Why Bother Making Home P Cs?

The digital future may be brighter than today's profits

If any company knows how to tend to the bottom line, it's Hewlett-Packard Co. Its sales and profits have zipped along at more than 20% per year since 1993, blowing away rivals in everything from lab equipment to network servers to laser printers. Then HP tried home PCs. The company made an impressive leap to No.4 in the U.S. market in just 16 months, but the business has barely broken even. Says Webb McKinney, general manager of HP's home-PC unit: "Making money in this business is like trying to land a man on the moon."

And about as common. With customers demanding ever-lower prices, gross margins are just 10%. By misjudging what models will sell, many home-PC makers have been stuck with inventory pileups, write-downs, market-share slides, and losses. Just ask Packard Bell. Once the undisputed top dog in consumer PCs, Packard Bell has seen its share plunge from 23.4% to 17.5% since last August, according to market researcher Computer Intelligence. And with no high-margin products to make up for shrinking home-PC profits, the company was running out of cash. In June, it took a capital infusion from NEC Corp., leaving the electronics giant with some 40% of what's now known as Packard Bell NEC Inc.

ANGRY RETAILERS. Matters won't get any easier this holiday season. Overall growth will still be strong, and analysts expect sales to jump 19%. But that's a considerable slowdown from last year's 29% expansion. And Japanese electronics powerhouses Sony Corp. and Toshiba Corp. are getting into the act, with sleek, new PCs. This season, many analysts figure that only market leader Compaq Computer Corp. will have a profitable home-PC business and CompUSA will be the only retailer to actually turn a profit on PC sales. "It's a losing category," says Robert A. Gunst, CEO of West Coast retailer The Good Guys Inc.

So why does anybody bother? Because home PCs are seen increasingly as the key to an emerging all-digital consumer-electronics business. PCs, say Gunst and others, will become the central information appliance in a network of devices for everything from watching TV to surfing the Internet. With an eye on that prize, a company like Sony is willing to lose money on home PCs now to make sure that it has a way to sell profitable add-ons down the road--items such as big-screen monitors, CD-ROM changers, wireless mice, digital cameras, and so on. "Profitability isn't the issue," says Timothy M. Errington, senior vice-president for Sony's home-PC unit. "Even if this is a break-even business, it's certainly worth pursuing."

Not for everybody. Some players are heading for the sidelines--even if that means writing off the 21st century living room. "This was absolutely not a market worth fighting for," says Bruce Claflin, a PC vice-president at Digital Equipment Corp., which pulled the plug on its home-PC efforts in January. Meanwhile, Apple Computer Inc., looking for ways to stem its losses, is easing out of the low end of the home market. It will sell older models at lower prices and emphasize new Performas with prices starting at $2,400 that are aimed at more sophisticated buyers. "We're determined to be a major player in the home," says Chief Operating Officer Marco Landi. "But we also want to make money."

HP is intent on sticking with home PCs--and turning the business into a moneymaker. Chief Financial Officer Robert P. Wayman concedes that the company's home-PC unit is breaking even at best but says the PC business did not contribute to the 26% fall in earnings last quarter, when HP was hit by a slowdown in Europe and took a $135 million write-off to scrap its disk-drive business. Still, the company will try to streamline its PC operation and has postponed entry into home-PC markets beyond North America, France, and Britain. "We're not happy yet with the whole situation in home PCs, so we're not rolling out to new countries at this time," Wayman says.

The company seemed on track for a textbook HP-style execution when it launched its Pavilion home PCs last April. Its success in the printer business helped it win widespread distribution in computer and consumer-electronics stores. To save money, it had Intel Corp. design the innards of the Pavilion and hired SCI Systems Corp. to build them. That allowed the company to throw in lots of features for an aggressive price.

By yearend, HP was a home-PC winner, having sold more than 200,000 systems. It was also about to get its first lesson in the home-PC school of hard knocks. Seeing inventories building up, HP executives halted production in mid-December. They had not realized, however, that the reason for the buildup was not slowing demand but their late response to price cuts from rivals such as Compaq. HP's misstep angered retailers that had been promoting the now overpriced models. Then dealers got even more upset when HP finally slashed prices, spurring fresh demand when no new inventory was coming from the factories.

