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The perfect storm

Surviving the PC downturn of 2001. Cover story hed: The perfect storm dek: surviving the PC downturn of 2001. dek: server sales were soft too, growing only .7 percent. dek: if there’s a computer maker living on borrowed time, it’s gateway. dek: smart companies will streamline while avoiding layoffs. By Phil Davies

The winds that once swelled the fortunes of computer manufacturers and produced smooth sailing for the entire industry have reached dangerous levels, resulting in heavy seas in 2001. Big PC and server makers such as IBM, Sun, and Hewlett-Packard–accustomed to forging ahead toward the next chip upgrade, their holds brimming with bullion from tech-happy consumers and businesses–now find themselves in a white-knuckle battle with the biggest storm in the history of the PC. Smaller PC wholesalers and local custom shops are also bailing furiously, on short rations and eyeing the sharks in the water.

Everybody’s praying for calmer seas–or at least a break from the brisk head winds–to get a better trim in his hardware sails. But market conditions for computer OEMs remain stormy. Tight IT budgets at businesses large and small combined with weak consumer demand have forced manufacturers to deeply discount their wares in order to reduce the inventories left in their holds.

The stormiest computer market in a decade is putting the survival skills of hardware manufacturers to the test. Both name-brand OEMs and local clone merchants (see sidebar) are trying to slash manufacturing costs, squeeze time and money out of the supply chain, and diversify into higher-margin products and services. More and more companies are migrating to a direct, build-to-order model, a la Dell and Gateway–except Apple, which appears to be charting a different course. Inevitably, down markets produce winners and losers. Some OEMs are coping with hostile conditions better than others because of their product mixes, business models, and their varying abilities to maximize shifting market winds. Who makes it to shore and who continues to take a pounding in the next few months may significantly alter the power balance among computer OEMs-and the nature of their customer relationships.

The calm after the storm

What ever happened to the Roaring Nineties, when OEM revenues and profits surged ever upward, driven by a burning desire on the part of businesses and home users to capitalize on the power of multimedia and the Internet?

Demand for computer hardware has fallen across the board, but has dropped off the edge of the earth in the consumer-driven PC market. According to Gartner Dataquest, U.S. PC sales declined 6.1 percent in the first half of this year, compared with the same period in 2000. Only Dell Computer increased its PC revenues, growing 15.2 percent. Compaq Computer’s PC revenues fell 17.3 percent, Hewlett-Packard suffered a 18.8 percent drop-off, and IBM saw its PC sales decline 10.7 percent.

Blame it on jaded computer buyers who see no compelling need for 1.5GHz machines running the same old software. “For a lot of consumers, the computing constraint they’re facing is bandwidth, not megahertz,” says Anne Bui, a senior desktop analyst with IDC in Mountain View, Calif. “There’s just a lack of incentive to upgrade to a new PC. Plus, their dollars are being diverted into other devices such as MP3 players, handhelds, and DVD players.”

Businesses are delaying plans to upgrade their desktops and notebooks until Microsoft’s Windows XP and Office XP show their true colors, Bui adds. It doesn’t help, of course, that tens of thousands of companies around the world are cash-poor right now and are looking for any excuse to put off IT purchases.

Server demand is also soft; according to Gartner Dataquest, worldwide server sales grew an anemic .7 percent year-over-year in the second quarter, and U.S. sales fell 11 percent–the sharpest drop ever. Market leader Compaq’s sales fell almost 5 percent, and HP and Sun Microsystems–dependent on telecom customers rocked by the economic downturn-both absorbed losses of more than 10 percent. But Web servers, storage area networks (SANs), and other enterprise hardware all yield higher margins than PCs, so the big OEMs are pouring R&D and marketing dollars into those segments. “There’s been a dramatic shift in the profit levels of the major vendors away from desktops and notebooks toward servers, storage, and services,” says Brooks Gray, senior analyst with Technology Business Research (TBR), based in Hampton, N.H.

CEOs and IT managers have adopted a conservative, show-me-the-ROI attitude in 2001, says Terry Cain, vice president of supplier sales and marketing at Avnet, Inc., a Phoenix, Ariz.-based distributor of computer systems and components. Businesses want equipment, software, and services packages that truly boost the bottom line, he says, not necessarily the latest and greatest hardware.

The jury is still out on whether Windows XP and fast-growing technologies such as SAN and wireless networking can get computer sales moving again. Until demand revives-by the New Year or 18 months from now, depending on who’s talking-computer OEMs must find a way to keep their ships afloat in rough seas.

Dell and IBM: full speed ahead

Dell is the Microsoft of hardware, a model of aggression and efficiency that inspires fear and emulation in its rivals. In the second quarter, Dell lost $101 million, but its market dominance only grew.The Texas behemoth supplanted Compaq as the world’s top PC seller, and year-over-year shipments of enterprise systems–servers, storage products and workstations–surged 33 percent.

