Don't let Taiwan shake you

By all accounts, given the magnitude of the quake and that 10 percent to 20 percent of the world's semiconductors are produced on the island (including 70 percent to 80 percent of all PC notebooks) the impact on PC production should have been catastrophic.

But as miraculous as it sounds, (and in large part due to the hard work by the Taiwanese people) the impact on the industry is expected to be minimal. Production has resumed, and PC manufacturers are reporting that they have secured supplies of critical components needed for production.

To put it simply: the system worked.

We should look at the PC supply chain not as a steel chain with secure, solid links between various suppliers, but instead more like a fabric that can stretch and mold to various environments. This fabric resembles the way computers are connected to the Internet--where slight disruptions in communications can "heal" as alternative avenues are found on a network. The same can be said for the PC supply chain--firms often can find alternative methods to supply needed parts, or create work-arounds designed to make use of other more commonly available parts.

And as the situation surrounding the devastating Taiwan earthquake demonstrates, the PC fabric is not only large and complex, but self-healing.

Not all PC companies will be able to escape unscathed, however. This situation should cause spot shortages of some critical PC components--I have heard that graphics, I/O, and DRAM fall in that category. This means that PC manufacturers will be scrambling to get the parts they need. And as with all supply shortages, the biggest and fastest growing companies get serviced first--another in the long line of reasons that I continue to predict further consolidation among PC players. For survival, especially in times of crisis, bigger companies are better off.

Back to Taiwan. The best news is that much of the country's semiconductor infrastructure--located in the Hsinchu Science industrial park--did not suffer structural damage. The Science Park is located further away from the quake's epicenter than the capital city of Taipei, and is built earthquake-safe. However, electricity was unavailable for days, and as a result, scientists had to reconfigure many of the compound's sensitive equipment. In short, much of the park's production capacity was shut down for one to two weeks.

However, much has been done to get production back to original levels. Michael Dell, chief executive of Dell Computer, visited Taiwan after the earthquake and told me that he was surprised to see that the Science Park looked as good as it did. He recounted stories of workers coming and cleaning up and even restoring production just hours after the event.

Also, while power shortages still exist, most outages are scheduled, giving plant operators flexibility to move production schedules around to fit specific needs. Furthermore, many Taiwanese companies, both in semiconductors and notebook production, have facilities outside of Taiwan and have shifted production accordingly. Inventory that was in the process of being built was lost, however, but I think the resulting impact will be minor.

In this environment, execution by the PC manufacturers is key. Having procurement managers stay up late to talk with Taiwanese vendors to work out component questions can be the difference in making shipment forecasts or missing them.

So I continue to like PC companies which have put in the extra hours to make the business work, and also those that are leaders in market share. I also prefer those companies with direct sales and manufacturing models, which are more flexible when it comes to repositioning their supply "fabric." These examples point to both Gateway and Dell.

Of course Dell has admitted that increased DRAM prices would affect their margins in October, but the company has also indicated that they have been able to secure needed supplies. Dell management would also agree with our belief that component prices will likely peak near-term, and resume their decline as we approach year-end.

Looking toward the end of the year, both Dell and Gateway are poised to take advantage of an expected strong consumer season. Dell expects to see margins rebound by year-end, as its growth also stems from servers, services, and storage, while Gateway's potential lies in its plans to expand overseas. I think that both companies will successfully meet these goals.

So the bottom line: don't let disruptions like the Taiwan earthquake scare you out of computer stocks. The industry outlook is bright, and I believe demand will be strong in the New Year, when companies turn budget dollars that were absorbed fixing Y2K toward new applications, like e-commerce and computer systems upgrades.

The author of this report has a long position in the common shares of Dell Computer. Mr. Philip Rueppel is a research analyst with Deutsche Banc Alex. Brown. Mr. Rueppel's comments that appear herein are not a publication of Deutsche Banc Alex. Brown and may not represent Mr. Rueppel's complete or current opinion with respect to any company. Persons who want to make an investment decision with respect to any company mentioned by Mr. Rueppel should obtain a copy of Mr. Rueppel's current and complete opinion as contained in the most recent publication of Deutsche Banc Alex. Brown. Mr. Rueppel's opinions are not intended as an offer or solicitation, nor as the basis for any contract for the purchase or sale of any security, loan, or other instrument.