Now, HP is following the lead of companies such as Compaq and IBM, which have been investing in systems to let them manage their PC businesses on a day-to-day basis. The idea is to create links to where consumers are buying so a manufacturer can instantaneously see what's selling and--even more important--what's not. Acer America Inc. learned that the hard way last year. It kissed off $20 million in profits by paying $10 million to air-freight monitors to keep up with demand--and $10 million more to write down much of that same inventory later, when demand abated.

At the other end of their operations, PC makers are fine-tuning links with suppliers. At HP, McKinney has renegotiated contracts with suppliers of memory chips and CD-ROM drives. Under the new deal, HP will agree to use standard parts rather than demand custom features, so long as the supplier agrees to change orders on just four weeks' notice. HP's efforts are paying off. McKinney says the company was able to boost production 20% in the second week of July because of the new arrangement with suppliers.

But can HP and other home-PC makers hope to avoid the holiday blues this fall? They're certainly trying. In addition to tightening operations to respond faster to market changes and avoid costly inventory snafus, they're looking for money wherever they can.

EYE-CATCHING DESIGN. In the past, for example, PC makers paid software developers for the right to bundle their programs with their hardware. This year, those payments are being slashed from dollars to pennies per unit where possible. And PC makers are insisting on a cut of any upgrade sales when a customer moves up to a new version of the program later. In an agreement with developer Seventh Level, for example, HP will pay a lesser amount per unit for demo versions of Tuneland and The Great Word Adventure.

Another tack is to do what Compaq is trying--to fine-tune products for demographic groups that will pay more than the prevailing bargain-basement price. Compaq, for example, has opted for eye-catching design to grab the attention of upscale consumers. Its Presario 3000, equipped with a flat-panel display and carrying a $3,499 price tag, is billed as the home PC that will look great in the kitchen or the den. By focusing on such models, Compaq expects the average price it gets from each home-PC sale to rise 5% to 10% over last fall--even as industry prices drop, says Vice-President Rodney Schrock.

There's another target for higher-priced gear among the millions of PC owners who are ready for an upgrade. Repeat shoppers now represent more than 60% of the market, up from 50% in 1993, says Computer Intelligence. On the whole, these buyers are more willing than neophytes to spend extra for higher-performance machines and brand names, says Matt Sargent, an analyst with Computer Intelligence.

To reach such top-drawer consumers, computer makers are tailoring their gear with hardware and software for specific uses. Game enthusiasts, for instance, will have a wide choice of pricey machines with which to pursue their passion. There's a special $3,199 HP Pavilion and NEC's $2,899 PowerPlayer, both of which are outfitted with 3D graphics, high-fidelity sound, and popular game titles.

Compaq is the leader of the pack when it comes to segmenting the home market. It will offer 12 models--twice as many as in 1995--each aimed at a particular audience. The new PC for home-based business has a modem with a two-line connection that enables the user to talk to a customer while faxing a response or cruising the Net.

PC makers can't depend only on consumers that are willing to buy pricey machines, though. In fact, with consumers so accustomed to constant PC price cuts, the average price of a home PC this holiday season will drop by $200, says Dataquest Inc. analyst Scott Miller.

A CUT OF CYBERSPACE. That's why PC makers are trying to sell everything from scanners to service contracts so they can generate more revenue--and profit--per PC. IBM is testing a service in Canada to build home networks. HP is exploring a new plan that would guarantee next-day service for home-office PCs. Acer machines, meanwhile, will come with a year of free Internet service: The PC maker hopes to profit by getting a cut of whatever the consumer purchases online.

Compaq, IBM, Sony, and HP are now looking at deals to distribute other manufacturers' peripherals, such as scanners, under their own brand names. PC makers "will see that aftermarket profits could dwarf the initial systems sale," predicts International Data Corp. analyst Richard J. Zwetchkenbaum. HP, for example, plans such a deal with Storm Technology Inc., which makes a photo scanner like the one that HP integrates in some of its models. Says Storm President L. William Krause: "More and more, add-on devices are going to become the razor blades of this business." But that won't keep competition from slashing profits this holiday season.