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Price drops, Net transforming PC industry

Companies are taking radical steps to survive the relentless declines in computer prices and to adapt to the brave new world of e-commerce and the Internet.

Natural selection is being especially brutal to the PC industry.

Shrinking computer prices, the Computer Darwinism rise of the Internet and electronic commerce, tough competition, and the pressure to maintain historical growth rates are forcing PC makers to dramatically reinvent their businesses in an effort to secure that extra edge.

It's a complicated time for PC makers, but one thing is clear: Companies are taking radical steps to survive the relentless declines in computer prices and to adapt to the new economy. Internal business structures are being overturned while strategies are expanding beyond PC making to involve, well, anything really, that can bring in the extra buck.

The news in the past two weeks alone shows how far the evolution has come:

  • Hewlett-Packard announced that it will spin off its test and measurement division into a separate company, get a new CEO in the next 12 to 18 months, and try to transform its widely admired corporate culture into one that is "a little more agile, a little tougher," said HP CEO Lew Platt.

  • Dell and IBM tied up on a $16 billion dollar megadeal that will give Dell access to advanced technology it can't afford on its own and a way for IBM to make money off the PC market.

  • Dell opened up an online superstore offering peripherals and software to all comers; the store had been in development only since December.

  • Compaq Computer, in a move that shows how the Internet is changing traditional businesses, suspended sales agreements with some online computer resellers.

  • Gateway got a boost in the stock market after the company described the profit potential behind its ISP service.

  • Compaq talked of plans to sell third party software on its Web site that can be downloaded directly to a computer, only the latest in a string of e-commerce moves the PC giant has made of late.

  • And analysts wondered whether revenue warnings from Compaq and Micron were isolated incidences or part of an ominous trend.

    The PC industry is "facing a mid-life crisis, taking a back seat to the new economy " said Bruce Stephen, PC analyst at International Data Corporation.

    Shrinking prices, the Net, and a competitive atmosphere are largely the culprits behind the trend. The major PC makers are selling more PCs than ever and typically growing much faster than the market as a whole. Revenue and profit per machine, however, is declining, making it tougher to match up to historical expectations. Dell, for example, grew revenue by 38 percent last quarter. While most businesses would jump for joy at such a growth rate, it was seen as troubling sign because Dell had been growing revenue at over 50 percent for a number of quarters.

    "PC makers are knocking the crap out of each other on ASPs [average selling prices], " said one source at a major PC maker. ASPs are a crucial benchmark for determining how much profit margin PC companies are making on systems. The source added that some large PC makers may be selling below cost to gain customers. Typically, ASPs for business systems have been around $1,600 but, ominously, are expected to fall to below $1,500, according to analysts, which is a big piece of change for margin-strapped PC makers.

    "The PC industry isn't as simple as it was a few years ago," said Matt Sargent, an analyst with ZD Computer Intelligence. "You just can't be an engineering company, build products, and expect people to buy them."

    Dell, for example, is pushing harder than ever to sell more peripheral devices, such as printers, with its PCs to boost sagging margins. Dell has always been good at selling its in-house displays with its PCs, according to Ashok Kumar, an analyst at Piper Jaffray, but needs to supplement this with other devices, he adds.

    Dell is also trying to build more systems with the same basic hardware. For example, a low-end workstation and consumer PC might be built from the same basic building blocks in order to cut costs, people familiar with Dell's strategy say.

    Caught in a Web
    Then, there's the Internet. As profit margins on PCs dwindle, manufacturers need to aggressively explore options for getting more revenue from Internet services, such as bundling ISP access with the PC. "Products equal revenue, but services equal profits," Stephen said. "The Internet is the new battle ground."

    Services make money for the PC maker while helping customers, Stephen said, pointing to Gateway's YourWare and Dell's Premier Page programs.

    The combination of portal companies and PC makers will also continue to drive down PC prices, meaning PC makers will have to be more creative than ever. Stephen expects to see more portal and online content companies team up with PC manufacturers to offer subsidized computers, but doesn't foresee the FreePC model taking off immediately.

    One of the more successful aspects of the YourWare program is Gateway's ISP service. Although an ISP is handling the project for Gateway, customers pay Gateway directly for the service. Gateway in turn splits the revenue with the ISP, sources said.

    "[Gateway is] in a position to sign them up," said Kurt King, an analyst with NationsBanc Montgomery Securities. "It beats the bell out of selling more computers."

    HP for its part will start to roll out "e-services" to complement its PC line, said Platt, a line of sophisticated search or transaction services. HP will try to make money two ways in e-services: by selling hardware and software to customers who want to provide services online and by operating its own front-end services, he said.

    "There is an opportunity to get directly involved in some of these services areas," he said. One example, he added, would lay in renting storage or server capacity.

    Cross-company collaboration
    IBM and Dell via their $16 billion hook-up announced yesterday are looking for a key that opens the door to a brave, new--and more profitable--computer world. The pact could lead to major economies of scale for IBM, with No. 3 computer maker Dell consuming large quantities of IBM components such as hard drives, chips, and liquid crystal displays.

    Meanwhile, Dell can tap into IBM's treasure trove of cutting-edge technologies, patents, and services to bolster its competitiveness and draw in the more customers.

    But however this ultimately works itself out, it's clear that companies--even fierce competitors in this case-are considering many radical options. It also signals that computer behemoths like IBM are desperately seeking other ways to make money. "There is only a limited amount of additional revenue that can be derived from box [PC] sales," Stephen said.

    PC market slowing down?
    While individual PCs may not be as profitable as they once were, analysts are divided on the current state of the PC industry. Recently, Compaq said that sales to small and medium-sized businesses was less than anticipated in the first two months of the year. Micron Electronics followed by announcing that sales for its second fiscal quarter would be approximately 9 percent less than the previous quarter. Both of these followed the Dell announcement.

    While some indicated that this could be the sign of a slowdown, others said these shortfalls were caused by the usual, cyclical downturn and issues isolated to the companies.

    "This is more of a forecasting issue than an industry issue," said NationsBanc Montgomery's King.

    Who will survive?
    The pressure of the new economy will likely continue to force companies to adapt. Three trends will be more consolidation, more segmentation into niche markets, and the rise of smaller, nimble companies.

    Expect to see more market segmentation as the top manufacturers pursue partnerships and acquisitions that boost bottom lines while playing to their target audience. At the same time, companies that are struggling in key markets, like Toshiba and Acer, will continue to be the victims of consolidation, analysts say.

    Dell, which gets 87 percent of its revenues from corporate sales, and other PC makers will likely continue adding services that appeal to larger customers.

    Meanwhile, more consumer-oriented companies such as Gateway will continue to focus on getting more revenue from things like Internet access contracts and peripheral sales. And there continues to be a niche for start-ups such as Emachines, which has exploded onto the scene with fully loaded PCs in the $399-$599 range. Emachines intends to go public late this year or early next.

    "The distribution role is migrating," said Tony Amico, an analyst with International Data Corporation. "1999 will be a crossover year."

    Stephanie Miles contributed to this story.