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Compaq consumer unit snags profits, but rivals looming

The company's commercial PC group may have returned to profitability in the second quarter, but fierce competition is squeezing profits out of its consumer division.

Compaq Computer's commercial PC group may have returned to profitability in the second quarter, but fierce competition is squeezing profits out of its consumer division.

Compaq's problem isn't so much one of poor execution: The company, after all, is the worldwide leader in consumer PCs. Instead, the problem is the result of a change in buying patterns that has gradually undermined Compaq's sales strategy.

One of the more dramatic challenges for the company has been a shift among consumers toward more advanced systems with features such as CD-RW drives, which have become popular with the rise of downloadable music. Compaq historically has relied on selling large numbers of less profitable, low-cost systems--an approach that is only becoming more troublesome.

In some ways, Compaq's consumer group looks like a titan. It has had 16 successive profitable quarters and has seen unit shipments rise for years.

In the first quarter, for example, Houston-based Compaq accounted for 19 percent of the units shipped to the U.S. consumer market. The company was followed by Hewlett-Packard at 18 percent and Gateway at 16 percent, according to market researcher International Data Corp.

Worldwide, the numbers are even better, with Compaq accounting for 12 percent unit share vs. HP's 9 percent and Gateway's 6 percent.

The dynamics of the market, however, have begun to change. Although the Compaq consumer group's revenue rose 32 percent to $1.6 billion during the second quarter compared with the same period last year, operating income declined $15 million year-over-year to $31 million. And although Compaq remained No. 1 overall in U.S. consumer shipments for the first quarter, HP has led Compaq in monthly retail sales for most months since February.

"Compaq is not able to make it up on volume the way they used to...and with the release of their (earnings) announcement, it's clear they're not executing flawlessly," Gartner analyst Kevin Knox said.

Mike Larson, the senior vice president of Compaq's consumer group, sees things differently.

"A 32 percent revenue increase stacks up with any of our competition and, in fact, beats many of the other guys in a space that was widely acknowledged as being unusually soft in" the second quarter, he said. "I think we deserve credit for generating pretty strong sales in a time when some of our competitors didn't do well."

Mike Larson Part of the problem results from Compaq's strategy, analysts said. The computer maker focused on selling lots of low-cost PCs and making up for slim margins through volume. Unfortunately, the company found itself grappling with Emachines for the sub-$600 market. While the approach led to high unit shipments--and thus the continued No. 1 sales rankings by research companies IDC and Gartner--it undermined Compaq's long-term profitability.

Meanwhile, HP and others didn't follow Compaq as far down the price curve and were able to sell more high-margin machines. IBM's retreat from selling consumer computers at retail especially benefited HP, according to many experts.

"It's almost like (Compaq) is bottom fishing, because the increase of units is the least desirable business," IDC analyst Roger Kay said.

Competitive pressure
In the second quarter, Emachines held an average selling price of $501. Compaq cut prices in May and June and saw its average selling price drop to $804 from $891 month-to-month, according to market researcher PC Data.

By contrast, HP's average selling price was about $100 more. Direct manufacturer Gateway was even higher at $1,830, when factoring extras such as Internet access.

"They (Compaq) don't want to sell the $399 machine. They want to sell the $2,000 machine with a big, bad video card, tons of memory, and big, fat hardware," Knox said. "If you look at what they're selling, they're really focusing on Emachines and some of those low-cost alternatives. But the margins are at the higher end of the spectrum, where they're getting a lot of competitive pressure from folks like Gateway, Dell and even HP to a degree."

Larson takes a different tack.

"There's no question our operating profit was down year-over-year on higher sales, and obviously you don't want to continue less and less on more and more," Larson said. "But we do believe that was an aberration. May sales were not what they expected, for anyone, so everybody was marketing the stuff down for back-to-school."

Another problem has been the collapse of the sub-$600 market, which accounted for 1.4 percent of the retail market so far this month, said Allison Boswell, author of industry tipsheet The Boswell Report.

"The sales aren't there"
"In November, the sub-$600 (market) started falling apart," Boswell said "In part because of the Taiwan earthquake, there wasn't any product.

"It's been trying to build back," she said. "Now they have a decent amount of inventory, but the sales aren't there."

While component cost increases have eroded this market, consumers also seem willing to spend more money for extras.

"We've seen a real growth in people buying the top-end computers," Boswell said. "What it is is perceived value vs. cheap PCs. People are really wanting DVD and CD-RW features, so that kicks up the price."

This has hurt Compaq in the broader retail market, as the percentage of people buying sub-$1,000 PCs rapidly shrinks, dropping to 58.3 percent in June from more than 80 percent last October, according to The Boswell Report. Beefier systems are selling better than ever, with systems over $2,000 going from 2.6 percent retail market share in January to 10.1 percent last month. So far this month, systems priced above $1,000 held 42.8 percent market share, while about 70 percent of Compaq's sales are in the lower-margin, sub-$1,000 category.

HP, which latched onto CD-RW early, has been one of the major beneficiaries of this trend. In June retail sales for PCs selling below $1,000, HP led with 39.9 percent of the market, compared with Compaq's 30.6 percent. For PCs above $1,000, HP in May had 59 percent, compared with Compaq's 28 percent.

A year of transition
"The store managers want more. The PC they want to carry most is HP," Boswell said.

Larson acknowledged some of the shift.

"We have lost some momentum in the market in '99," Larson said. "I think HP has been a very strong competitor. The last year has been a year of transition for us because we realized the old model we drove hard and did extremely well on is showing some signs of wear."

HP is poised to take the overall U.S. consumer sales crown, not just retail, in the second quarter, trailing Compaq by a single percentage point, according to IDC. Kay wouldn't disclose those figures because they aren't final, but he noted that "in recent quarters in the U.S. home desktop segment, HP had the strongest momentum of any of the top vendors."

"Part of what's happening the last six months is there is a one-on-one fight now," PC Data analyst Stephen Baker said. "There's no more IBM, and there's not a lot of other companies to get in the way. It's just them and HP."

Compaq is also poorly positioned to compete against the inherent advantages of direct manufacturers, such as Dell and Gateway. While Compaq's commercial division in the United States sells 40 percent direct, which makes the cost of distributing PCs much cheaper, only about 12 percent of consumer PCs are sold direct.

"This is going to continue to hurt Compaq," Baker said.

Focusing less on volume
Going forward, Compaq is going to have to make hard strategic decisions if it wants to remain competitive. That may mean worrying less about moving volume--which keeps Compaq the unit sales leader--and focusing more on profits, say analysts.

An example to follow is Gateway, said Knox, which is cushioning already higher-selling, more profitable system sales with extras such as Internet access and other services. During the second quarter, these so-called beyond-the-box sales accounted for 40 percent of Gateway's consumer revenue.

About 20 percent of Compaq's consumer operating profit comes from beyond-the-box sales, Larson said. Compaq increasingly collects additional revenue from printers, Internet access, maintenance contracts and other services.

"And you can expect a lot from some exciting non-PC announcements we will be making next month," he said.