How does Dell do it? Simply by running a leaner operation than anyone else, and assembling computers to order at lightning speed from components bought at rock-bottom prices. Dell’s direct, build-it-when-they-come approach virtually eliminates inventory and takes advantage of constantly falling component prices, wringing 12 percent gross profits out of deeply discounted machines. “The direct model takes out the middleman, the channel partner,” says Gray of TBR. “It’s the model of the future, it’s the model of the present even in terms of profit levels.”

Dell constantly refines its back-end processes, using Web-based tools from WebMethods and i2 Technologies to automate customer orders and control the flow of raw materials and components in the supply chain. “[The Internet] helps us drive our inventories down, compresses cycle times, and, we believe, improves the quality of our products and the speed with which we can get them to customers,” says Dell spokesman Venancio Figueroa.

IBM Corp.’s PC sales are flagging, but Big Blue has proven adept at selling servers and storage systems to the enterprise, eating into HP’s and Sun’s customer base. IBM domestic server sales rose nearly 8 percent in the second quarter, according to Gartner Dataquest, allowing the company to easily retain its title as the country’s top server seller. The father of the Wintel PC has remained a force in hardware by becoming more efficient and emphasizing what IBM has always been known for-cutting-edge technology and the business services necessary to support it.

Over the past two years IBM has pulled out of retail stores, opting to sell directly to end-users over the Web and toll-free phone lines. And the firm has overhauled its manufacturing methods and back-end systems, producing small batches of machines to order and tightly integrating its supply chain. Sound familiar? “There’s no doubt that IBM has taken a lot of cues from Dell,” says Bob Sutherland, a TBR analyst who follows the firm.

Greater efficiency allows IBM to cut prices, making its Intel-based xSeries servers, Shark disk storage, and ThinkPads competitive with offerings from Dell and HP (Sutherland expected the PC Group, which lost $8 million in the second quarter, to turn a small profit in the third by cutting costs). Then IBM folds its hardware into a soup-to-nuts package of software, infrastructure, and business services unrivaled in the industry. Systems management, professional training, network integration, business intelligence-IBM Global Services does it all, stimulating demand for additional hardware.

Bailing for dear life

In their dreams, other computer CEOs run organizations with the ruthless efficiency of a Michael Dell and the empathy of a Lou Gerstner for IT managers’ everyday anxieties. But in real life they fall short. Competitors of Dell and IBM face stiff challenges in steering a course back to financial health-some by their own making, others the result of external circumstances.

Hewlett-Packard, in the midst of a $25 billion merger with Compaq Computer, is still entangled in reseller and retail partnerships that maroon hundreds of millions of dollars worth of inventory in warehouses and stores. New, faster machines built for less can’t be sold until the old ones go out the door. When they do, they’re usually unloaded on the cheap, with the OEM paying the reseller “price protection”–compensation for lost profit margin. No wonder HP’s year-over-year profits plummeted 89 percent in its third quarter, and Compaq’s PC and enterprise computing sales have dropped by a fifth in the past year.

As separate entities, both companies tried to reduce inventory costs and meld hardware with software, services, and IT consulting. HP, in an attempt to boost efficiency without abandoning its retail presence, last summer unveiled kiosks in OfficeMax stores that let customers configure and order PCs and peripherals online. Compaq launched Computing on Demand, a utility-style program that lets enterprises acquire IT infrastructure and support services as needed. Supposedly, the creation of a computing colossus with combined revenues close to $90 billion will help “the new HP” shed costs and evolve into a services and consulting giant like IBM.

But analysts question whether HP will be able to swallow Compaq without losing more ground to Dell and IBM. Sutherland of TBR says that the merger invites supply-chain disarray and does nothing to move either partner toward a more direct strategy, perhaps involving widespread deployment of online kiosks and premiums charged on retail purchases. “If they weren’t addressing [channel costs] before the acquisition, I’m not sure they’re going to be addressing it afterward,” he says.

Apple Computer’s focus on creative professionals and education protects it somewhat from the mainstream PC-market gales. But year-over-year earnings still plunged 70 percent in Apple’s third fiscal quarter. The company managed to squeeze out a $61 million profit on the strength of iBook notebook sales to schools, repelling a K-12 assault from Dell. Apple’s balance sheet has also benefited from fully ramped, high-margin sales of Mac OS X, and an effective Web presence that now accounts for 40 percent of global sales.

Not that Apple is aping Dell and IBM; in a move that runs counter to the direct-sales trend, the firm has opened more than 20 retail stores across the country this year-showcases for the iBook, retooled iMacs, and consumer-oriented applications such as iTunes and iMovie. Time will tell whether greater retail exposure translates into increased volume.

