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Indirect computer dealers struggle

If Wall Street's view is any indication, direct PC retailers such as Dell may have a better business model than indirect sellers like Compaq.

Who has the better business model: indirect PC sellers like Compaq or direct retailers such as Dell?

If Wall Street's view is any indication, it's not the indirect model, analysts say. Indirect PC sellers essentially sell to retailers, which sell to consumers. Direct sellers sell direct to consumers.

Of the 10 worst-performing tech stocks of 1999, three are companies that distribute or resell computers and peripherals, and two are component manufacturers that sell through distributors and dealers.

Moreover, distributor Inacom this week laid off 1,000 employees, capping off a year of disappointment for computer wholesalers, dealers and PC makers, such as Compaq Computer, which sell through indirect channels.

Typical indirect PC companies depend on a complex supply chain that is more costly than direct competitors, such as Dell Computer. Whereas Dell builds systems to order, indirect manufacturers largely still build according to forecasted demand for systems so they can stock dealers' shelves. The method is less efficient and generally means less profit per PC, particularly if PC makers have to take products back or compensate dealers for price cuts.

And things are likely to get a lot worse before they get any better, analysts say.

A year ago, dealers and indirect PC companies often brushed off the success of Dell and other direct PC manufacturers, but now the denial is over, said Jeff Matthews, general partner in Ram Partners, a Greenwich, Conn., investment firm.

"What was interesting about the Inacom conference call was that the [dealer] channel is accepting the inevitable," he said. "The Inacom guys said it: 'This model doesn't work.'"

Falling hardware margins are biting every area of the distribution channel, from PC makers to dealers. Compaq, for example, is so inefficient that its operating margin on commercial PCs was -6.3 percent during the third quarter, said Technology Business Research analyst Lindy Lesperance. By contrast, some PC makers claim margins in the double digits.

Lesperance estimates Dell's costs are half of Compaq's on every PC it builds. And unlike Compaq, Dell doesn't deal with costly excess inventory. Compaq, for example, ended the third quarter with nearly four weeks' worth of inventory vs. just a few days' worth for Dell.

Compaq's troubles illustrate the growing problem facing PC makers largely dependent on distributors and dealers to get their products to market. While Compaq has set a goal of moving to 40 percent direct sales next year, the transition is likely to hurt the Houston-based PC maker, something it acknowledged last month in a filing with the Securities and Exchange Commission.

The 10-Q filing notes that "the market for personal computers has shifted from sales through [dealers] toward direct sales to end users" and that "direct sales frequently present a more efficient business model."

The filing warns, "Compaq has not kept pace with changes in the industry's sales and distribution model and does not currently have in place processes for order entry, production of individualized units and direct distribution that can operate efficiently to manage a large portion of its current personal computer sales."

Besides other supply-chain changes this year, such as building more PCs to order, Compaq reduced from 39 to four the number of distributors it uses--indicating the company's move toward a more direct model.

As Compaq and other indirect manufacturers follow Dell's lead, distributors and dealers are left with little maneuvering room. Ingram Micro, the world's largest distributor, saw its third-quarter profit drop by 71 percent. The news compounded earlier quarters' dismal performance.

"There's not a lot of margin left in hardware sales, and what's left the vendors are trying to keep for themselves," Lesperance said. "They need to evolve their business models, and the obvious solution is higher margins and services."

Dell, which built its business on moving boxes cheaply to customers, is increasingly adding services to boost its bottom line.

Computer dealers mistakenly believed that because of their direct relationship with customers, they didn't need to worry about Dell, said analysts. Many customers, it turns out, want to turn to one source for low-cost hardware and services.

"A year ago, the [direct] enemy was very far off, sort of on the horizon," Matthews said. "Now the enemy is going through the camps, swarming over the campfire. And the [dealers] are the ones sleeping around the campfire, running around trying to pull their pants up and find their guns. But they can't find them."