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PC makers ride out low-cost trend

With desktop computers selling for as low as $699, the high-tech equivalent of a $99 airfare from Los Angeles to New York, how can PC makers stay afloat?

No, the sky isn't falling on the personal-computer industry.

At first glance, the cutthroat price wars, like those in the airline and long distance phone industries, would appear to be sending PC makers into turmoil. With desktop computers selling for as low as $699--the high-tech equivalent of a $99 airfare from Los Angeles to New York--how can manufacturers stay afloat?

To be sure, PC makers have been hurt by lower profit margins resulting from the price reductions. But a closer look shows that, in many cases, the cost of components is falling faster than PC prices--about a 40 percent year-over-year decline, by some estimates. As a result, the blow of free-falling prices--which has bruised the stocks of some PC makers--is more cushioned than largely publicized.

What appears to be separating the winners from losers is how many units they can sell. Direct PC suppliers such as Gateway and Dell appear to be weathering the storm.

"I think [falling ASPs#93; have affected the stocks more than the earnings," said Lou Mazzuchelli, an analyst with investment bank Gerard Klauer Mattison. ASP refers to the average selling price of a PC.

"These manufacturers aren't stupid," he added. "They're not going to make these machines at a loss. But the investing public sees these falling prices and says, 'There's no way you can make money.'"

Gateway executives said last week that the company's ASPs fell more than 12 percent from last year and 2 percent sequentially to $2,200. That decline partly offset the upside: a 33 percent increase in computer sales during the second quarter compared with a year ago. On Friday, a day after its earnings announcement, Gateway's stock price fell 10 percent.

But Mazzuchelli said he is not concerned about the company's long-term performance, despite its sales of lower-cost PCs.

"Their business cycle just didn't mesh with the reporting cycle," he said. "The stock market isn't in a particularly forgiving mood, and they got hammered."

It's not as if Gateway didn't turn a profit. The company reported second-quarter net income of $60.7 million, or 38 cents a share, compared with net income of $56.4 million, or 36 cents a share, reported for the like quarter a year ago. Wall Street, however, predicted that the company would post profits of 44 cents a share, according to First Call.

Richard Chu, managing director at investment banking firm SG Cowen, said that Dell's average selling prices slipped 9 percent last quarter and that he expects them to fall 12 percent next quarter.

Dell posted better-than-expected first-quarter earnings in spite of the lower-cost units.

The profits per computer, or gross margins, for Dell and other PC makers have not declined much, analysts say, because computer component prices already have hit rock bottom.

"ASPs are coming down, but not nearly as fast as component prices," said Charles Wolf, an analyst with Credit Suisse First Boston. "In the history of the industry, we've never seen component prices come down collectively as fast as they have. It has not only been memory, but storage and processors."

Chu added: "In general, component prices are falling just as fast, if not faster, than unit prices."

But a $699 desktop PC simply doesn't sound very profitable compared to the $3,000 PC of two years ago.

Intel announced today that it is slashing chip prices by up to 31 percent, marking the fourth time it has cut semiconductor prices this year. (Intel is an investor in CNET: The Computer Network.) The disk drive and memory industries also have been hit by low-budget battles.

Compaq Computer, for its part, posted a better-than-expected second-quarter profit. When revenues and earnings from the company's buyout of Digital Equipment are removed, however, Compaq posted lower revenues than it did during the same period the year before, showed relatively flat unit growth, and could have suffered a loss. Nineteen days of Digital's revenue were added to Compaq's numbers for the quarter.

IBM also surprised Wall Street with a slim increase in profits last week. But much of the gain stemmed from IBM's booming services business. Personal computer revenues declined.

Hewlett-Packard has warned of lower third-quarter earnings. But the multinational corporation is much more diversified than the other top PC makers and is attributing much of the expected disappointment to tumultuous Asian markets, not necessarily to less-expensive desktop PC sales.

Some analysts say the trend toward low-cost components has been a competitive advantage for direct PC vendors such as Dell and Gateway.

"Essentially the direct guys bought [the components] yesterday and are selling [them] tomorrow, so they can sell through the lower cost to their customers," Chu said. Stock in Dell and Gateway has been up significantly since January.

There's no denying that lower-cost PCs require manufacturers to sell more units in order to turn the same profit they once did, startling some shareholders and company executives. But the changing market has forced some PC makers to provide new services.

"If costs are going down, you can make money," Mazzuchelli said. "And if you're adding services beyond just selling the box, you can make money. Look at Compaq, they're expanding into services for the corporate space. A lot of these companies are becoming value-added manufacturers."

News.com's Sandeep Junnarkar contributed to this report.