If there’s a computer maker living on borrowed time, it’s Gateway Computer, a $21 million loser in the second quarter that has shut down its operations in Europe, Asia, and Australia. In the last two years Gateway has been out-hustled by Dell and Compaq in workstations, servers, and storage, as well as consumer PCs. “Gateway has come from the consumer market and tried to scale up,” says TBR’s Gray. “It hasn’t worked. They haven’t been able to build a niche in the business market.”

Now CEO and founder Ted Waitt is trying to remake Gateway into a friendly neighborhood IT department for home users and small businesses, peddling software, service and support, financing, training, and a pared-down lineup of PCs over the Web and in its Country Stores. But Gray and other analysts believe that Gateway’s strategy is destined to fail. The company can’t match Dell’s efficiency and is too dependent on the lackluster U.S. consumer market.

Into the unknown

Some analysts and hurting OEMs predict a hardware renaissance in the first quarter of next year, driven by widespread adoption of Windows XP and the growing popularity of consumer applications such as wireless networking and digital photography. Other, less optimistic observers believe that the market will remain sluggish well into 2003.

If the storm continues to blow, computer manufacturers are in for more belt-tightening and reengineering. “What everybody’s doing right now is kind of looking at where they want to be and using this downturn as a way to rethink their business and maybe come out of this with a different focus,” says Stephen Baker, director of research in the Reston, Va., office of NPD Intelect, a market research firm.

When the computer-trade winds do come around to the stern, companies weakened by the downturn may have trouble responding to rising demand. A case in point: Gateway, which has laid off more than 7,500 employees so far this year. In June Gateway offered a $400 discount on its low-end 6400 server–then had to tell irate customers that delivery would take two to three months because of factory backlogs. Second-tier, foreign PC makers such as Acer America, NEC, and Fujitsu may also be too battered and demoralized to crank up their U.S. operations.

The advantage in a resurgent tech economy logically belongs to companies such as IBM and Dell, which have strived to streamline their operations while minimizing layoffs in critical areas such as assembly, customer service, and tech support. Both companies will probably emerge stronger from the Perfect Storm of 2001, with IBM making headway in the high-end server and storage markets while Dell surges ahead in the SME and consumer segments with ever-cheaper PCs, notebooks, and appliance servers.

Unless the new HP can dramatically slash PC costs by going to a more direct distribution model, it’s likely to shift its long-term hardware focus to high-end servers and storage. Sun, suffering mightily from the dot-com bust, has to figure out a way to avoid irrelevance as Intel-based servers gain ground over RISC machines in the enterprise, especially with the new 64-bit Itanium systems coming online. And Gateway must either seek a buyer or accept a diminished role as a niche PC vendor.

Until the hardware market does recover, the only sure winners are home users and businesses desperately missed by the big OEMs. As long as manufacturers weep, computers will stay cheap.

Local shops also weather the storm

All this strategic churning by the dreadnoughts of the computer industry has left small, no-name computer makers struggling to stay afloat in their own back-yard ponds. Penny-pinching customers, price cuts by the big OEMs, and a flood of high-quality used equipment from distressed businesses has forced many PC distributors and local clone shops out of business.

White-box wholesalers have been hit particularly hard. Sales at S&K Computers Inc., a Denver firm that builds PCs and servers to order for system integrators and PC resellers across the country, are down 40 to 50 percent from the boom times of the late ’90s. The company laid off a third of its staff last year, and closed one of its two warehouses in May. S&K is “plugging along,” CEO Scott Lasater says, eking out a slim profit on reduced volume and low-ball pricing. A new marketing campaign stresses the company’s high-quality components and attentive customer service.

Local integrators and assemblers with keen survival instincts are diversifying into networking, on-site repair, and training-areas in which a homegrown company with a loyal customer base can excel, even in lean times. “In a downturn economy they’re trying to figure out new ways and new niche markets they haven’t previously served,” says John Venator, CEO of CompTIA, a trade group representing more than 8,000 computing and communications companies.

One local computer manufacturer that seems well positioned to weather the hardware headwinds is Botnay Bay Computers of Portsmouth, N.H. The 13-employee firm derives about 80 percent of its sales from repairs, network design, and on-site installation for SMEs and SOHO users in the Portsmouth region. And for reasons that owner Myles S. Bratter doesn’t fully understand, Botnay Bay’s PCs and servers are moving OK as well-at about the same rate as last year, just not as steadily from day to day. “We’re not finding that we’re being affected by this too badly,” Bratter says. Other small local shops that offer the kind of service Botnay Bay provides should also sail through calmer seas in the months ahead.

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