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PC prices, profits on the way down

Personal computer prices will drop during the second half of the year, and there's a good chance that profits at the main manufacturers may too.

Personal computer prices will drop during the second half of the year, and there's a good chance that profits at the main manufacturers may too.

Compaq Computer (CPQ) will follow the lead of low-cost leaders Dell and Gateway 2000 by rolling out its first Deskpros made under the new Optimized Distribution Model, a collection of manufacturing techniques that promise to slash street prices by an average of about 15 percent.

A Compaq Deskpro 2000 desktop PC with a 166-MHz Pentium, for example, will now sell for $999, about 16 percent less than the equivalent computer did yesterday. On Monday, a Hewlett-Packard desktop PC with a 233-MHz Pentium II processor will drop to $2,040, a surprisingly low price for a Pentium II system.

Indeed, HP has responded to Compaq's price cuts with equivalent reductions across its Vectra line, while analysts and executives expect companies like IBM (IBM) and Dell Computer (DELL) to follow suit.

This is leading not only to lower prices but possibly lower earnings for PC manufacturers. "We're starting to see downward pressure on gross margins," said Ashok Kumar, an analyst at Southcoast Capital. "Eventually, you are going to get weak comparison earnings."

While seen as a price war on the consumer front, the battle brewing between the manufacturers could also be called an operations war. Current and future improvements in back-room operations have allowed manufacturers to undercut each other in retail price.

Compaq's newly announced Optimized Distribution Model, a two-year systems overhaul that combines a variety of build-to-order manufacturing techniques, was designed to allow the company to catch up with Dell.

"Dell will probably adjust over time to find a 5 percent price delta over Compaq, where it will settle in," said Mike Winkler, senior vice president of the PC products group at Compaq.

"HP is right around us, [but] they did their price cuts without new products or efficiencies. There isn't a heck of a lot of margin. IBM will have to come down," Winkler said.

As reported last night by CNET's NEWS.COM, HP will cut prices from 15 to 25 percent across the Vectra PC line Monday. The price cuts span the entire Vectra line, including high-end machines containing Pentium II processors and lower-end models with Pentium processors.

One Vectra, for example, with a 266-MHz Pentium II, after the price cuts, will sell for around $2,770, according to sources at HP. A Vectra VE with a 166-MHz Pentium will drop to about $1,000, the company confirmed.

Interestingly enough, while other manufacturers may now be playing catch-up, Compaq is claiming that the operations battle between the two Texas companies has already ground out. "Our cost structure is as good as Dell's in distribution and better than Dell's in manufacturing," he said.

The top-tier companies that may be affected the most are HP and IBM. HP has not fully implemented a build-to-order strategy, although sources indicate that the company will come up with such a plan later this summer.

IBM, on the other hand, has tried to compete by starting a "channel assembly" strategy, a practice under which the manufacturer ships components to resellers for final assembly.

"We will not do channel assembly. It's the worst of the options. There is no economy of scale and no flexibility," Winkler said.

Traditionally, higher growth rates have gone hand in hand with price cuts. Therefore, moves to increase market share by dominant manufacturers will likely fuel more prices cuts.

"I would not be surprised if all this causes a bubble of growth in the second half of the year," said Charles Smulders, a senior analyst at Dataquest. "The second- and third-tier manufacturers will be the ones affected the most."

And, while manufacturers generally deny that they would reduce gross margins, Kumar and other investors said that higher-level manufacturers can reduce the margins they need to recover on desktops by making it up on higher-end products like servers and workstations.

Which, again, will still not likely stop the trend.

"It's going to hurt their earnings for a while," said Peter Jackson, chief executive officer of Intraware, who gave up a position at a large hardware reseller to start his own software company last year. "If I had stock in some of those companies, I'd sell it right now."