent their gadget budgets on more novel devices such as the new personal video recorders (up 300% in unit sales during the holidays, according to NPD Intelect) and Palm-type personal digital assistants (up more than 200%).

This changing market presents almost all the major PC companies with strategic quandaries. The exception may be Dell, which has a hoard of $7.9 billion in cash--more than Hewlett-Packard, Gateway and Compaq combined. Dell, which sells computers mainly by direct marketing over the Internet and by phone, can afford to pursue its strategy of relentless price-cutting, which allowed it to expand its domestic market share to 22.3% last year from 16.9% in 1999, lengthening its lead over Compaq in the U.S.

Dell’s rivals say they offer unique strategies that will enable them to weather the slowdown. Compaq, for example, says it offers technologies that will transform its PCs from generic home and business appliances into “hubs” that will allow users to remain connected with their homes and offices at all times.

“There’s going to be a whole additional market for ‘access’ appliances like wireless phones, digital cameras, global positioning services,” said Michael Winkler, executive vice president of Compaq’s global business units. “These are extensions of what the PC was in the past.” These services, he said, will rise to 25% of Compaq’s revenue from their current 15%.

Winkler said there are hidden limits to Dell’s potential growth as long as the company sticks exclusively to its direct-sales model.

“Less than 40% of [the] market buys direct,” he said, “and the pundits don’t believe it will ever be more than 50%.”

Multiple Outlets to Remain Competitive

In the increasingly competitive PC market, Winkler said, manufacturers will have to sell their machines through all available channels--direct as well as via retail stores, as Compaq does. That’s especially true as people spend more of their money on wireless devices and hand-held appliances, which they prefer to handle in the retail shop and bring home for instant gratification.

Hewlett-Packard, meanwhile, said it expects to retain its solid No. 3 position in the U.S. and abroad and has no plans to withdraw from the PC market. One reason is that HP believes it needs to offer the entire range of equipment and services any large customer requires--a strategy also pursued by IBM.

In the end, however, chances are the PC industry will be confronting the same growing pains as other mature industries over the decades. “We don’t think the PC industry is bad,” Neff said. “It’s just growing slower. It’s the same thing that happened to airlines, steel and the railroads.”

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PC Market Share

The personal computer market is highly fragmented, with a handful of leading vendors and a multitude of small competitors.

Source: International Data Corp.

Unmerry Christmas

Purchases of desktop PCs slumped in holiday buying last year as newer and handier devices corralled shoppers’ dollars.

Source: NPD Intelect