Cheap computers: A scary business

If Compaq's example holds for the rest of the industry, computer vendors can turn a profit in the bargain-basement market, but they probably can't do it forever.

The underlying effects of the sub-$1,000 computer were once again brought into relief by the Houston vendor's tepid second-quarter financial results, reported yesterday.

Compaq said that its most profitable computer for the quarter turned out to be an $899 Presario, as total PC unit sales jumped 36 percent worldwide. But the surge in sales produced flat product revenues of $5.4 billion.

CNET Radio talks to reporter Michael Kanellos

Thus Compaq--and the rest of the computer industry--faces the nagging worry that the low-cost PC is still largely an unknown quantity in the revenue-profit equation. In other words, it is not clear how much low-cost computers can contribute to the bottom line, even though they make up an increasing proportion of sales for all PC makers across both consumer and business lines.

To be sure, PC prices continue to drop because of component declines, but the reductions are also being fueled by an expectation of ever-decreasing price points. To make up the difference in gross margins, vendors will have to cut costs, expand into other markets, and boost volume.

"It doesn't take a brain surgeon to see that at $899 you'd better be selling a boatload of them," added Asif Hudani, president of NovaQuest InfoSystems, a large reseller in Southern California.

"The good news here is that sales are growing at a healthy rate. Compaq is looking good for the second half," said Scott Miller, an analyst at Dataquest.

But, he added, "in the long run, revenue growth is what matters. Unit growth in a stable pricing environment is great to track. In a declining price environment, you have to look at the dollars spent."

Few observers believe that the decline in prices foretells imminent cataclysm, but claims that low-cost PCs are a cash cow can be deceiving. "The [$899] number itself is an anomaly. That it is [Compaq's] most profitable computer won't be true a quarter from now," pointed out Roger Kay, an analyst with International Data Communications.

Because of a massive surfeit of commercial desktops, Compaq had to sell a number of systems at huge discounts during the last quarter. With the bulge partly dissipated, gross margins will improve on these systems over the third quarter. Compaq will also realize cost gains in the realm of manufacturing as it expands its build-to-order effort.

Interestingly, customer expectations of lower prices are causing pressure for price drops in the corporate realm as well, said Gene Glazer, vice president at Fortis Advisers, among others. Last year, the sweet spot for corporate machines ran from $1,500 to $1,800, said Hudani. Currently it's down to $1,200 to $1,500.

At least Compaq is managing to turn a profit, said David Goldstein, president of Channel Marketing Corporation. "There is no question that the fastest growing market is the sub-$1,000 market, soon to be the sub-$500 market," he said. "Compaq has their business model tuned to be profitable as these price points. Others don't."

To break the cycle, Compaq is likely to push its high-end products, most said. Kay and others think that the Alpha processor platform from Digital could move closer to center stage for the company. Margins are high on Alpha-related products and competing technologies from Intel.

In addition, expect to see the company hustle more on cost reductions and market share.

"Demand is still there," said Daniel Kunstler, an analyst with J.P. Morgan Securities. "But people are going to have to go the extra mile to get it."