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PC price wars hurt Compaq

The company says low prices and tepid demand for business PCs will cut its profit expectations in half.

Compaq Computer today blamed its surprising first-quarter financial shortfall on troubles with business PCs, reflecting pricing problems that are endemic to the industry but seem to be hitting the No. 1 PC maker the hardest.

In a conference call with analysts, chief executive Eckhard Pfeiffer said Compaq's problems are rooted in weak PC demand, intense price wars, and an unfavorable mix of lower-margin products. Compaq and others are casting IBM as the culprit in the price war, accusing Big Blue of low-ball pricing to aggressively target new customers.

"The inference is that IBM is using its much-improved PC cost structure and...product mix to price extremely aggressively in corporate desktops," said Richard Gardner, an analyst with Salomon Smith Barney. IBM was down more than 2.5 points today.

Dell Computer has also criticized IBM, contending that it is making deals at price levels that are prohibitively low.

Although Compaq is looking worse than others, Gardner thinks that "clearly, all...vendors need to grow units and revenues at significantly above market rates in order to achieve current consensus expectations."

"Overall, U.S. PC market revenue growth will likely be zero to 5 percent this year--15 percent unit growth with a 10-to-15 percent price decline--with certain important customer segments showing revenue declines," he said.

Ashok Kumar of Piper Jaffray believes that Compaq's shortfall does not represent the health of the entire industry. "We estimate that PC unit shipments are down sequentially over 20 percent for Compaq versus a 15 percent decline for the broad market."

"Dell is expected to be up 9 percent and Gateway about flat sequentially. Intel, the true barometer of the market, is expected to be up sequentially in units, albeit some of the growth is the result of share gains."

The upshot for the market, as he sees it: "Neither hot nor a disaster--just lukewarm."

But commoditization--where in some cases it's hard to tell the difference between products from two separate manufacturers--is starting to catch up to the PC industry. "The increasing commoditization of the PC...has progressed to such a degree that there is little or no 'easy' market share left to take from weaker tier 2 and tier 3 players in the U.S. If the largest vendors want to continue growing at significantly above-market rates in the U.S., they must do so at the expense of other large branded players or non-branded 'white boxes' in the small to mid-sized business market," Gardner said.

Gardner also points to inventory problems with older Pentium II systems that may begin to crop as a result of the introduction of systems with the newer Pentium III processor. "We believe Compaq incurred unexpected price protection charges this quarter on Pentium II-based channel inventories which did not sell through during the month of February," he said.

The market reacted early to the news today as Compaq dropped 23 percent in morning trading, dragging other stocks down with it, though many stocks eventually rebounded. (See related story.)

Earnings will be about 15 cents per share, the Houston computer maker said. Analysts had anticipated a profit of 31 cents a share, according to First Call.

"The quarter's shortfall reflects lower-than-anticipated market demand and increased competitive pricing in the commercial PC sector," Earl Mason, Compaq's chief financial officer, said in a statement.

A variety of factors--including price competition, the usual seasonal slowdown, overheated expectations, and the odd circumstances of the Pentium III release--have been depressing PC revenues in the quarter, although manufacturers are still selling more PCs than in the past. Some companies have run the gauntlet better than others, analysts said.

"It's bad. It's roughly 50 percent of consensus. This is a big shortfall," said J.P. Morgan Securities analyst Daniel Kunstler.

Compaq's problems are further exacerbated by issues specific to the company. Compaq has been trying to sell PCs indirectly through its dealers and directly across its Web site.

Although this gives the company broader reach, it has added costs and caused disruptions. In February, the company warned that slower than expected sales in the small business market, part of Compaq's direct effort, would drag down earnings.

"They have people on the street calling on small businesses, they have people calling on resellers. They are trying to be all things to all people," said Asif Hudani, president of NovaQuest, a Los Angeles-based computer reseller. "They definitely don't have a low-cost model."

The world's largest PC maker rose to prominence selling Intel-based PCs and low-end servers, but Compaq broadened its focus after acquiring Tandem in 1997 and Digital Equipment in 1998 and began transforming itself into a company with the full-fledged product lines of competitors like IBM and Hewlett-Packard. Not only that, but Compaq has been tackling ambitious projects in the Internet space, such as the spinoff of its AltaVista portal (acquired via Digital) and the purchase of local information guide Zip2.

"The synergies there haven't quite materialized yet. They need to articulate a strategy and stick with it instead of taking one step forward and two steps back," said Kumar of Piper Jaffray. Three weeks ago, Kumar lowered his estimate for Compaq's earnings to 20 cents, well below the rest of the analyst crowd.

More competition from Dell
The changes at Compaq have coincided with ever-growing competition from Dell Computer, whose business is based around selling directly to customers. Compaq has historically relied on the traditional network of computer resellers, called the "channel."

In one telling statistic, Compaq's market share in large U.S. companies slipped from 30.2 percent in the fourth quarter of 1998 to 21.5 percent in the first quarter of 1999, according to Matt Sargent of ZD Market Intelligence.

Dell, meanwhile, continued gaining among firms with more than 500 employees, increasing from 29.3 percent to 30.9 percent over the same period. IBM gained from 13.9 percent to 16 percent, while HP increased from 8.6 percent to 15 percent.

Compaq has also been hit by the tumbling price of PCs. In January 1996 the average retail system cost $2,100. By January 1998, that price dipped to $1,200, according to Sargent's data.

The tumble tends to hurt Compaq more than Dell, because many of Compaq's systems are prebuilt weeks or months before they actually are sold to end users. The result is that Compaq can't lower prices on its already-built machines without sacrificing profit, a crucial flaw when demand slows.

"If the demand doesn't come, then all you're stuck with is cheaper boxes," said Cody Acree, an analyst with Southwest Securities in Dallas, who rates Compaq a "buy."

Still another reason for Compaq's shortfall is that it has alienated its sales channel with its push toward direct sales, analysts said. Compaq recently began selling small-business ProSignia models via its Web site, a move that's been questioned. The results of that shift seem particularly pronounced in Compaq's precipitous corporate decline.

"There may have been some demotivation of the channel," Kunstler said.

"Compaq's charter is not to eat Dell's market share, but to grow using the infrastructure they have in place today," Kumar added.

Evidence that slow sales would hurt earnings started appearing several weeks ago, said Kumar. For instance, in late February Compaq said Prosignia sales to small and medium businesses were lower than expected.

"The company should have pre-announced [weeks ago] and started off with a clean slate. There's an issue of management credibility," Kumar said. Compaq's troubles are company-specific, he added.

"They're pointing to the market, but there's a discrepancy compared to what Dell was saying as recently as yesterday," Kunstler said. "Compaq has been very forward about their ambitions to be very dominant in the industry, but it turns out there are problems."

Deja vu?
Last week's announcement is an eerie sequel of Compaq's first quarter of 1998. The company shocked the industry by admitting that its first-quarter profits would be well below expectations because of a surfeit in channel inventory. As with this year, the announcement came on a Friday after the market closed.

Compaq estimated revenue of $9.4 billion for the quarter, which ended March 31. The company will announce full quarterly results April 21.

The warning comes on the eve of Compaq's own trade show, Innovate 99, which begins this week. At the show, Compaq plans to flesh out its strategy for corporate customers. Many observers have noted that much of the company's success depends on how well it can incorporate the higher-end products the company inherited from Digital.

IBM also is having trouble with PC sales. The company's PC division lost nearly a billion dollars last year because of dropping computer prices.

Micron, too, has suffered from the general unease that PC sales for the first quarter aren't up to expectations. The company reported a drop in sales and profits in March.

Bloomberg and Reuters contributed to this report.